At December 31, 2004, Harleysville Group Inc. (Company) was approximately 56% 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 consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, 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.
Harleysville Group has written down to fair value, without exception, any equity security that has declined below cost by more than 20% and maintained such decline for six months, or by 50% or more, in the quarter in which either such decline occurred. In some cases, securities that have declined by a lesser amount or for a shorter period of time are written down if the evaluation indicates the decline is other than temporary. For example, one equity security had declined for a short period of time but was written down in the fourth quarter of 2002 when the sale of the company at a value less than our cost was announced. Fair value of equity securities is based on the closing market value as reported by a national stock exchange or Nasdaq. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities but Harleysville Group does not own a material amount of non-traded securities.
paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the 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.
The key elements of Harleysville Group’s business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner that assures claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general as described above and factors unique to Harleysville Group as described in the following discussion.
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 Mutual. However, the pooling agreement provides for the right of offset and the amount of credit risk with Mutual was not material at December 31, 2004 and 2003. Mutual has an A. M. Best rating of “A-” (Excellent).
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 $3.7 million, $3.6 million and $3.5 million for 2004, 2003 and 2002, respectively, and is included in other income after elimination of intercompany amounts of $2.3 million in 2004 and $2.2 million in 2003 and 2002. 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.
Harleysville Group borrowed $18.5 million from Mutual 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. In February 2005, the maturity was extended 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 $0.4 million, $0.3 million and $0.5 million in 2004, 2003, and 2002, respectively.
Premiums earned increased $14.3 million, or 1.7% for the year ended December 31, 2004. The increase was primarily due to an increase in premiums earned for commercial lines of $35.5 million, or 5.6%, partially offset by a decrease of $21.2 million, or 10.9%, in personal lines premiums earned. The increase in premiums earned for commercial lines primarily was due to higher rates 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. The reduction in personal lines volume was driven primarily by a reduction in personal automobile business from the continued implementation of more stringent underwriting processes.
Income (loss) before income taxes increased $145.1 million for the year ended December 31, 2004 compared to the same prior year period. The increase was primarily due to a lesser underwriting loss and greater realized investment gains.
The lesser underwriting loss was primarily due to lesser loss frequency, a decrease in the provision for insured events in prior years and lower catastrophe losses. The 2004 provision for insured events in prior years was $12.5 million of net adverse development compared to $119.1 million of net adverse development in 2003.
Statutory pension expense totaled $6.7 million in 2004 and $18.2 million in 2003, and added 0.8 points and 2.2 points to the combined ratios for 2004 and 2003, respectively. However, GAAP pension expense totaled $6.2 million in 2004 and $4.7 million in 2003 and thus had a lesser impact on GAAP earnings comparisons.
The 2003 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 continued in 2004 as increased litigation and a slow 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.
Harleysville Group records the actuarial best estimate of the ultimate unpaid losses and loss settlement expenses incurred. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.
A statistically determined range of estimates of the ultimate unpaid losses and loss settlement expenses incurred for commercial lines is $834.6 million to $1,097.2 million and for personal lines is $120.2 million to $151.4 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.
The property and casualty industry has had substantial aggregate loss experience from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures. Harleysville Group has not incurred significant losses from such claims.
Other expenses increased $1.1 million for the year ended December 31, 2004 primarily due to the write-off of capitalized costs for a software project that will not be utilized.
The insurance industry has recently received adverse publicity about alleged anti-competitive activities by certain insurance brokers and insurers. Harleysville Group primarily distributes its products through its agents and writes less than 1% of its premiums through brokers. There are no contingent commission arrangements with such brokers.
Investment income increased $0.3 million for the year ended December 31, 2003, resulting from an increase in invested assets, partially offset by a lower yield on the fixed maturity investment portfolio.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. The compensation cost will be measured based on the fair value of the equity or liability instruments issued. The Statement is effective as of the beginning of the first interim or annual period beginning after June 15, 2005. The impact of adopting SFAS No. 123(R) on net income and earnings per share is not currently expected to be materially different from the pro forma amounts disclosed in Note 1 of the Notes to Consolidated Financial Statements, which includes all share-based payment transactions through December 31, 2004. The impact that any future share-based payment transactions will have on our financial position or results of operations is not yet known.
Net cash provided by operating activities was $115.7 million and $134.6 million for 2004 and 2003, respectively. The decrease in net cash provided by operating activities primarily consists of a decrease in cash provided by underwriting activities.
Net cash used by investing activities was $112.7 million and $127.3 million for 2004 and 2003, respectively. The change is primarily due to decreased net purchases of investments due to the decrease in cash provided by operating activities.
Financing activities used net cash of $16.1 million in 2004 and provided net cash of $3.2 million in 2003. The change was primarily due to a decline in the net issuance of debt and an increase in dividends paid, partially offset by a decline in 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, 2004, Harleysville Group held cash collateral of $139.5 million related to securities on loan with a market value of $136.0 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 $23.2 million of cash and marketable securities at December 31, 2004, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. Harleysville Group Inc. has adopted a stock repurchase plan under which it may, from time to time, repurchase up to 500,000 shares of Harleysville Group Inc. common stock. Mutual had authorized purchases of the common shares of Harleysville Group Inc. in an equal amount. At March 1, 2005, the authorization had expired and the Company had repurchased 397,909 of the shares authorized to be repurchased. Harleysville Group has no material commitments for capital expenditures as of December 31, 2004.
Applying the current regulatory restrictions as of December 31, 2004, $51.0 million would be available for distribution to the Company by its subsidiaries in 2005 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.
Harleysville Group had off-balance-sheet credit risk related to $71.0 million of premium balances due to Mutual from agents and insureds at December 31, 2004.
The table above does not include capital lease obligations, operating lease obligations or purchase obligations as they are either not applicable or not material. The timing of the amounts for the net liability for unpaid losses and loss settlement expenses are an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts stated above.
We are required to maintain loss reserves for our estimated liability for losses and loss settlement expenses associated with reported and unreported claims for each accounting period. We regularly review our reserving techniques and our overall amount of reserves and, based on our estimated liability, raise or lower the levels of our reserves accordingly. If our estimates are incorrect and our reserves are inadequate, we are obligated to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. For every 1% change in our reserve, our pre-tax income is affected by approximately $11.3 million. Our reserve amounts are estimated based on what we expect our ultimate liability for losses and loss settlement expenses to be. These estimates are based on facts and circumstances of which we are aware, predictions of future events, trends in claims severity and frequency and other subjective factors. Although we use a number of methods to project our ultimate liability, there is no method that can always exactly predict our ultimate liability for losses and loss settlement expenses.
fluctuations in interest rates and other changes in the investment environment that affect returns on our investments;
Many reinsurers experienced significant losses related to the terrorist acts of September 11, 2001, and future terrorist acts may have similar effects. As a result, we may incur significantly higher reinsurance costs and more restrictive terms and conditions, or may be unable to obtain reinsurance for some types of commercial exposures.
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 Harleysville Group, as well as a decrease in our stockholders’ equity, net income and/or revenue. The effects of changes related to Harleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002 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.
We are subject to the application of GAAP, which is periodically revised and/or expanded. As such, we are periodically 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.
Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenues and earnings. Any significant decline in our investment income as a result of falling interest rates, decreased dividend payment rates or general market conditions would have an adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholders’ equity and our policyholders’ surplus, which could impact our ability to write additional business.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Ratings are not recommendations to buy, hold or sell our securities.
Although other agencies cover the property and casualty industry, we believe our ability to write business is most influenced by our rating from A. M. Best. According to A. M. Best, its ratings are designed to assess an insurer’s financial strength and ability to meet ongoing obligations to policyholders. Currently, our rating from A. M. Best is “A-”, the 4th of A. M. Best’s 15 ratings. A rating below “A-” from A. M. Best could materially adversely affect the business we write. We believe that our financial strength rating from Moody’s (which is A3, the 7th of Moody’s 21 ratings), although important, has less of an impact on our business. An unfavorable change in our Moody’s financial strength rating, however, could make it more expensive for us to access capital markets. We cannot be sure that we will maintain our current A. M. Best or Moody’s ratings. Although Standard & Poor’s rates our debt securities at BBB-/Negative (the 10th of Standard & Poor’s 23 ratings), Standard & Poor’s does not currently rate our financial strength and ability to meet ongoing obligations.
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 $26.6 million of dividends to us in 2004, none in 2003, and $12.0 million in 2002. 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, 2004, $51.0 million would be available for distribution to us without prior approval during 2005. We anticipate no objections to the payment of the dividends described in the preceding sentence.
Harleysville Group is approximately 56% owned by Harleysville Mutual Insurance Company (Mutual).
fair value based method for all awards, 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 2004, 2003, and 2002.
Harleysville Ltd. leases the home office to Mutual, which shares the facility with Harleysville Group. Rental income under the lease was $3,697,000, $3,606,000 and $3,531,000 for 2004, 2003 and 2002, respectively, and is included in other income after elimination of intercompany amounts of $2,262,000, $2,207,000 and $2,161,000 in 2004, 2003 and 2002, respectively.
Harleysville Group Inc. received $6,782,000, $7,221,000 and $6,808,000 of management fee income in 2004, 2003 and 2002, respectively, under agreements whereby Harleysville Group Inc. provides management services to Mutual and other affiliates. Such amounts are included in other income.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2004 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 amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2004 and 2003 amounted to $33,429,000 and $30,949,000, respectively.
Of the total fixed maturity securities with an unrealized loss at December 31, 2004, securities with a fair value of $207.8 million and an unrealized loss of $3.5 million are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $79.8 million and an unrealized loss of $1.2 million are classified as held to maturity on the balance sheet and are carried at amortized cost.
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 $55.9 million in fixed maturity securities, at fair value, that at December 31, 2004, had been below amortized cost for over 12 months. Of the $2.3 million of unrealized losses on such securities, $0.7 million relates to securities which carry A or higher debt ratings and have declined in fair value roughly in line with market interest rate changes. The remaining $1.6 million of unrealized losses are comprised of airline enhanced equipment trust certificates (EETC) as follows:
There are eight positions that comprise the unrealized loss in equity investments at December 31, 2004. 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 $29,623,000 and $36,142,000 at December 31, 2004 and 2003, respectively.
Losses and loss settlement expenses are net of reinsurance recoveries of $84,960,000, $117,687,000 and $38,172,000 for 2004, 2003 and 2002, respectively.
Harleysville Group recognized favorable development in the provision for insured events of prior years of $4,648,000 in 2002 primarily related to lower-than-expected claim severity in the commercial and personal lines of business.
In establishing the liability for unpaid losses and loss settlement expenses, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known losses (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its
liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted losses. Estimates of the liabilities are reviewed and updated on a regular basis.
A source of cash for the payment of dividends is dividends from subsidiaries. Harleysville Group Inc.’s insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2004, $50,982,000 would be available for distribution to Harleysville Group Inc. during 2005 without prior approval.
Cash paid (refunded) for federal income taxes in 2004, 2003 and 2002 was $(11,659,000), $(3,465,000) and $13,250,000, respectively.
Harleysville Group maintains stock option plans for substantially all employees and certain designated agents. The plans provide for the granting of options to purchase a maximum of 850,000 shares of common stock. The plans provide that the options become exercisable from three to 10 years from the date of grant with an option price not less than fair market value on the date of grant.
The following table summarizes information about fixed stock options at December 31, 2004:
The per share weighted-average fair value of options granted during 2004, 2003 and 2002 was $5.64, $6.79 and $9.04, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004, 2003 and 2002, respectively: dividend yield of 3.53%, 2.84% and 2.21%; expected volatility of 38.67%, 38.99% and 37.34%; risk-free interest rate of 3.36%, 2.55% and 4.60%; and an expected life of 6 years, 5.25 years and 5.25 years.
Harleysville Group Inc. is authorized to issue up to 1,650,000 shares of common stock under the terms of the 1995 Employee Stock Purchase Plan as amended in 2003. Virtually all employees are eligible to participate in the plan, under which a participant may elect to have up to 15% of base pay withheld to purchase shares. 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. Each subscription period runs from January 15 through July 14, or July 15 through January 14. Under the plan, Harleysville Group Inc. issued 116,294, 95,048 and 92,175 shares to employees in 2004, 2003 and 2002, respectively.
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 2004, 2003 and 2002 respectively, there were 4,475, 8,038 and 9,647 shares issued under the plan for which $12,000, $30,000 and $31,000 of expense was recognized. This plan was discontinued and the last subscription period ends January 14, 2005.
Harleysville Group has incentive bonus plans. Cash and common stock bonuses are earned on a formula basis depending upon the performance of Harleysville Group and Mutual in relation to certain targets. There are 600,000 shares of common stock available under the Long Term Incentive Plan and 165,848 of these shares were issued in 2003. Harleysville Group’s expense (benefit) for such plans was $1,694,000, $(1,999,000) and $7,291,000 for 2004, 2003 and 2002, respectively.
The plan merger amounts above relate to the merger of an affiliate of Mutual into the plan. This merger had no impact on Harleysville Group’s portion of the plan.
The accumulated benefit obligation for the entire plan was $171,678,000 and $146,456,000 at December 31, 2004 and 2003, respectively.
Harleysville Group’s pension plan asset allocations at December 31, 2004 and 2003 are as follows: