At December 31, 2003, Harleysville Group Inc. (Company) was approximately 57% owned by Harleysville Mutual Insurance Company (Mutual). Harleysville Group Inc. and its wholly owned subsidiaries (collectively, Harleysville Group) 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, Mid-America Insurance Company, and Harleysville Ltd., a real estate partnership that owns the home office.
the Company’s ability to maintain its A- (“excellent”)rating by A.M. Best
Harleysville Group provides certain management services to Mutual and other affiliates. Harleysville Group received a fee of $7.2 million, $6.8 million and $7.3 million in 2003, 2002 and 2001, respectively, for its services under these management agreements. Under related agreements, Harleysville Group serves as the paymaster for Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense based upon time allocation. The level of fees has been approved by each state insurance department having jurisdiction.
Premiums earned increased $58.8 million, or 8% for the year ended December 31, 2003. The increase was primarily due to an increase in premiums earned for commercial lines of $75.8 million, or 14%, partially offset by a decrease of $17.0 million, or 8%, in personal lines premiums earned. The increase in premiums earned for commercial lines primarily was due to higher rates. The decrease in premiums earned for personal lines primarily was due to fewer policy counts and was partially offset by higher rates. The reduction in personal lines volume was driven primarily by a reduction in personal automobile business from the implementation of more stringent underwriting processes.
After the events of September 11, 2001, air travel and the value of these airlines’ EETC securities declined. The EETCs are all “A tranche” holdings, which means they are in a senior credit position to the underlying airplane collateral value as compared to B and C tranche holders. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. Recent estimates indicate that in a distressed sale scenario, the value of the collateral would be approximately the same as the EETCs’ cost. These EETC’s currently carry
an investment grade debt rating and the market value has improved over the past year. Harleysville Group is participating in certain EETC creditor committees and is monitoring developments. It is possible that these EETCs may be written down in the income statement in the future, depending upon developments involving both the issuers and world events which impact the level of air travel.
Income (loss) before income taxes decreased $145.9 million for the year ended December 31, 2003 compared to the same prior year period. The decrease was primarily due to a greater underwriting loss, partially offset by lesser realized investment losses.
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 123.2% for the year ended December 31, 2003, from 101.9% for the year ended December 31, 2002. Such increase was due to a higher underwriting loss in both commercial lines and personal lines, primarily resulting from the adverse loss development and catastrophe losses.
The statutory combined ratios by line of business for the year ended December 31, 2003, as compared to the year ended December 31, 2002, were as follows:
The following table presents the liability for unpaid losses and loss settlement expenses by major line of business:
The adverse development in commercial and personal automobile primarily was due to higher loss severity trends that became evident in the third and fourth quarters when case reserve increases were recognized. The case reserve increases for commercial automobile included the impact of adverse litigation trends. Harleysville Group had previously publicly noted an increase in litigation on bodily injury cases and a slowing of the rate of settlement. The combination of all of these factors resulted in the increased estimate of ultimate losses.
The adverse development in commercial multi-peril primarily was due to higher loss severity trends that became evident in the third and fourth quarters when case reserve increases were recognized. Like commercial auto, the trend of increased litigation and a slowing rate of settlement resulted in the increased estimate of ultimate losses. While Harleysville Group had not incurred material construction defect liability losses prior to 2003, it increased its provision for insured events of prior years by an additional $3.6 million for estimated losses on construction defect liability claims because of increased case activity in the third and fourth quarters of 2003.
A statistically determined range of estimates for commercial lines is $767.8 million to $977.5 million and for personal lines is $123.9 million to $166.0 million. The range of estimates around the actuarial best estimates is statistically determined in order to provide information regarding the variability of the actuarial best estimates. The ranges were determined using both paid and incurred loss development data with a 1,000 trial simulation run against each set of data. Development factors within each 12-month development period were assumed to be normally
distributed with the means equal to the estimated age-to-age factors, and the standard deviations equal to the actual standard deviations of the data used. The resulting ranges produced by the simulation were then 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.
Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. The aforementioned reorganization of the claims operation has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and give rise to uncertainty as to the pattern of future loss settlements. Litigation on bodily injury liability cases has increased during the past two years while the rate of settlement has slowed. These changed patterns give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury liability claims. There are uncertainties regarding future loss cost trends particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2003. For every 1% change in the estimate, the effect on pre-tax income would be $10.6 million.
The personal lines statutory combined ratio increased to 121.8% for the year ended December 31, 2003 from 108.1% for the year ended December 31, 2002. In addition to the aforementioned effects of adverse development, the remaining increase primarily was due to higher catastrophe losses which affected the homeowners line and higher loss severity which affected each of the personal lines.
Effective for one year from July 1, 2003, the Company’s subsidiaries and Mutual and its wholly-owned subsidiaries renewed its catastrophe reinsurance which provides coverage ranging from 85.5% to 95.0% of up to $140 million in excess of a retention of $30 million for any given catastrophe excluding terrorism for commercial lines. Harleysville Group’s 2003 pooling share of this coverage would range from 85.5% to 95.0% of up to $100.8 million in excess of a retention of $21.6 million for any given catastrophe. Pursuant to the terms of the treaty, the maximum recovery would be $129 million for any catastrophe involving an insured loss equal to or greater than $170 million. Harleysville Group’s 2003 pooling share of this maximum recovery would be $93 million for any catastrophe involving an insured loss of $122 million or greater. The treaty includes reinstatement provisions providing for coverage for a second catastrophe and requiring payment of an additional premium in the event of a first catastrophe occurring. Harleysville Group and Mutual have purchased property per risk excess of loss reinsurance which covers certain terrorism losses and provides for recovery of up to $8.5 million in excess of $1.5 million of terrorism losses for any one risk under certain circumstances. The maximum recovery by Harleysville Group on a terrorism loss occurrence is $8.6 million.
Premiums earned increased $34.7 million, or 5% for the year ended December 31, 2002. The increase was primarily due to an increase in premiums earned for commercial lines of $59.8 million, or 12%, partially offset by a decrease of $25.1 million, or 11%, in personal lines premiums earned. The increase in premiums earned for commercial lines primarily was due to higher rates and was partially offset by fewer policy counts. The decline in policy counts was primarily in the workers compensation line of business. The decrease in premiums earned for personal lines primarily was due to fewer policy counts and was partially offset by higher rates. The reduction in personal lines volume was driven primarily by a planned reduction of business in certain less profitable states and the implementation of other more stringent underwriting processes.
Investment income increased $0.7 million, or 1%, for the year ended December 31, 2002, resulting from an increase in invested assets, partially offset by a lower yield on a fixed maturity investment portfolio.
Realized investment losses increased $15.4 million for the year ended December 31, 2002, primarily due to a $3.9 million decrease in gains on the sale of fixed maturity securities and an $11.5 million increase in losses from equity securities.
During the third and fourth quarters of 2002, Harleysville Group began to sell equity securities as part of a plan to carry back realized tax losses to recover taxes previously paid. All but two of the equity securities recognized as impaired were sold in a subsequent quarter of 2002.
Harleysville Group had gross realized equity investment losses of $28.6 million in 2002, which consisted of impairment charges of $28.2 million and $0.4 million from equity securities that were sold. Harleysville Group had gross realized fixed maturity losses of $2.7 million in 2002, which consisted of impairment charges of $0.9 million, and $1.8 million from sales of one issuer’s bonds with a cost of $8.3 million that had been below cost for approximately six months at the time of sale.
Income before income taxes increased $4.7 million, or 9%, for the year ended December 31, 2002 due to the higher investment income and a lower underwriting loss, partially offset by the increased realized investment losses.
Harleysville Group’s statutory combined ratio improved to 101.9% for the year ended December 31, 2002 from 104.2% for the year ended December 31, 2001. Such decrease was due to improved results in both commercial lines and personal lines. The commercial lines combined ratio improved to 99.5% for the year ended December 31, 2002 from 100.0% for the year ended December 31, 2001. The personal lines combined ratio improved to 108.1% for the year ended December 31, 2002 from 113.1% for the year ended December 31, 2001. The improvement in commercial lines primarily was due to improved results in the commercial automobile and commercial multi-peril lines of business, partially offset by worse results in the workers compensation line of business, where losses have trended higher. The improvement in personal lines primarily was due to benefits from higher pricing, re-underwriting and agency management efforts, partially offset by higher loss trends in the personal automobile lines. The year ended December 31, 2001 also included estimated losses of $3.6 million resulting from the September 11, 2001 terrorist acts and a $2.6 million charge for guaranty fund and other assessments resulting from the liquidation of Reliance Insurance Company. These charges adversely affected the statutory combined ratio by 0.5 points and 0.4 points, respectively.
Of the $4.6 million of favorable development in 2002, $2.9 million was from commercial lines and was net of $6.7 million of favorable development in the 2001 accident year and $4.8 million of adverse development in the 1999 accident year and smaller amounts of development in every other accident year. The net liability for commercial lines unpaid losses
and loss settlement expenses at December 31, 2001 for the 2001 and 1999 accident years was $236.2 million and $91.9 million, respectively. Favorable development in personal lines was $1.7 million for 2002 and was net of $3.8 million of favorable development in the 2001 accident year and $0.9 million of adverse development in the 1998 accident year and smaller amounts of development in every other accident year. The net liability for personal lines unpaid losses and loss settlement expenses at December 31, 2001 for the 2001 and 1998 accident years was $71.5 million and $11.7 million, respectively. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses were not actuarially significant and reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends and primarily relate to lower-than-expected claim severity.
Of the $17.4 million of favorable development in 2001, $14.8 million was derived from a reduction in anticipated loss settlement expenses. During 2000, Harleysville Group completed a plan to consolidate its claims operations from 23 general claims offices into a centralized direct reporting center and four specialized regional claims centers, which resulted in the termination of 173 employees. At December 31, 2000, the liability for loss settlement expenses of $151.0 million was established based on historical trends with consideration given to benefits from staffing reductions that were expected from the claims reorganization.
New accounting standards that have been issued did not, or are not expected to, have a material impact on the consolidated financial statements.
Net cash provided by operating activities was $134.6 million and $113.2 million for 2003 and 2002, respectively. The increase in net cash provided by operating activities primarily consists of an increase in cash provided by underwriting activities.
Financing activities provided net cash of $3.2 million in 2003 and used $11.1 million in 2002. The change was primarily due to the net increase in debt, partially offset by an increase in dividends paid and the purchase of treasury stock.
Harleysville Group participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time in return for a fee. At December 31, 2003, Harleysville Group held cash collateral of $221.5 million related to securities on loan with a market value of $215.7 million. Harleysville Group’s policy is to require initial collateral of 102% of the market value of loaned securities plus accrued interest, which is required to be maintained daily by the borrower at no less than 100% of such market value plus accrued interest over the life of the loan. Acceptable collateral includes cash and money market instruments, government securities, “A” rated corporate obligations, “AAA” rated asset-backed securities or GICs and Funding Agreements from issuers rated “A” or better.
The Company had $9.1 million of cash and marketable securities and $11.6 million of dividends receivable from its subsidiaries at December 31, 2003, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. The Company repaid $75.0 million of notes payable which were due November 2003 from the proceeds of $100.0 million of notes payable due July 2013 which were issued in July 2003. The Company has adopted a stock repurchase plan under which the Company may purchase up to 500,000 shares of Harleysville Group Inc. common stock. Mutual has authorized purchases of the common shares of Harleysville Group Inc. in an equal amount. At March 1, 2004, the Company had repurchased 397,909 of the shares authorized to be repurchased leaving 102,091 shares authorized to be repurchased. Harleysville Group has no material commitments for capital expenditures as of December 31, 2003.
Applying the current regulatory restrictions as of December 31, 2003, $47.6 million would be available for distribution to the Company by its subsidiaries in 2004 without prior regulatory approval. See the Business-Regulation section of this Form 10-K, which includes a reconciliation of net income and shareholders’ equity as determined under statutory accounting practices to net income and shareholders’ equity as determined in accordance with accounting principles generally accepted in the United States of America. Also, see Note 8 of the Notes to Consolidated Financial Statements.
These RBC standards require the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2003 statutory financial statements, the ratio of total
The table above does not include capital lease obligations, operating lease obligations or purchase obligations as they are either not applicable or not material.
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. In the last 5 years, the largest catastrophe to affect our results of operations was Hurricane Floyd in the third quarter of 1999, which resulted in $15.1 million of losses.
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 shareholders 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 an 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 equity 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 the Harleysville Group, as well as a decrease in our stockholders’ equity, net income and/or revenue. The effects of changes related to the Harleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002 requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2005. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.
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 adversely impacted. There are more than 250 groups writing property and casualty insurance in the United States, and we are approximately 60th 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 new distribution channel and from new competitors.
changing practices caused by the internet, which have led to greater competition in the insurance business and, in some cases, greater expectations for customer service.
geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency’s ability to control growth and profitability, thereby adversely affecting our business.
In addition, many state insurance laws require prior notification to the state insurance department of a change of control of a non-domiciliary insurance company licensed to transact insurance in that state. Although these pre-notification statutes do not authorize the state insurance departments to disapprove the change of control, they authorize regulatory action -- including a possible revocation of our authority to do business -- in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change of control of us may require prior notification in the states that have pre-acquisition notification laws.
As of December 31, 2003, the Mutual Company owned approximately 57% 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.
Held to maturity, at amortized cost (fair value $463,953 and $411,235)
Held to maturity, at amortized cost (fair value $3,532 and $5,707)
Harleysville Group is approximately 57% owned by Harleysville Mutual Insurance Company (Mutual).
if the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), “Accounting for Stock-Based Compensation,” had been applied to all periods presented.
The insurance subsidiaries participate in a reinsurance pooling agreement with Mutual whereby such subsidiaries cede to Mutual all of their insurance business and assume from Mutual an amount equal to their participation in the pooling agreement. All losses and loss settlement expenses and other underwriting expenses are prorated among the parties on the basis of participation in the pooling agreement. The agreement pertains to all insurance business written or earned on or after January 1, 1986. Harleysville Group’s participation was 72% for 2003, 2002 and 2001.
Because this 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 Mutual. However, the reinsurance pooling agreement provides for the right of offset, and the amount of credit risk with Mutual was not material at December 31, 2003 and 2002. Mutual has an A. M. Best rating of “A-” (Excellent).
Harleysville Group Inc. received $7,221,000, $6,808,000 and $7,316,000 of management fee income in 2003, 2002 and 2001, respectively, under agreements whereby Harleysville Group Inc. provides management services to Mutual and other affiliates. Such amounts are included in other income.
Harleysville Group has off-balance-sheet credit risk related to approximately $71,000,000 and $68,000,000 of premium balances due to Mutual from agents and insureds at December 31, 2003 and 2002, respectively.
The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2003 and 2002 amounted to $30,949,000 and $25,555,000, respectively.
The fixed maturity investments with continuous unrealized losses for less than twelve months were primarily due to the impact of higher market interest rates rather than a decline in credit quality. The fixed maturity investments with continuous unrealized losses for more than twelve months were comprised of airline enhanced equipment trust certificates (EETC’s). After the events of September 11, 2001, air travel and the value of these airlines’ EETC’s declined. The EETC’s are all “A tranche” holdings, which means they are in a senior credit position to the underlying airplane collateral value as compared to B and C tranche holders. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETC’s. Recent estimates indicate that in a distressed sale scenario, the value of the collateral would be approximately the same as the EETC’s cost. These EETC’s currently carry an investment grade debt rating and the market value has improved over the past year.
In the ordinary course of business, Harleysville Group cedes insurance to, and assumes insurance from, insurers to limit its maximum loss exposure through diversification of its risks. See Note 2(a) for discussion of reinsurance with Mutual. Reinsurance contracts do not relieve Harleysville Group of primary liability as the originating insurer. After excluding reinsurance
transactions with Mutual under the pooling arrangement, the effect of Harleysville Group’s share of other reinsurance on premiums written and earned is as follows:
Losses and loss settlement expenses are net of reinsurance recoveries of $117,687,000, $38,172,000 and $68,852,000 for 2003, 2002 and 2001, respectively.
Rental expense under leases with non-affiliates amounted to $2,960,000, $2,469,000 and $2,832,000 for 2003, 2002 and 2001, respectively. Operating lease commitments were not material at December 31, 2003.
Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Litigation on bodily injury liability cases has increased during the past two years while the rate of settlement has slowed. These changed patterns give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury liability claims. There are uncertainties regarding future loss cost trends particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past.
The fair value of the notes was $94,706,000 and $76,069,000 at December 31, 2003 and 2002, respectively, based on quoted market prices for the same or similar debt. The carrying value of the remaining debt approximates fair value.
The EDC obligation is secured by Lake States’ building. Interest is payable semiannually at a variable rate (1.4% at December 31, 2003) equal to the market interest rate that would allow the bonds to be remarketed at par value. The bonds are subject to redemption prior to maturity in 2006 at levels dependent upon the occurrence of certain events.
Interest paid was $5,436,000, $5,599,000 and $6,134,000 in 2003, 2002 and 2001, respectively.
Various states have adopted the National Association of Insurance Commissioners (NAIC) risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company’s operations. These RBC standards have not affected the operations of Harleysville Group since each of the Company’s insurance subsidiaries has statutory capital and surplus in excess of RBC requirements.
The actual income tax rate differed from the statutory federal income tax rate applicable to income (loss) before income taxes as follows:
The tax effects of the significant temporary differences that give rise to deferred tax liabilities and assets are as follows:
Under Harleysville Group Inc.’s 1995 Agency Stock Purchase Plan, eligible independent insurance agencies may invest up to $12,500 in shares of common stock at 90% of the fair market value at the end of each six-month subscription period. There are 1,000,000 shares of common stock available under the plan. There were 41,984, 43,174 and 29,980 shares issued under the plan for which $76,000, $76,000 and $180,000 of expense was recognized in 2003, 2002 and 2001, respectively.
Harleysville Group Inc. has a pension plan that covers substantially all full-time employees. Retirement benefits are a function of both the years of service and level of compensation. Harleysville Group Inc.’s funding policy is to contribute annually an amount equal to at least the minimum required contribution in accordance with minimum funding standards established by ERISA. Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. Harleysville Group Inc. uses a December 31, measurement date for the pension plan.
The accumulated benefit obligation for the entire plan was $146,456,000 and $121,950,000 at December 31, 2003 and 2002, respectively.
Harleysville Group’s pension plan asset allocations at December 31, 2003 and 2002 are as follows:
The pension plan assets are managed to maximize total return over the long-term while providing sufficient liquidity and current return in order to satisfy the cash flow requirements of the plan. In order to meet these objectives, the target allocation for equity securities is a range of 65% to 75% of the market value of the fund’s portfolio and the target allocation for debt securities is a range of 25% to 35% of the market value of the fund’s portfolio.