limitation on available business arising from a need to maintain the quality of underwritten risks
The application of certain of these critical accounting policies to the years ended December 31, 2005 and 2004 is discussed in greater detail below.
Harleysville Group’s premium growth and underwriting results have been, and continue to be, influenced by market conditions. Insurance industry price competition has often made it difficult both to obtain and to retain properly priced personal and commercial lines business. It is management’s policy to maintain its underwriting standards, even at the expense of premium growth.
Harleysville Ltd. is a subsidiary of the Company and leases the home office to Mutual, which shares the facility with Harleysville Group. Rental income under the lease was $4.0 million, $3.7 million and $3.6 million for 2005, 2004 and 2003, respectively, and is included in other income after elimination of intercompany amounts of $2.4 million in 2005, $2.3 million in 2004 and $2.2 million in 2003. The lease has been renewed for a five-year term expiring December 31, 2009 and includes a formula for additional rent for any additions, improvements or renovations. Mutual is responsible for the building operating expenses including maintenance and repairs. The pricing of the lease was based upon an appraisal obtained from an independent real estate appraiser.
There are 30 positions that comprise the unrealized loss in equity investments at December 31, 2005. All have had volatile price movements and have not been significantly below cost for significant continuous amounts of time. Harleysville Group has been monitoring these securities and it is possible that some may be written down in the income statement in the future.
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. The investment in these securities generally took place between January 2000 and August 2001. The fair value of the EETCs reflects the market price of the securities provided by our custodian bank, the Bank of New York, through an unaffiliated third party pricing service. The collateral associated with the EETCs consists of large pools of late model aircraft, which are essential components of their carriers’ fleets. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. The collateral securing the airline EETCs is attributed a value in excess of the security primarily as a result of common practice with respect to EETC collateral valuation. The value of the collateral securing the EETCs is directly related to the current supply and demand for aircraft, and, because supply and demand for aircraft is affected by geopolitical events, the EETC market applies a credit buffer to the value of the collateral which is designed to build in a margin for the risk that future geopolitical events could have a severe economic impact on the airline industry in general and EETC issuers specifically. According to the most recent (August 2005) report provided by JP Morgan, the market value of the aircraft collateral underlying the EETCs exceeds the cost of our A Tranche holdings. The report was prepared by JP Morgan based on its own research as well as research from Aviation Specialists Group. The fair value of the EETCs has increased since 2001, when the fair value first went below cost. Harleysville Group currently has the ability and intent to continue to maintain its holdings in the EETC investments until maturity. In February 2006, holders of Subordinate B Tranche securities in the United Airlines 2000-1 EETC exercised their right to invoke a mandatory purchase of all outstanding A Tranche bonds with respect to the United Airlines 2000-1 EETCs at par plus interest due and accrued. As a result of this transaction, Harleysville Group received a principal payment of $6.6 million, plus accrued interest, representing repayment of the United Airlines EETC maturing in 2012. It is possible that the remaining 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.
The statutory combined ratios by line of business for the year ended December 31, 2005 as compared to the year ended December 31, 2004 were as follows:
A reduction in workers compensation severity in accident years 2004 and 2003 was observed during 2005 and led to the recognition of favorable development for those accident years in 2005. An increase in workers compensation severity in accident years prior to 2003 was observed during 2005 and led to the recognition of adverse development for those accident years in 2005. In total, $0.5 million in adverse development was recognized in the workers compensation line during 2005.
A reduction in both personal automobile and homeowners severity was broadly observed during 2005 and led to the recognition of favorable development for those lines of business in 2005. In total, $9.6 million in favorable development was recognized in the personal automobile line and $4.8 million in favorable development was recognized in the homeowners line during 2005.
In January 2006, Harleysville Group announced that it will freeze its defined benefit pension plan at current benefit levels as of March 31, 2006, and that it will enhance its 401(K) retirement savings plan to provide for a company contribution equal to 5% of salary for all eligible employees, effective April 1, 2006. As a result of these changes, Harleysville Group expects to reduce annualized operating expenses by approximately $5.0 million. In connection with the freeze of the defined benefit plan, a curtailment charge of $0.5 million was recognized in the fourth quarter of 2005. A curtailment benefit of approximately $0.3 million will be recognized in the first quarter of 2006 in connection with the freeze of the supplemental executive retirement plan as of March 31, 2006.
Harleysville Group expects, subject to shareholder approval, to make enhancements to its incentive compensation programs for employees in 2006 that will result in approximately $1.7 million of additional annualized expense.
Harleysville Group’s statutory combined ratio decreased to 105.9% for the year ended December 31, 2004, from 123.2% for the year ended December 31, 2003. Such decrease was due to improved underwriting results in both commercial lines and personal lines, primarily resulting from the lower loss development and lower catastrophe losses.
The statutory combined ratios by line of business for the year ended December 31, 2004, as compared to the year ended December 31, 2003, were as follows:
The personal lines statutory combined ratio decreased to 102.8% for the year ended December 31, 2004 from 121.8% for the year ended December 31, 2003. In addition to the aforementioned effects of favorable development, the remaining decrease primarily was due to lesser catastrophe losses which affected the homeowners line.
Net cash used by investing activities was $149.8 million and $112.7 million for 2005 and 2004, respectively. The change is primarily due to increased net purchases of investments due to the increase in cash provided by operating activities.
Financing activities used net cash of $15.2 million and $16.1 million for 2005 and 2004, respectively. The change was primarily due to an increase in the issuance of common stock, partially offset by an increase in the repayment of debt and an increase in dividends paid.
The Company had $20.1 million of cash and marketable securities at December 31, 2005, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. Harleysville Group has no material commitments for capital expenditures as of December 31, 2005.
As a holding company, the Company’s principal source of cash for the payment of dividends is dividends from its subsidiaries. The Company’s insurance subsidiaries are subject to state laws that restrict their ability to pay dividends.
Applying the current regulatory restrictions as of December 31, 2005, $62.8 million would be available for distribution to the Company by its subsidiaries in 2006 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.
The following summarizes Harleysville Group’s contractual obligations at December 31, 2005.
You should consider carefully the following risks, as well as the other information contained in this 2005 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 adversely affected. You should refer to the other information set forth in this 2005 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. In the last 7 years, the largest non-flood 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 heavily regulated in the states in which we operate and if we violate those regulations or if the regulations unreasonably restrict our ability to do business, or if they change significantly, it could have an adverse effect on our business.
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
The demand for property and casualty insurance, particularly commercial lines, also can vary with the overall level of economic activity. In addition to the cyclicality of the property and casualty industry, our surety business is affected adversely by economic downturns that make it difficult for the insureds whose obligations we guarantee to fulfill their obligations.
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
We are subject to the application of GAAP and other accounting standards, which are periodically revised and/or expanded. As such, we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in material adverse impacts on our results of operations and financial condition.
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 distribution channel and from new competitors.
We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors’ insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to
Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary for the preceding year. Our insurance subsidiaries paid $15.0 million of dividends to us in 2005, $26.6 million in 2004, and none in 2003. Of the dividends paid in 2004, $11.6 million were declared by our insurance subsidiaries in 2002. Applying the current regulatory restrictions as of December 31, 2005, $62.8 million would be available for distribution to us without prior approval during 2006. We anticipate no objections to the payment of the dividends described in the preceding sentence.
Applicable insurance laws and certain provisions in our certificate of incorporation make it difficult to effect a change of control of our Company, and a large shareholder may have significant influence over potential change of control transactions, which could affect our share value.
Available for sale, at fair value (amortized cost $1,235,841 and $1,028,457)
Available for sale, at fair value (amortized cost $138,718 and $128,183)
The accompanying financial statements include the accounts of Harleysville Group prepared in conformity with U.S. generally accepted accounting principles, which differ in some respects from those followed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated in consolidation.
Realized gains and losses on sales of investments are recognized in net income on the specific identification basis. A decline in the fair value of an investment below its cost that is deemed other than temporary is charged to earnings. 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.
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, 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 acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.
In September 2005, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company does not expect the impact of adopting SOP 05-1 to have a material impact on the consolidated financial statements.
Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recognized for fixed stock option grants and an employee stock purchase plan. Compensation expense would be recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. The following table illustrates the effect on net income (loss) and earnings (loss) per share as 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.
Plus: Stock-based employee compensation expense (benefit) included in reported net income (loss), net of related tax effects
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 2005, 2004, and 2003.
The following amounts represent reinsurance transactions between Harleysville Group and Mutual under the pooling arrangement:
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. Interest expense on the loan from Mutual described in Note 7 was $699,000, $395,000 and $341,000 in 2005, 2004 and 2003, respectively.
The amortized cost and estimated fair value of investments, including amounts on loan under the securities lending agreement, in fixed maturity and equity securities are as follows:
The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2005 and 2004 amounted to $34,883,000 and $33,429,000, respectively.
Of the total fixed maturity securities with an unrealized loss at December 31, 2005, securities with a fair value of $584.7 million and an unrealized loss of $10.8 million are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $144.9 million and an unrealized loss of $3.8 million are classified as held to maturity on the balance sheet and are carried at amortized cost.
value roughly in line with market interest rate changes. The remaining $0.7 million of unrealized losses are comprised of airline enhanced equipment trust certificates (EETC) as follows:
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. The investment in these securities generally took place between January 2000 and August 2001. The fair value of the EETCs reflects the market price of the securities provided by our custodian bank, the Bank of New York, through an unaffiliated third party pricing service. The collateral associated with the EETCs consists of large pools of late model aircraft, which are essential components of their carriers’ fleets. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. The collateral securing the airline EETCs is attributed a value in excess of the security primarily as a result of common practice with respect to EETC collateral valuation. The value of the collateral securing the EETCs is directly related to the current supply and demand for aircraft, and, because supply and demand for aircraft is affected by geopolitical events, the EETC market applies a credit buffer to the value of the collateral which is designed to build in a margin for the risk that future geopolitical events could have a severe economic impact on the airline industry in general and EETC issuers specifically. According to the most recent (August 2005) report provided by JP Morgan, the market value of the aircraft collateral underlying the EETCs exceeds the cost of our A Tranche holdings. The report was prepared by JP Morgan based on its own research as well as research from Aviation Specialists Group. The fair value of the EETCs has increased since 2001, when the fair value first went below cost. Harleysville Group currently has the ability and intent to continue to maintain its holdings in the EETC investments until maturity. In February 2006, holders of Subordinate B Tranche securities in the United Airlines 2000-1 EETC exercised their right to invoke a mandatory purchase of all outstanding A Tranche bonds with respect to the United Airlines 2000-1 EETC’s at par plus interest due and accrued. As a result of this transaction, Harleysville Group received a principal payment of $6.6 million, plus accrued interest, representing repayment of the United Airlines EETC maturing in 2012. It is possible that the remaining EETCs may be written down in the income statements in the future, depending upon developments involving both the issuers and world events which impact the level of air travel.
There are 30 positions that comprise the unrealized loss in equity investments at December 31, 2005. All have had volatile price movements and have not been significantly below cost for significant continuous amounts of time.
Deferred income taxes applicable to net unrealized investment gains included in shareholders’ equity were $18,371,000 and $29,623,000 at December 31, 2005 and 2004, respectively.
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:
Harleysville Group recognized favorable development in the provision for insured events of prior years of $17,533,000 in 2005 primarily due to lower-than-expected claims severity in accident years 2004 and 2003, partially offset by greater-than-expected claims severity in commercial lines in 2002 and prior accident years. The favorable development consisted of $3,940,000 in commercial lines and $13,593,000 in personal lines.
The fair value of the notes was $97,515,000 and $95,022,000 at December 31, 2005 and 2004, 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 was paid in 2005.
Interest paid was $6,462,000, $6,174,000 and $5,436,000 in 2005, 2004 and 2003 respectively.
Unrealized investment holding gains (losses) arising during period, net of taxes (benefits) of $(11,170), $(2,099)
Reclassification adjustment for (gains) losses included in net income, net of (taxes) benefits of $(81), $(4,419) and $541
Cash paid (refunded) for federal income taxes in 2005, 2004 and 2003 was $14,100,000, $(11,659,000) and $(3,465,000), respectively.
Harleysville Group has an Equity Incentive Plan (EIP) for key employees. Awards may be made in the form of stock options, stock appreciation rights (SARs), restricted stock or any combination of the above. The EIP was amended in 1997 and limited future awards to an aggregate of 4,260,946 shares of Harleysville Group Inc.’s common stock. The plan provides that stock options may become exercisable from six months to 10 years from the date of grant with an option price not less than fair market value on the date of grant. The options normally vest 50% at the end of one year and 50% at the end of two years from the date of grant. SARs have not been material. Restricted stock awards for 52,222 shares of common stock were granted in 2005, for which expense of $188,000 was recognized. These awards vest over a three year period.
Information regarding activity in Harleysville Group’s fixed stock option plans is presented below:
The income tax benefit related to the difference between the market price at the date of exercise and the option price for non-qualified stock options was credited to additional paid-in capital.
The 1996 Directors’ Stock Purchase Plan provides for the issuance of up to 200,000 shares of Harleysville Group Inc. common stock to outside directors of Harleysville Group Inc. and Mutual. The purchase price of the stock is 85% of the lower of the beginning-of-the-subscription-period or end-of-the-subscription-period fair market value. In 2005, 2004 and 2003 respectively, there were 3,887, 4,475 and 8,038 shares issued under the plan for which $23,000, $12,000 and $30,000 of expense was recognized. This plan was discontinued and the last subscription period ended January 14, 2005.
The 2005 Non-Employee Directors’ Deferred Stock Unit Plan provides for the grant of up to 110,000 fully vested deferred stock units to outside directors of Harleysville Group Inc. and Mutual. Each stock unit represents the right to receive, without payment to the Company, one share of common stock of Harleysville Group Inc. At each April Board of Directors meeting, through the April 2009 meeting, each non-employee director shall receive a number of deferred stock units equal to the result of dividing $30,000 by the fair market value of a share of HGI common stock. In 2005, there were 13,500 deferred stock units issued under the plan for which $232,000 of expense was recognized.
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 plan will be frozen at the current benefit levels as of March 31, 2006, at which time the accrual of future benefits for eligible employees will cease. The curtailment loss for the qualified plan has been reflected in the year-end status of the plan as of December 31, 2005 and in the net periodic pension cost for 2005. The curtailment benefit for the supplemental executive retirement plan of approximately $300,000 will be recognized in the first quarter of 2006.
The following table sets forth the year-end status of the plan including Mutual:
Harleysville Group’s pension plan asset allocations at December 31, 2005 and 2004 are as follows:
Harleysville Group evaluates the performance of the personal lines and commercial lines primarily based upon underwriting results as determined under statutory accounting practices (SAP). Assets are not allocated to the personal and commercial lines, and are reviewed in total by management for purposes of decision making. Harleysville Group operates only in the United States, and no single customer or agent provides 10 percent or more of revenues.
The computation of basic and diluted earnings (loss) per share is as follows:
We have audited the accompanying consolidated balance sheets of Harleysville Group Inc. and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.