The buildings which house the headquarters of Harleysville Group and the Mutual Company in Harleysville, Pennsylvania are leased to the Mutual Company by a subsidiary of Harleysville Group. See “Business-Relationship with the Mutual Company.” The Mutual Company charges Harleysville Group for an appropriate portion of the rent under an intercompany allocation agreement. See “Certain Relationships and Related Transactions, and Director Independence,” Item 13 in Part III of this Form 10-K. The buildings containing the headquarters of Harleysville Group and the Mutual Company have approximately 220,000 square feet of office space. Harleysville Group also rents office facilities in certain of the states in which it does business.
At December 31, 2011, the Mutual Company owned approximately 53% of the Common Stock of the Company. Harleysville Group Inc. and its wholly owned subsidiaries are engaged in property and casualty insurance. These subsidiaries are: Harleysville-Atlantic Insurance Company, Harleysville Insurance Company, Harleysville Insurance Company of New Jersey, Harleysville Insurance Company of New York, Harleysville Insurance Company of Ohio, Harleysville Lake States Insurance Company, Harleysville Preferred Insurance Company, Harleysville Worcester Insurance Company, and Harleysville Ltd., a real estate partnership that owns the home office. Harleysville-Atlantic Insurance Company and Harleysville Insurance Company of Ohio were merged into Harleysville Worcester Insurance Company in December 2011.
specific adverse events affecting the issuers of debt obligations held by the Company; and
Loss and loss settlement expenses are affected by a number of factors, including:
the amount of flood insurance written and ceded to the National Flood Insurance Program; and
Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. A fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell, or more likely than not will be required to sell, the security before recovery of its value. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.
The fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities, but Harleysville Group does not own a material amount of non-traded securities.
Property and casualty insurance premiums are established before the amount of losses and loss settlement expenses, or the extent to which inflation may affect such expenses, are known. Consequently, Harleysville Group attempts, in establishing rates, to anticipate the potential impact of inflation. In the past, inflation has contributed to increased losses and loss settlement expenses.
Effective January 1, 2011, the Company’s property and casualty subsidiaries and the Mutual Company and Pennland amended their intercompany pooling agreement as it relates to their workers compensation business. The amendment established that the financial results associated with the workers compensation business for accident years
Because the pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the pooling agreement provides for the right of offset and the amount of credit risk with the Mutual Company was not material at December 31, 2011 and 2010. The Mutual Company has an A. M. Best rating of “A” (Excellent).
Intercompany balances are created primarily from the pooling arrangement (settled quarterly), allocation of common expenses, collection of premium balances and payment of claims (settled monthly). No interest is charged or received on intercompany balances due to the timely settlement terms and nature of the items.
Harleysville Group holds securities with unrealized losses at December 31, 2011 as follows:
Of total fixed maturity securities with an unrealized loss at December 31, 2011, securities with a fair value of $11.0 million and an unrealized loss of $22,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $6.0 million and an unrealized loss of $26,000 are classified as held to maturity on the balance sheet and are carried at amortized cost.
The unrealized losses on fixed maturity investments were primarily due to the expected call of a municipal bond and the widening of credit spreads on securities in the financial sector. Per the Company’s policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. The Company believes, based on its analysis, that these securities are not other than temporarily impaired. However, depending on developments involving both the issuers and worsening economic conditions, these investments may be written down in the income statement in the future.
The fair value and amortized cost of general obligation and special revenue bonds held by the Company as of December 31, 2011 is as follows:
For each category above, no state, municipality or political subdivision comprised more than 10% of the total.
The break-down of the special revenue bonds category, by nature of activity for activities comprising more than 10% of the category, is as follows:
Income before income taxes decreased $66.5 million for the year ended December 31, 2011 compared to the prior year. The decrease was primarily due to a greater underwriting loss in 2011 compared to 2010 and a decrease in investment income, partially off set by greater realized gains in 2011.
An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium, (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium, and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio increased to 119.9% for the year ended December 31, 2011 from 102.5% for the year ended December 31, 2010. The combined ratio for 2011 includes 0.9% due to the impact of the statutory treatment of the ceding commission received on the unearned premiums transferred to the Mutual Company on January 1, 2011. Excluding the impact of the pool transfer, the statutory combined ratio was 119.0% for 2011. The increase in the combined ratio was primarily due to greater catastrophe losses, greater non-catastrophe weather losses and less favorable development in 2011. Net catastrophe losses increased to $93.2 million (11.6 points) for 2011 from $35.7 million (4.1 points) for 2010.
The statutory combined ratios by line of business for the year ended December 31, 2011 as compared to the year ended December 31, 2010 are shown below.
The commercial lines statutory combined ratio increased to 115.4% (excluding the impact of the pooling transfer) for the year ended December 31, 2011 from 102.3% for the year ended December 31, 2010. This increase was primarily due to unusually high catastrophe and non-catastrophe weather losses experienced in all four quarters of 2011. In the first quarter of 2011, unusually severe winter weather resulted in catastrophe and non-catastrophe losses that contributed to elevated loss activity, particularly in the Northeast and Mid-Atlantic regions. In the second quarter of 2011, all regions were significantly impacted by catastrophes, with the Southeast and Midwest regions being most adversely affected due to tornado and hail losses. In the third quarter of 2011, Hurricane Irene, Tropical Storm Lee, and other hail and windstorm events contributed to significant losses, particularly in the Northeast and Mid-Atlantic regions. In the fourth quarter of 2011, an unusual October snow event contributed to losses in the Mid-Atlantic and the Northeast regions. Catastrophe losses in the commercial lines represented 9.2 points of the combined ratio in calendar year 2011 compared to 2.6 points in calendar year 2010. The commercial automobile line of business also contributed to the overall increase in the commercial lines combined ratio in 2011. The increase in the commercial automobile combined ratio from 100.0% for the year ended December 31, 2010 to 105.4% for the year ended December 31, 2011 is primarily due to higher than expected frequency and severity in accident year 2011.
Incurred Counts and Averages Method (Based on Exponential Fit of Severity)
An actuarial central estimate, which is management’s best estimate, of ultimate loss is selected for each line of business based on a review of the indications produced by the above methodologies. More consideration is given to those methods that the actuaries deem to be more appropriate in a particular situation. In addition, other metrics such as claim closing ratios, average case reserve levels, paid loss to incurred loss ratios, individual large loss information, and recent insurance pricing changes are reviewed to help the actuaries select the most appropriate estimates of ultimate loss.
As mentioned previously, the selection of ultimate loss is based on information unique to each line of business and accident year subject to exceptions, such as the emergence of one or more unusually large claims in a particular accident period for a short-tail line. In this case, the indications produced by the development methods may be overstated (due to development of ultimate losses to amounts in excess of policy limits) and such information would be considered in the actuaries’ process of selecting ultimate loss.
A decrease in commercial automobile severity, primarily in accident years 2005 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. Slightly higher than expected severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $5.6 million of favorable prior year development was recognized in this line during 2011.
A decrease in workers compensation severity, primarily in accident years 2003 through 2008, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $11.8 million of favorable prior year development was recognized in this line during 2011.
A decrease in commercial multi-peril severity was widely observed during 2011, which led to the recognition of favorable development in most accident years prior to 2009. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these years. In aggregate, $10.6 million of favorable prior year development was recognized in this line during 2011.
A decrease in personal automobile severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $0.1 million of favorable prior year development was recognized in this line during 2011.
A slight decrease in other personal lines severity was observed during 2011, primarily in accident year 2009. In aggregate, $0.3 of favorable prior year development was recognized in other personal lines during 2011.
Between the Years Ended December 31, 2010 and December 31, 2011
Harleysville Group records the actuarial central estimate, which is management’s best estimate, of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or before December 31, 2011. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.
Reserve ranges are determined using both paid and incurred loss development data with a 10,000 trial simulation run against each set of data for each line of business presented in the table below. Each simulation generates a unique set of loss development factors randomly generated from the normal distribution with mean and standard deviation as defined above. Each unique set of loss development factors, when applied to the data, produces
a unique reserve estimate. At the completion of the simulation, there are 20,000 unique reserve estimates which can be ordered from lowest to highest creating a range of reserve estimates. The resulting range produced by the simulation is used to create a reasonable representation of a 90% confidence interval using the 5% point as the low end of the range and the 95% point as the high end of the range. The 90% confidence interval represents the range of reserve estimates for which there is approximately a 90% probability that the actual reserve amount (which will not be known for many years) is contained within the defined range. The total commercial lines range and total personal lines range were developed as separate simulations using the means and standard deviations of the individual lines as inputs. Therefore, the 90% confidence interval for all lines of business is smaller than the straight sum of the individual lines of business 90% intervals.
Investment income decreased $3.3 million for the year ended December 31, 2010, primarily due to a lower investment yield on fixed income securities and short-term investments and a greater percentage of fixed income securities invested in tax-exempt securities. During the second half of 2010, Harleysville Group purchased an additional $50 million of equity securities in order to generate additional investment income. Investments were made in high-quality, large-cap companies with strong balance sheets and a history of paying and increasing their dividends. In 2011, Harleysville Group plans to add an additional $120 million to dividend paying equities, with $50 million of this amount resulting from a re-allocation of its broad-based equity index fund.
Income before income taxes decreased $33.3 million for the year ended December 31, 2010 compared to the prior year. The decrease was primarily due to an underwriting loss in 2010 compared to an underwriting gain in 2009 and a decrease in investment income.
The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2010 by line of business:
In the commercial multi-peril line of business, a reduction in severity, primarily in accident years 2004 through 2009, led to the recognition of $18.9 million of favorable development during 2010.
In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, “Fair Value Measurements and Disclosures.” ASU 2010-06 applies to all entities that are required to make disclosures about recurring or non-recurring fair value measurements. ASU 2010-06 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories is for interim and annual periods beginning after December 15, 2009. The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category is for interim and annual periods beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s results of operations or financial position.
In December 2010, the FASB issued ASU 2010-28, “Intangibles-Goodwill and Other.” The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For these units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. For public entities, this ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s results of operations or financial position.
Investing activities provided net cash of $104.5 million and used net cash of $2.8 million for 2011 and 2010, respectively. The change is primarily due to net sales of investments in 2011 due to the use of cash by operating activities and financing activities.
Harleysville Group’s investment strategy is designed to complement and support the insurance operations. Harleysville Group considers projected cash flow (premiums, investment income, reinsurance programs, liability payout patterns, general expenses, large seasonal obligations, intercompany transfers, etc.) to assure that sufficient
The Company had $43.4 million of cash and marketable securities at December 31, 2011, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. On July 30, 2009, the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed on August 3, 2010. On August 6, 2010, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009. As of December 31, 2011, the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased. Provisions in the Merger Agreement with Nationwide restrict the Company from repurchasing further shares. Harleysville Group has no other material commitments for capital expenditures as of December 31, 2011.
You should consider carefully the following risks, as well as the other information contained in this 2011 Annual Report on Form 10-K. If any of the following events described in the risk factors below actually occur, our business, financial condition and results of operations could be materially adversely affected. You should refer to the other information set forth in this 2011 Annual Report on Form 10-K including our consolidated financial statements and the related notes.
Our insurance subsidiaries have experienced, and are expected in the future to experience, catastrophe losses. It is possible that a catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the operating results and financial condition of our insurance subsidiaries, thereby limiting the ability of our insurance subsidiaries to pay dividends to us. The largest non-flood catastrophe to affect our results of operations was Hurricane Irene in the third quarter of 2011, which resulted in $28.0 million of losses. In 2010, we experienced losses totaling $37.7 million from twenty-seven different catastrophes. In 2011, we experienced losses totaling $91.5 million from twenty-five different catastrophes.
We are subject to extensive supervision and regulation in the states in which we transact business. The purpose of supervision and regulation is to protect individual policyholders and not stockholders or other investors. Our business can be adversely affected by private passenger automobile insurance regulations and any other regulations affecting property and casualty insurance companies. For example, laws and regulations can reduce or set rates at levels that we do not believe are adequate for the risks we insure. Other laws and regulations can limit our ability to cancel or refuse to renew policies and require us to offer coverage to all consumers. Changes in laws and regulations, or their interpretations, pertaining to insurance, including workers compensation, may also have a material adverse effect on our business. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry.
The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the financial markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of Harleysville Group, as well as a decrease in our shareholders’ equity, net income and/or revenue. The effects of changes related to Harleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002, which was originally extended in 2005 and extended again in 2007, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2014. In addition, some of the assets in our investment portfolio may be materially adversely affected by declines in the financial markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.
Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenues and earnings. Any significant decline in our investment income as a result of falling interest rates or general market conditions would have a material adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholders’ equity and our policyholders’ surplus, which could impact our ability to write additional business.
The announcement of the Merger Agreement with Nationwide was made in September 2011, however, due to the need for a number of regulatory approvals, and approvals of the stockholders of the Company and the members of the Mutual Company and Nationwide, the Mergers are not expected to close until of the first half of 2012. While expected, the delay between
announcement and closing, and the risk that the transactions will not be consummated, could disrupt our business in the following ways, among others:
the attention of the Company’s management may be directed toward the completion of the Merger and transaction-related considerations and may be diverted from the day-to-day business operations of the Company, and the matters related to the Merger may require commitments of time and resources that could otherwise have been devoted to other opportunities that might have been beneficial to the Company;
Any of these matters could adversely affect our financial condition, results of operations or business prospects.
Failure to complete the Merger could negatively affect our stock price and our future business and financial results.
the Company would need to re-evaluate its strategic alternatives and operational functions, including the need to establish retention programs to retain employees, evaluate its investment portfolio and re-establish its strategic path as a stand-alone company, and may not be successful in retaining employees and re-establishing its stand-alone operational functions.
We have incurred and expect to continue to incur a number of substantial non-recurring transaction fees and other costs associated with the Merger. Additional unanticipated costs may be incurred in the integration of the merged businesses. In the event the Merger Agreement is terminated, under certain circumstances we may be required to pay Nationwide a termination fee of $29.6 million and reimburse them for their expenses.
The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be materially adversely impacted. There are more than 200 groups writing property and
casualty insurance in the United States, and we rank among the top 60 in size. Our most significant competitors vary significantly in our different lines of business and in the geographic markets in which we compete. The Internet also could emerge as a significant source of new competition, both from existing competitors using their brand name and resources to write business through this distribution channel and from new competitors.
programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage; and
As of December 31, 2011, the Mutual Company owned approximately 53% of our outstanding common stock. The Mutual Company’s stock ownership and ability, by reason of such ownership, to elect our board of directors, provides it with significant influence over potential change of control transactions. Further, Section 203 of the Delaware General Corporation Law provides that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock, subject to certain exceptions. Section 203 may discourage a potential change of control transaction. Our Board of Directors is divided into three classes (A, B
Consolidated Statements of Cash Flows for Each of the Years in the Three-year Period Ended December 31, 2011
Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with, and are primarily related to, the production of business, are deferred and amortized over the effective period of the related insurance policies in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claims paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the deferred acquisition costs are not recoverable, they are written off and further analyses are performed to determine if an additional liability would need to be accrued.
The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, which includes the gross liabilities to Harleysville Group’s policyholders plus the net liability to the Mutual Company under the pooling agreement. See Note 3(a). Such estimates may be more or less than the amounts ultimately paid when the claims are settled. These estimates are periodically reviewed and adjusted as necessary; such adjustments are reflected in current operations.
The Company adopted the accounting guidance on “Participating Securities and the Two-Class Method,” in 2009. This guidance redefines participating securities to include unvested share-based payment awards that contain non-forfeitable dividends or dividend equivalents as participating securities to be included in the computation of EPS pursuant to the “two-class method.” Outstanding unvested restricted stock and restricted stock units issued by the Company under employee compensation programs containing such dividend participation features are considered participating securities subject to the “two-class method” in computing EPS rather than the “treasury stock method.” Adoption of this guidance reduced 2009 basic and diluted EPS by $.04 and $.02, respectively.
The transactions are subject to customary closing conditions, including, among others, approvals from stockholders of the Company, policyholders of the Mutual Company and Nationwide, the Pennsylvania Insurance Department, the Ohio Insurance Department and various other regulatory bodies. The transactions are expected to close in the first half of 2012. The Merger Agreement provides certain termination rights. In the event that the agreement is terminated under certain conditions by the Company’s Board of Directors, the Company will be required to pay Nationwide a termination fee of $29.6 million and reimburse Nationwide for its transaction expenses.
Effective January 1, 2011, the Company’s property and casualty subsidiaries and the Mutual Company and Pennland amended their intercompany pooling agreement as it relates to their workers compensation business. The amendment established that the financial results associated with the workers compensation business for accident years 2011 and following will be retained 100 percent by the Mutual Company. The financial results of this business for prior accident years will continue to be shared between the Company’s property and casualty subsidiaries, the Mutual Company and Pennland under the existing pool participations. Harleysville Group paid cash of $33 million on January 3, 2011 associated with the transfer of the unearned premium liability on the workers compensation business as of January 1, 2011. Harleysville Group’s unearned premium liability decreased by $40 million and Harleysville Group received a ceding commission of $7 million for expenses that were incurred to generate the business transferred to the Mutual Company, which ceding commission reduced deferred policy acquisition costs.
Harleysville Group Inc. received $8,520,000, $5,843,000 and $5,109,000 of management fee income in 2011, 2010 and 2009, respectively, under agreements whereby Harleysville Group Inc. provides management services to the Mutual Company and other affiliates. Such amounts are included in other income. Effective January 1, 2010, the management agreement was amended to include voluntary assumed reinsurance business written by the Mutual Company.
When the independent pricing service provides a fair value estimate, the Company uses that estimate. At December 31, 2011 and 2010, the independent pricing service provided a fair value estimate for all of the investments classified as Level 1 investments within the fair value hierarchy and approximately 99% of the investments classified as Level 2 estimates within the fair value hierarchy. The fair value of all Level 2 securities is based on observable market inputs.
Management reviews, on an ongoing basis, the reasonableness of the methodologies employed by the independent pricing service. As part of the monthly review process, management examines the prices obtained from the independent pricing service. This process routinely involves reviewing any available recent transaction activity reported via various investment research tools. Additionally, the Company tracks changes in credit ratings of all fixed maturity securities on a monthly basis and performs a more in-depth, quarterly evaluation of fixed income securities that are rated below single A by Moody’s and/or S&P. If, as a result of its review, management does not believe that a price received with respect to any particular security is a reasonable estimate of the fair value of the security, it will discuss this with the independent pricing service to resolve the discrepancy. Management then determines the appropriate level of classification of each investment within the fair value hierarchy based on its evaluation of the inputs used in determining the fair value.
The following is a summary of the fair value measurements of applicable Company assets by level within the fair value hierarchy as of December 31, 2011 and 2010. These assets are measured at fair value on a recurring basis. There were no transfers to or from Levels 1 and 2 of the fair value hierarchy in 2011. Harleysville Group’s policy is to recognize transfers between levels as of the end of the reporting period.
Income taxes on realized investment gains were $26,417,000, $209,000 and $803,000 for 2011, 2010 and 2009, respectively.
Deferred income tax liabilities applicable to net unrealized investment gains included in shareholders’ equity were $58,362,000 and $60,555,000 at December 31, 2011 and 2010, respectively.
There were impairment charges of $381,000 on fixed maturity securities in 2011that Harleysville Group intended to sell. All of these securities were subsequently sold in 2011. At September 30, 2011, a bond with an amortized cost of $999,000 was transferred from the held to maturity category to the available for sale category due to a significant deterioration in the credit worthiness of the issuer. An impairment charge of $21,000 recognized on this security is included in the fixed maturity impairment total of $381,000. Harleysville Group had no credit-related impairment charges on non-equity securities in 2010. Harleysville Group recognized credit-related impairment charges on non-equity securities of $1,548,000 in 2009. The 2009 impairment charges consisted of $568,000 on bonds the Company sold in 2010 and $980,000 on structured investment vehicles.
There were impairment charges of $3,586,000 on equity securities in 2011 that Harleysville Group intended to sell. In October 2011, the Company sold virtually all of its equity securities, at a gain of $62 million, in order to reduce potential volatility in statutory surplus. Harleysville Group had no impairment charges on equity securities in 2010 or 2009.
Losses and loss settlement expenses are net of reinsurance recoveries of $88,418,000, $44,414,000 and $53,563,000 for 2011, 2010 and 2009, respectively.
Assumed and ceded written premiums for 2009 include $6,200,000 and assumed and ceded earned premiums for 2010 and 2009 include $5,280,000 and $920,000, respectively, for Harleysville Group’s share of flood insurance business the Mutual Company assumed from another carrier, which is ceded 100% to the National Flood Insurance Program.
Property and equipment consisted of the Company’s home office land and buildings with a cost of $28,971,000 and $28,737,000, and equipment, including software, with a cost of $4,906,000 and $5,749,000 at December 31, 2011 and 2010, respectively. Accumulated depreciation related to such assets was $21,114,000 and $21,174,000 at December 31, 2011 and 2010, respectively.
A decrease in commercial automobile severity, primarily in accident years 2005 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. Slightly higher than expected severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $5,600,000 of favorable prior year development was recognized in this line during 2011.
A decrease in other commercial lines severity, primarily in accident years 2007 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $2,800,000 of favorable prior year development was recognized in this line during 2011.
A decrease in homeowners severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $900,000 of favorable prior year development was recognized in this line during 2011.
A reduction in personal automobile severity in accident years 2008 and prior was widely observed during 2010. Claim frequency in accident year 2009 increased, which led to $506,000 of adverse development during the year. In total, $4,356,000 of favorable prior year development was recognized in this line during 2010.
A decrease in workers compensation severity in accident years 2003 through 2006 was observed during 2009 which led to the recognition of favorable development for those accident years during 2009. An increase in workers compensation medical severity in accident years 2002 and prior was observed during 2009 which led to the recognition of adverse development for those accident years during 2009. An increase in severity in accident year 2008 was observed in this line during 2009 and led to the recognition of $1,134,000 of adverse development during the year. In total, $9,118,000 of favorable development was recognized in the workers compensation line during 2009. Approximately $3,400,000 of the favorable development experienced in this line during 2009 is related to the Company’s involuntary pools.
In the commercial multi-peril line of business, a reduction in severity in accident years 2003 through 2006 led to the recognition of favorable development for those accident years during 2009. An increase in claim frequency in accident year 2007 and an increase in severity in accident year 2008 led to the recognition of a small amount of adverse development for those accident years during 2009. In total, $1,863,000 of favorable development was recognized in the commercial multi-peril line of business during 2009 for all accident years.
A reduction in homeowners severity was widely observed during 2009, especially in accident year 2008, which led to the recognition of $2,995,000 of favorable development during 2009 for all accident years.
The fair value of the notes was $103,322,000 and $99,413,000 at December 31, 2011 and 2010, respectively, based on quoted market prices for the same or similar debt. The carrying value of the remaining debt approximates fair value.
A source of cash for the payment of dividends is dividends from subsidiaries. Harleysville Group Inc.’s insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2011, $65,135,000 would be available for distribution to Harleysville Group Inc. in 2012 without prior approval.
The compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $6,389,000, $6,363,000 and $6,300,000 for 2011, 2010 and 2009, respectively with a corresponding income tax benefit of $2,138,000, $2,130,000 and $2,083,000 for 2011, 2010 and 2009, respectively.
The per share weighted-average fair value of options granted during 2011, 2010 and 2009 was $6.58, $6.84 and $5.67, respectively. The total intrinsic value of options exercised was $5,577,000, $4,066,000, and $1,199,000 for 2011, 2010 and 2009, respectively.
The total fair market value of restricted shares which vested during 2011, 2010 and 2009 was $5,723,000, $2,034,000 and $122,000, respectively. In 2009, 15,735 restricted shares granted included a performance condition. No restricted shares were granted in 2011 or 2010.
The total fair market value of restricted stock units which vested during 2011 was $3,066,000. In 2011 and 2010, respectively, 30,855 and 39,485 of the restricted stock units granted included a performance condition (at target). All of the restricted stock units granted in 2009 included a performance condition (at target).
The 2005 Non-Employee Directors’ Deferred Stock Unit Plan provided for the grant of up to 110,000 fully vested deferred stock units to outside directors of Harleysville Group Inc. and the Mutual Company. Each stock unit represents the right to receive, without payment to the Company, one share of common stock of Harleysville Group Inc. The plan was amended and restated in 2007 to provide for the grant of awards in the form of stock options, deferred stock units and restricted stock and was renamed the Amended and Restated Directors’ Equity Compensation Plan. The aggregate number of shares which may be issued under the plan is 500,000, which may be either authorized and unissued shares or treasury shares. At each April Board of Directors meeting, each non-employee director continuing in office receives a number of deferred stock units equal to the result of dividing $50,000 by the fair market value of a share of HGI common stock.
The expense to be recorded for the deferred stock units is determined utilizing the number of awards granted and the grant date fair market value. The expense is recognized at the date of grant as the awards are fully vested. In 2011, 2010 and 2009, respectively, there were 15,600, 16,830 and 17,985 units issued under the plan for which $443,000, $493,000 and $450,000 of expense was recognized. The weighted average grant date fair value of units granted during 2011, 2010 and 2009 was $31.89, $32.58 and $27.83 per unit, respectively.
Cash received from option exercises under all share-based payment arrangements for 2011, 2010 and 2009 was $2,622,000, $8,476,000 and $4,721,000, respectively. The actual tax benefit realized for the tax deductions from option exercises of the share-based payment arrangements was $1,952,000, $1,423,000 and $419,000, respectively, for 2011, 2010 and 2009.
The following table sets forth the year-end status of the plan including the Mutual Company:
Fair value measurements are determined under the three-level hierarchy consistent with the methodologies discussed in Note 4.
At December 31, 2011, the independent pricing service provided a fair value estimate for all of the pension plan investments classified as Level 1 investments within the fair value hierarchy and approximately 97% of the pension plan investments classified as Level 2 estimates within the fair value hierarchy. The fair value of all Level 2 securities is based on observable market inputs.
(d) This category is comprised of an equity investment in a company that engages in venture capital investment activities with selected businesses that have significant potential for growth and long-term appreciation
Harleysville Group has a profit-sharing plan covering qualified employees. Harleysville Group’s expense under the plan was $1,959,000, $2,140,000 and $2,834,000 for 2011, 2010 and 2009, respectively. The plan also requires a Company core contribution, equal to 4% of salary in 2011 and 2010 and 5% of salary in 2009, to be automatically contributed to all eligible employees’ accounts on a biweekly basis regardless of the employees’ salary deferral amounts into the plan. Harleysville Group’s expense for the Company core contribution was $2,988,000, $3,051,000 and $3,957,000 in 2011, 2010 and 2009, respectively.
Net income per basic and diluted share for 2011 excluded the allocation of $107,000 of undistributed losses to participating share-based awards, since such allocation would result in anti-dilution of basic and diluted earnings per share.
The Harleysville Group insurance subsidiaries are subject to disputes, including litigation and arbitration, arising in the ordinary course of their insurance business. The Company’s estimates of the costs of settling such matters are reflected in its liability for unpaid losses and loss settlement expenses, and the Company does not believe that the ultimate outcome of such matters will have a material adverse effect on its financial condition or results of operations. However, adverse outcomes of insurance claims are possible and could negatively impact the Company’s financial condition and results of operations in the future.
Harleysville Group is also subject to two class action lawsuits in connection with the Merger Agreement with Nationwide described in Note 2 of the Notes to Consolidated Financial Statements. The Company does not believe that the ultimate liability associated with these lawsuits will have a material adverse effect on its financial condition or results of operations. However, adverse outcomes are possible and could negatively impact the Company’s financial condition and results of operations in the future.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harleysville Group Inc. and Subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Harleysville Group Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 14, 2012 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.