The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with the Mutual Company. Harleysville Group’s participation was 72% for all years presented. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and Note 2(a) of the Notes to Consolidated Financial Statements.
Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to the Company’s growth and economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on Harleysville Group. There can be no assurance that future developments will be in accordance with management’s expectations. Actual financial results, including premium growth and underwriting results, could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; catastrophe losses; competition in insurance product pricing; government regulation and changes therein which may impede the ability to charge adequate rates; performance of the financial markets; fluctuations in interest rates; availability and price of reinsurance; the A. M. Best rating of Harleysville Group; and the status of labor markets in which the Company operates.
Variations on investment income are subject to a number of factors, including
The Company seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside of the control of the Company.
The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require Harleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements). Harleysville Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and estimation. The judgments, or the methodology on which the judgments are made, are reviewed quarterly with the Audit Committee.
Historically, Harleysville Group’s results of operations have been influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry have been subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.
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.
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, 2006 and 2005. The Mutual Company has an A. M. Best rating of “A-” (Excellent).
Harleysville Group has attempted to reduce the potential impact of future catastrophes by achieving greater geographic distribution of risks, reducing exposure in catastrophe-prone areas and through reinsurance, including an agreement with the Mutual Company. Effective January 1, 1997, Harleysville Group entered into a reinsurance agreement with the Mutual Company whereby the Mutual Company, in return for a reinsurance premium, reinsured accumulated catastrophe losses up to $14.4 million in a quarter for 2005 and 2004. This reinsurance coverage was in excess of a retention of $3.6 million in a quarter for 2005 and 2004. The agreement excluded catastrophe losses resulting from earthquakes, terrorism or hurricanes, and supplemented the existing external catastrophe reinsurance program. Under this agreement, Harleysville Group ceded no premiums earned to the Mutual Company in 2006 and premiums earned of $8.8 million and $8.6 million for 2005 and 2004, respectively. Losses incurred of $0.2 million, $(0.2) million, and $0.7 million for 2006, 2005, and 2004, respectively were ceded to the Mutual Company under the agreement. The premiums for this reinsurance were established in consultation with an independent actuarial firm. The agreement was terminated December 31, 2005 and the coverage was not replaced as it is no longer deemed necessary based on the current catastrophe risk profile.
Harleysville Ltd. is a subsidiary of the Company and leases the home office to the Mutual Company, which shares the facility with Harleysville Group. Rental income under the lease was $4.1 million, $4.0 million and $3.7 million for 2006, 2005 and 2004, respectively, and is included in other income after elimination of intercompany amounts of $2.5 million in 2006, $2.4 million in 2005 and $2.3 million in 2004. The lease has a five-year term expiring December 31, 2009 and includes a formula for additional rent for any additions, improvements or renovations. The Mutual Company 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.
Harleysville Group borrowed $18.5 million from the Mutual Company in connection with the acquisition of Mid-America and HIC New York in 1991. It was a demand loan with a stated maturity in March 1998 which had been extended to March 2005. In February 2005, the maturity was extended again to March 2012 and the interest rate became LIBOR plus 0.45%, which was a commercially reasonable market rate in 2005. Interest expense on this loan was $1.0 million, $0.7 million and $0.4 million in 2006, 2005 and 2004, respectively.
Harleysville Group holds securities with unrealized losses at December 31, 2006 as follows:
The improved underwriting results were primarily due to improved underwriting results in both commercial and personal lines.
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 decreased to 98.6% for the year ended December 31, 2006 from 102.2% for the year ended December 31, 2005. Such decrease was due to improved underwriting results in both commercial lines and personal lines, primarily resulting from improved loss experience, partially offset by greater catastrophe losses and higher underwriting expenses in 2006.
The statutory combined ratios by line of business for the year ended December 31, 2006 as compared to the year ended December 31, 2005 were as follows:
The commercial lines statutory combined ratio decreased to 100.3% for the year ended December 31, 2006 from 104.3% for the year ended December 31, 2005. The decrease is primarily due to declines in the combined ratio for all lines of business due to improved loss severity. The personal lines statutory combined ratio decreased to 90.6% for the year ended December 31, 2006 from 93.1% for the year ended December 31, 2005. The decrease is primarily due to improved property results in the homeowners line, partially offset by higher catastrophe losses.
Increase (Decrease) in the Liability for Unpaid Losses and Loss Settlement Expenses
A reduction in commercial automobile severity in accident years 2002 through 2004 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in commercial automobile severity in accident year 2005 and in accident years prior to 2002 was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $5.1 million in favorable development was recognized in the commercial automobile line during 2006.
A reduction in workers compensation severity in accident years 2002 through 2005 was observed during 2006 and led to the recognition of favorable development for those accident years in 2006. An increase in workers compensation medical severity in accident years 1997 through 2001 was observed during 2006 and led to the recognition of adverse development for those accident years in 2006. In total, $0.3 million in adverse development was recognized in the workers compensation line during 2006.
A reduction in homeowners severity was broadly observed during 2006 and led to the recognition of favorable development of $5.5 million in this line in 2006.
Reinsurance receivables were $167.2 and $249.0 million at December 31, 2006 and 2005, respectively. Of these amounts, $93.9 million and $183.9 million, respectively or 56% and 74%, respectively, of the receivables were due from governmental bodies, regulatory agencies or quasi governmental pools and reinsurance facilities where, Harleysville Group believes, there is virtually no credit risk. The decrease in the amounts due from these types of pools and facilities is primarily based on a decrease of $85.1 million in the amount due from the National Flood Insurance Program primarily as a result of settling 2005 claims arising from Hurricane Katrina. The remainder of the reinsurance recoverables are principally due from reinsurers rated A- or higher by the A.M. Best Company.
The income tax expense for the year ended December 31, 2006 includes the tax benefit of $8.6 million associated with tax-exempt income compared to $10.2 million in the prior year.
Harleysville Group froze its defined benefit pension plan at the then current benefit levels as of March 31, 2006. Harleysville Group's portion of pension expense for the plan was $1.9 million and $9.7 million for 2006 and 2005, respectively. Harleysville Group enhanced 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, and recognized expense of $2.9 million in 2006 due to this enhancement.
Other income increased $1.2 million for the year ended December 31, 2006 primarily due to an increase of $1.7 million in claim handling fees received in connection with the National Flood Insurance Program, related primarily to flood claims from Hurricane Katrina.
Premiums earned increased $3.9 million for the year ended December 31, 2005. The increase was primarily due to an increase in premiums earned for commercial lines of $22.7 million, partially offset by a decrease of $18.8 million in personal lines premiums earned. The increase in premiums earned for commercial lines was primarily due to higher average premiums partially offset by fewer policy counts in the commercial automobile and workers compensation lines of business. The decline in premiums earned for personal lines was primarily due to fewer policy counts. The reduction in personal lines volume was driven primarily by a reduction of personal automobile business from the continued implementation of more stringent underwriting processes.
Investment income increased $3.4 million for the year ended December 31, 2005, resulting from an increase in invested assets partially offset by a lower yield on the fixed maturity investment portfolio.
Realized investment gains decreased $12.4 million for the year ended December 31, 2005, primarily resulting from gains on the sale of two equity securities in the first quarter of 2004.
Harleysville Group's statutory combined ratio decreased to 102.2% for the year ended December 31, 2005 from 105.9% for the year ended December 31, 2004. Such decrease was due to improved underwriting results in both commercial lines and personal lines, primarily resulting form improved loss experience and lower catastrophe losses in 2005. The improved loss experience reflects lower claims severity in general and lower claim frequency in property coverage.
Other expense decreased $1.4 million for the year ended December 31, 2005 primarily related to the write-off of capitalized costs for a software project during the year ended December 31, 2004.
In February 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 155, "Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140." This accounting standard permits fair value remeasurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year beginning after September 15, 2006. The impact of adopting this statement on Harleysville Group's results of operations and financial condition is not material.
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, 2006, Harleysville Group held cash collateral of $124.8 million related to securities on loan with a market value of $121.0 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 $22.0 million of cash and marketable securities at December 31, 2006, 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, 2006.
Applying the current regulatory restrictions as of December 31, 2006, $117.5 million would be available for distribution to the Company by its subsidiaries in 2007 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.
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 8 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.
The demand for property and casualty insurance, particularly commercial lines, also can vary with the overall level of economic activity.
We can offer no assurances that the threats of future terrorist-like events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.
New competition from these developments could cause the supply or demand for insurance to change, which could adversely affect our results of operations and financial condition.
Our principal assets are the shares of capital stock of our insurance company subsidiaries. We principally rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations and for paying corporate expenses and dividends to shareholders. As described below, the payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as other regulatory restrictions. As a result, we may not be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our obligations or to allow us to pay dividends.
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 dividends to us of $15.0 million in 2005, and $26.6 million in 2004. No dividends were paid in 2006. Applying the current regulatory restrictions as of December 31, 2006, $117.5 million would be available for distribution to us without prior approval during 2007. We anticipate no objections to the payment of the dividends described in the preceding sentence.
Available for sale, at fair value (amortized cost $1,600,940 and $1,235,841)
Available for sale, at fair value (amortized cost $116,711 and $138,718)
Premiums earned from affiliate (ceded to affiliate, $742,752, $749,085 and $740,416)
Harleysville Group consists of Harleysville Group Inc. and its subsidiaries (all wholly owned). Those subsidiaries are:
Harleysville Group has several share-based compensation plans. Harleysville Group had accounted for the plans under the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation expense was recognized prior to 2006 for fixed stock option grants and an employee stock purchase plan. Effective January 1, 2006, Harleysville Group adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123(R)), which replaces SFAS No. 123 and supercedes APB Opinion No. 25, using the modified prospective application provisions. SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements.
In February 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140." This accounting standard permits fair value remeasurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year beginning after September 15, 2006. The impact of adopting this statement on Harleysville Group's results of operations and financial condition is not material.
Harleysville Group Inc. received $6,420,000, $6,697,000 and $6,782,000 of management fee income in 2006, 2005 and 2004, respectively, under agreements whereby Harleysville Group Inc. provides management services to Mutual and other affiliates. Such amounts are included in other income.
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 $1,016,000, $699,000 and $395,000 in 2006, 2005 and 2004, respectively.
Harleysville Group has off-balance-sheet credit risk related to approximately $77,000,000 and $73,000,000 of premium balances due to Mutual from agents and insureds at December 31, 2006 and 2005, respectively.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2006 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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. There are $603.4 million in fixed maturity securities, at fair value, that at December 31, 2006, had been below amortized cost for over 12 months. The $15.0 million of unrealized losses on such securities primarily relates to securities which carry an investment grade debt rating and have declined in fair value roughly in line with market interest rate changes. Harleysville Group currently has the ability and intent to hold these securities until recovery.
Income taxes on realized investment gains were $14,212,000, $81,000 and $4,433,000 for 2006, 2005 and 2004, respectively.
Deferred income tax liabilities applicable to net unrealized investment gains included in shareholders’ equity were $4,808,000 and $18,371,000 at December 31, 2006 and 2005, respectively.
At December 31, 2006, Harleysville Group held cash collateral of $124,755,000 related to securities on loan with a market value of $121,028,000. 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.
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:
Property and equipment consisted of land and buildings with a cost of $29,679,000 and $29,220,000, and equipment, including software, with a cost of $11,579,000 and $12,542,000 at December 31, 2006 and 2005, respectively. Accumulated depreciation related to such assets was $24,568,000 and $23,724,000 at December 31, 2006 and 2005, respectively.
Rental expense under leases with non-affiliates amounted to $3,033,000, $2,753,000 and $3,073,000 for 2006, 2005 and 2004, respectively. Operating lease commitments were not material at December 31, 2006.
In 2006, Harleysville Group recognized net favorable development of $18,085,000 in the provision for insured events of prior years, primarily due to lower-than-expected claims severity in casualty lines in accident years 2002 through 2005, partially offset by adverse development in prior accident years. The favorable development consisted of $8,096,000 in commercial lines and $9,989,000 in personal lines.
The fair value of the notes was $97,394,000 and $97,515,000 at December 31, 2006 and 2005, respectively, based on quoted market prices for the same or similar debt. The carrying value of the remaining debt approximates fair value.
Interest paid was $6,760,000, $6,462,000 and $6,174,000 in 2006, 2005 and 2004 respectively.
Cash paid (refunded) for federal income taxes in 2006, 2005 and 2004 was $32,750,000, $14,100,000 and $(11,659,000), respectively.
A summary of share option activity under the plan is as follows:
For share options and restricted stock awards granted under the plan, the Company recognized compensation expense of $3,109,000 in 2006. The Company recognized compensation expense for restricted stock of $61,000 and $57,000 in 2005 and 2004, respectively. As of December 31, 2006 the Company's total unrecognized compensation cost related to nonvested share-based compensation arrangements (including share options and restricted stock awards) granted under the plan was $4,086,000. The cost is expected to be recognized over a weighted average period of 2.8 years.
The Long Term Incentive Plan (LTIP) provides for the issuance of up to 600,000 shares of Harleysville Group Inc. common stock, which may be authorized and unissued shares or treasury shares. Shares are awarded to key employees based on the total shareholder return of the Company's stock relative to the total shareholder return of a group of insurance company stocks for a three year period. Current plans are in effect for the three year period January 1, 2004 through December 31, 2006 and January 1, 2005 through December 31, 2007. The fair value of the stock component of the plan was estimated on the date of grant using a 10,000 trial simulation with the following assumptions:
The weighted-average grant date fair value of the 2004-2006 plan and 2005-2007 plan stock awards was $19.65 and $19.64 per share, respectively. Compensation expense of $823,000, $832,000 and $500,000 was recognized related
Cash received from option exercises under all share-based payment arrangements for 2006, 2005 and 2004 was $20,050,000, $5,101,000 and $3,684,202, respectively. The actual tax benefit realized for the tax deductions from option exercises of the share-based payment arrangements was $3,281,000, $557,828 and $299,000, respectively, for 2006, 2005 and 2004.
Harleysville Group has incentive bonus plans. The plans were amended in 2006 to include virtually all employees. Cash bonuses are earned on a formula basis depending upon the performance of Harleysville Group and Mutual in relation to certain targets. Harleysville Group’s expense for such plans was $6,901,000, $3,836,000 and $1,495,000 for 2006, 2005 and 2004, 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 for benefits attributed to service through March 31, 2006. Harleysville Group Inc. uses a December 31, measurement date for the pension plan. The plan was frozen at the then current benefit levels as of March 31, 2006, at which time the accrual of future benefits for eligible employees ceased. 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 $146,000 was recognized in the first quarter of 2006.
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, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, Harleysville Group Inc. and Subsidiaries adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”, on January 1, 2006.