The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with the Mutual Company and Pennland. Harleysville Group’s participation was 80% for 2008 and 2009 and 72% for 2005 through 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” 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 economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the control of Harleysville Group Inc. (the Company) and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on the Company and its wholly owned property and casualty insurance subsidiaries (collectively, Harleysville Group). There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results, including premium levels 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; the insurance product pricing environment; changes in applicable law; government regulation and changes therein that may impede the ability to charge adequate rates; performance of and instability in the financial markets; investment losses; fluctuations in interest rates; significant catastrophe events in the geographic regions where we do business; decreased demand for property and casualty insurance; availability and price of reinsurance; the pooled A. M. Best rating of Harleysville Group; and the status of labor markets in which the Company operates. In addition, see “Management’s Discussion and Analysis - Risk Factors.”
the Company’s ability to maintain its A- (“excellent”) pooled rating by A.M. Best
changes in the prices of debt and equity securities generally and those held by the Company specifically
Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Per the Company’s current policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.
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 continue to maintain its underwriting standards.
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 designed to assure that 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.
Effective January 1, 2008, the Company’s property and casualty subsidiaries and the Mutual Company and Pennland amended their intercompany pooling agreement to increase Harleysville Group’s share of the pool from 72% to 80%. Harleysville Group received cash and investments of $192.1 million on January 3, 2008 associated with the transfer of liabilities from the Mutual Company to Harleysville Group in connection with the pool change. The Company’s liabilities increased $203.4 million and the Company reimbursed the Mutual Company $11.3 million, through a ceding commission, for expenses that were incurred to generate the additional business assumed by the Company’s property and casualty subsidiaries, which ceding commission was deferred as policy acquisition costs.
When the Company’s property and casualty insurance subsidiaries’ pooling participation increases, there is a larger retrocession of this pooled business from the Mutual Company. Through this retrocession, Harleysville Group is assuming a larger share of premiums, losses and underwriting expenses for current and future periods originating both from its subsidiaries and the Mutual Company. An increase in Harleysville Group’s pooling participation results in a larger share of the pooled liabilities being assumed by Harleysville Group. Cash and investments are received by Harleysville Group equal to this greater share of loss reserves, unearned premiums and other insurance liabilities (primarily commissions and premium taxes) less a ceding commission based on acquisition costs related to unearned premiums. An increase in pool participation also increases Harleysville Group’s leverage and exposure to prior period development.
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, 2009 and 2008. The Mutual Company has an A. M. Best rating of “A-” (Excellent).
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 $4.2 million, $4.2 million and $4.1 million for 2009, 2008 and 2007, respectively, and is included in other income after elimination of intercompany amounts of $2.9 million, $2.8 million and $2.5 million in 2009, 2008 and 2007, respectively. The lease had a five-year term expiring December 31, 2009 and included a formula for additional rent for any additions, improvements or renovations. The lease has been renewed for a one-year period expiring December 31, 2010 under its current terms. 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 subsidiaries Mid-America Insurance Company (Mid-America) and Harleysville Insurance Company of New York (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 $0.3 million, $0.6 million, and $1.1 million in 2009, 2008 and 2007, respectively.
Harleysville Group has off-balance-sheet credit risk related to approximately $82.0 million and $74.0 million of premium balances due to the Mutual Company from agents and insureds at December 31, 2009 and 2008, respectively. The Mutual Company bills and collects such receivables on behalf of Harleysville Group for efficiency reasons. Harleysville Group recognizes any associated bad debts, which have not been material.
Harleysville Group holds securities with unrealized losses at December 31, 2009 as follows:
Of the total fixed maturity securities with an unrealized loss at December 31, 2009, securities with a fair value of $218.2 million and an unrealized loss of $3.2 million are classified as available for sale and are carried at fair value on the balance sheet, while securities with a fair value of $6.4 million and an unrealized loss of $0.1 million are classified as held to maturity on the balance sheet and are carried at amortized cost.
The statutory combined ratios by line of business for the year ended December 31, 2009 as compared to the year ended December 31, 2008 are shown below. The statutory combined ratios for 2008 are shown both including and excluding the impact of the pool transfer. The combined ratios excluding the pool transfer are shown, as they are prepared on a basis that is comparable to the combined ratios for 2009.
The personal lines statutory combined ratio decreased to 96.8% for the year ended December 31, 2009 from 100.1% for the year ended December 31, 2008 (excluding the impact of the pool transfer). The decrease in the personal lines combined ratio for the year ended December 31, 2009 primarily relates to the lower incidence of personal lines catastrophe losses during 2009 (1.0 points) compared to the catastrophe losses in 2008 (7.7 points). The favorable impact of lower catastrophe experience in 2009 was partially offset by a lower amount of favorable prior year development in the personal auto line in 2009 (3.2 points) compared to 2008 (9.8 points).
An ultimate severity is selected by fitting an exponential curve to the historical ultimate severities indicated using the ratio of the ultimate loss and ultimate claim counts. This method yields ultimate severities that are based on the underlying historical trends in the data. Ultimate claim counts and ultimate severities are multiplied together to produce an estimate of ultimate losses.
Bornhuetter-Ferguson Method: The Bornhuetter-Ferguson Method is a blended method that explicitly takes into account both actual loss development to date and expected future loss emergence. Two versions of this method exist: one based on paid loss and one based on incurred loss. This method uses the selected loss development patterns from the Development Methods to calculate the expected percentage of loss unpaid (or unreported). The expected component of the method is calculated by multiplying earned premium for the given exposure period by a selected a priori loss ratio. The resulting dollars are then multiplied by the expected percentage of unpaid (or unreported) loss described above. This provides an estimate of future loss payments (or reporting) that is then added to actual paid (or incurred) loss data to produce estimated ultimate loss.
Harleysville Group recognized net favorable development in the provision for insured events of prior years of $36.1 million in 2009, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2002 through 2006, partially offset by adverse development in accident year 2008 and accident years prior to 2002. A lower-than-expected level of claims severity was observed in personal lines in accident year
A reduction in homeowners severity was widely observed during 2009, especially in accident year 2008, which led to the recognition of $3.0 million of favorable development during 2009 for all accident years.
The tables below break out the change in the estimate of ultimate losses between December 31, 2008 and December 31, 2009 for the 2008, 2007, 2006 and 2005 accident years into severity and frequency components for the major commercial and personal lines of business. Table 1 summarizes the Company’s percentage change in the estimate of ultimate loss and loss settlement expense by line of business between December 31, 2008 and December 31, 2009. Tables 2 and 3 summarize the Company’s percentage change in the estimate of ultimate severity and ultimate claim counts, respectively. The relationship between the three tables is as follows: (1+ the % change in estimated ultimate loss) = (1+ the % change in estimated ultimate severity) x (1+ the % change in estimated ultimate claim counts). The estimated ultimate severity is calculated as the ratio of estimated ultimate loss to estimated ultimate claim counts. The amounts underlying these tables are based on direct loss and claim experience minus ceded loss experience and exclude a small portion of losses associated with business assumed from involuntary pools.
Between the Years Ended December 31, 2008 and December 31, 2009
These tables illustrate that the changes to the Company’s estimates of ultimate loss for prior accident years between December 31, 2008 and December 31, 2009 are primarily driven by the severity component of loss. In this context, the term “severity” does not refer to an actuarial assumption, rather, it refers to “severity” as a descriptive statistic derived from the ratio of estimated ultimate loss to estimated ultimate claim counts. In general, as estimates of the ultimate number of claims were relatively stable for the prior accident periods, the changes in estimates of ultimate loss are characterized as resulting from a reduction in severity.
The following table presents workers compensation claim count information for the total pooled business in which Harleysville Group participates and payment amounts which are Harleysville Group’s pooling share of the total pooled amounts:
Harleysville Group records the actuarial best estimate of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or before December 31, 2009. 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.
The use of this technique to analyze reserve ranges assumes historical data has validity in predicting future outcomes. This assumption is consistent with a key assumption underlying much of insurance pricing and reserving theory.
Underwriting expenses, including amortization of deferred policy acquisition costs, decreased $10.7 million for the year ended December 31, 2009 compared to the prior year, primarily due to a decrease in amortization of deferred acquisition costs due to the decrease in premiums earned.
Investment income increased $2.7 million for the year ended December 31, 2008, primarily due to a higher level of invested assets, partially offset by a lower investment yield on fixed income securities and a greater percentage of fixed income securities invested in tax-exempt securities. The higher level of invested assets was primarily due to the investments received January 1, 2008 in connection with the pool change, partially offset by a decrease in investments due to the increase in shares repurchased under the Company’s stock repurchase program.
Net realized investment gains (losses) decreased $60.7 million for the year ended December 31, 2008, primarily due to an increase in impairment charges in 2008.
Harleysville Group’s statutory combined ratio increased to 100.3% for the year ended December 31, 2008 from 96.7% for the year ended December 31, 2007. The statutory combined ratio for 2008 includes a benefit of 0.4% due to the impact of the transfer of liabilities in connection with the pool change. This benefit results from the statutory treatment of the ceding commission paid on the unearned premiums transferred on January 1, 2008. Excluding the impact of the pool transfer, the statutory combined ratio increased to 100.7% for 2008. The increase in the combined ratio was due to higher catastrophe losses in 2008 and greater non-catastrophe property losses. Net catastrophe losses increased to $34.7 million (3.8 points) for 2008 from $9.2 million (1.l points) for 2007. The 2008 catastrophe losses were primarily due to tornadoes and hail storms impacting Arkansas and Minnesota during the second quarter.
The commercial lines statutory combined ratio increased to 100.4% for the year ended December 31, 2008 from 97.5% for the year ended December 31, 2007. Excluding the impact of the pool transfer, the commercial lines statutory combined ratio increased to 100.9% for the year ended December 31, 2008 from 97.5% for the year ended December 31, 2007. The increase in the commercial lines combined ratio for the year ended December 31, 2008 primarily relates to the higher incidence of catastrophe losses during this year (2.9 points) compared to the catastrophe losses in the prior year (0.7 points) and non-catastrophe property loss activity. The higher than average catastrophe experience primarily relates to losses associated with tornado activity in Arkansas during the second quarter and, to a lesser extent, losses from Hurricane Ike during the third quarter.
The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2008 by line of business:
In 2008, Harleysville Group recognized net favorable development of $31.8 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2003 through 2006, partially offset by adverse development in accident year 2007 and accident years prior to 2003. A higher-than-expected level of claims severity was observed in accident year 2007 and led to the recognition of approximately $4.3 million of adverse development in this accident year during 2008.
A reduction in other commercial lines severity in accident years 2006 and prior was widely observed during 2008 and led to the recognition of $3.2 million of favorable development in this line during 2008.
Underwriting expenses, including amortization of deferred policy acquisition costs, increased $28.6 million for the year ended December 31, 2008 compared to the prior year, primarily due to the pool change. Excluding the impact of the pool change, underwriting expenses decreased $2.9 million primarily due to a decrease in headcount resulting from on-going expense reduction initiatives and lower incentive compensation.
Other income decreased $4.2 million for the year ended December 31, 2008 primarily due to a $2.7 million gain realized on the sale of the Company’s office building in Traverse City, Michigan in the second quarter of 2007 and a decrease of $1.1 million in fees received in connection with the National Flood Insurance Program.
In April 2009, the FASB issued guidance on “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” This provided additional guidance for estimating fair value in accordance with FASB Accounting Standards Codification (ASC) 820 on fair value measurements when the volume and level of activity for the asset or liability have significantly decreased and provided guidance on identifying circumstances that indicate a transaction is not orderly. This guidance lists a series of factors which should be evaluated to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with normal market activity for the asset or liability. If the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, transactions or quoted prices may not be determinative of fair value and further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value. A reporting entity should also evaluate the circumstances to determine whether the transaction is orderly based on the weight of the evidence. This guidance is effective for interim and annual reporting periods ending after June 15, 2009, with prospective application. The adoption of this guidance did not have a material impact on the Company’s results of operations or financial position.
on debt and equity securities in the financial statements. For debt securities that have fair values less than their amortized cost, this guidance modifies the prior requirements that to avoid recognizing an other-than-temporary impairment, management must assert that it has both the intent and ability to hold a security for a period of time sufficient to allow for an anticipated recovery in its fair value to its amortized cost basis. Instead, an entity should assess whether the entity (a) has the intent to sell the debt security or (b) more likely than not will be required to sell the debt security before its anticipated recovery. An entity must recognize an other-than-temporary impairment if either of these conditions is met. Also, if an entity does not expect to recover the entire amortized cost basis of a security, an other-than-temporary impairment shall be considered to have occurred. If the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the other-than-temporary impairment shall be separated into (a) the amount representing the credit loss, which is recognized in earnings, and (b) the amount related to all other factors, which is recognized in other comprehensive income. This guidance is effective for interim and annual reporting periods ending after June 15, 2009. Adoption of this guidance did not have a material impact on the Company’s results of operations or financial position.
In June 2009, the FASB issued guidance which replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity. The guidance, which is effective for financial statements issued for fiscal years beginning after November 15, 2009, also requires additional disclosures about an enterprise’s involvement in variable interest entities. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations or financial position.
The Company had $29.1 million of cash and marketable securities at December 31, 2009, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. In June 2007, the Company’s Board of Directors authorized a stock repurchase plan under which up to 1.6 million shares of its outstanding common stock could be repurchased through an open market purchase program. The Company was authorized to repurchase shares from the Mutual Company, which owned 53% of the Company’s stock at that time, at fair market value terms on the date of purchase and from the public float in amounts that were proportional to the respective ownership percentages of the Mutual Company and the public float as of the authorization date. This program was completed on July 18, 2007. On August 1, 2007, the Board of Directors authorized the Company to repurchase an additional 1.6 million shares of its outstanding common stock over a two year period under terms similar to the first repurchase authorization. This program was completed on May 16, 2008. On May 20, 2008, the Board of Directors authorized the Company to repurchase up to an additional 1.5 million shares of its outstanding common stock over a two year period under terms similar to the first repurchase authorization. This program was completed on November 20, 2008. On February 19, 2009, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases, or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed on June 15, 2009. On July 30, 2009 the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its outstanding common stock over a two year period under terms similar to the repurchase authorization of February 19, 2009. The Company currently intends to repurchase shares in open market transactions from the public float, and not repurchase shares from the Mutual Company. As of March 3, 2010, the Company had repurchased 358,081 shares under this authorization, leaving 441,919 shares authorized to be repurchased. Harleysville Group has no other material commitments for capital expenditures as of December 31, 2009.
The following summarizes Harleysville Group’s contractual obligations at December 31, 2009.
If our estimated liability for losses and loss settlement expenses is incorrect, our reserves may not be adequate to cover our ultimate liability for losses and loss settlement expenses and may have to be increased.
We transfer a portion of our exposure to selected risks to other insurance and reinsurance companies through reinsurance arrangements. Under our reinsurance arrangements, another insurer assumes a specified portion of our losses and loss adjustment expenses in exchange for a specified portion of policy premiums. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. Any decrease in the amount of our reinsurance will increase our risk of loss. Furthermore, we face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Therefore, the inability of any of our reinsurers to meet its financial obligations could materially and adversely affect our financial condition and results of operations.
The capital and credit markets have been experiencing extreme volatility and disruption for more than 12 months. The volatility and disruption in the markets have exerted downward pressure on the availability of liquidity and credit capacity for certain issuers. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by continued disruptions in the capital and credit markets.
If our financial strength ratings are reduced, we may be materially adversely impacted.
We primarily write property and casualty insurance business in the eastern and midwestern United States. Consequently, unusually severe storms or other natural or man-made disasters that destroy property in these states could materially adversely affect our operations. Our revenues and profitability also are subject to prevailing economic and regulatory conditions in the states in which we write insurance. We may be exposed to risks of adverse developments that are greater than if we conducted business nationwide.
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 expand our network of agencies to successfully market
If our use of predictive modeling is not effective, our business could be materially adversely impacted.
We use predictive modeling in underwriting a significant portion of our commercial lines business. We believe this tool allows us to more accurately match underwriting risk with pricing to operate more profitably. If the model does not accurately reflect the level of losses that we ultimately will incur, our ability to write business and our financial results could be materially adversely affected.
If our technology initiatives are not successful, or the benefits are not realized, our business could be materially adversely affected.
If we lose our key personnel our business could be materially adversely affected.
Under applicable insurance laws and regulations of the states in which our subsidiaries are domiciled, no person may acquire control of us unless that person has filed a statement containing specified information with the insurance commissioner of each state and obtains advance approval for such acquisition. Under applicable laws and regulations, any person acquiring, directly or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our common stock without obtaining advance approval of the insurance commissioner of each state would be in violation of applicable insurance laws and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the insurance commissioner of each such state.
Common stock, $1 par value, authorized 80,000,000 shares; issued 2009, 34,583,182 and 2008, 34,254,581 shares; outstanding 2009, 27,615,120 and 2008, 28,156,672 shares
Losses and loss settlement expenses (ceded to affiliate, $476,641, $524,735 and $490,058)
Accounting for fixed maturities depends on their classification as held to maturity, available for sale or trading. Fixed maturities classified as held to maturity are carried at amortized cost. Fixed maturities classified as available for sale are carried at fair value. There were no investments classified as trading. Equity securities are carried at fair value. Short-term investments are recorded at cost, which approximates fair value. The fair value of level 1 and 2 fixed maturities is based upon data supplied by an independent pricing service. The fair value of level 3 fixed maturity securities is based on cash flow analysis and other valuation techniques. The fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund.
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 gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Per the Company’s current policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value.
The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, which includes the gross liabilities to Harleysville Group’s policyholders plus the net liability to the Mutual Company under the pooling agreement. See Note 2(a). Such estimates may be more or less than the amounts ultimately paid when the claims are settled. These estimates are periodically reviewed and adjusted as necessary; such adjustments are reflected in current operations.
Basic earnings per share (EPS) is calculated using the weighted average shares outstanding, including participating securities with non-forfeitable rights to dividends, such as unvested restricted stock and restricted stock units. In calculating diluted EPS, the weighted average shares outstanding includes all potentially dilutive securities. Basic and diluted EPS are calculated by dividing net income available to common shareholders by the applicable weighted average number of shares outstanding during the year.
The Company adopted the accounting guidance on “Participating Securities and the Two-Class Method,” in 2009. This guidance redefines participating securities to include unvested share-based payment awards that contain non-forfeitable dividends or dividend equivalents as participating securities to be included in the computation of EPS pursuant to the “two-class method.” Outstanding unvested restricted stock and restricted stock units issued by the Company under employee compensation programs containing such dividend participation features are considered participating securities subject to the “two-class method” in computing EPS rather than the “treasury stock method.” Prior period EPS has been adjusted retroactively to conform to this guidance. Adoption of this guidance reduced basic EPS by $.04, $.01 and $.03 for 2009, 2008 and 2007, respectively, and diluted EPS by $.02, $.01 and $.02 for 2009, 2008 and 2007, respectively.
In December 2008, the Financial Accounting Standards Board (FASB) issued guidance on “Employers’ Disclosures about Postretirement Benefit Plan Assets.” This guidance requires disclosures about plan assets in an employers’ defined benefit pension plan or other postretirement plan to provide users of financial statements with an understanding of how investment allocation decisions are made, the major categories of plan assets, the inputs and valuation techniques used to measure the fair value of plan assets, the effect of fair value measurements using significant unobservable inputs on changes in plan assets for the period and significant concentrations of risk within plan assets. This guidance was effective for fiscal years ending after December 15, 2009. The adoption of this guidance did not have an impact on the Company’s results of operations or financial position.
In May 2009, the FASB issued guidance on “Subsequent Events.” This guidance establishes general standards of accounting for, and requires disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance was effective for interim or annual periods ending after June 15, 2009. This guidance was updated in February 2010 to remove the requirement for an SEC filer, as defined, to disclose the date through which subsequent events have been evaluated. Adoption of this guidance did not have a material impact on the Company’s results of operations or financial position.
In June 2009, the FASB issued guidance on “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles” which established the FASB Accounting Standards Codification as the single source of authoritative accounting principles in the preparation of financial statements in conformity with U.S. GAAP. This guidance also explicitly recognized rules and interpretive releases of the U.S. Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. This guidance was effective for financial statements issued for periods ending after September 15, 2009. The adoption of this guidance did not have an impact on the Company’s results of operations or financial position.
Mutual Company and other affiliates. Such amounts are included in other income. Effective January 1, 2010, the management agreement was amended to include voluntary assumed reinsurance business written by the Mutual Company.
Harleysville Group has off-balance-sheet credit risk related to approximately $82,000,000 and $74,000,000 of premium balances due to the Mutual Company from agents and insureds at December 31, 2009 and 2008, respectively.
Level 2 - Inputs other than Level 1 that are based on observable market data. These include quoted prices for similar assets in active markets, quoted prices for identical assets in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from or corroborated by observable market data.
The Company utilizes a nationally recognized independent pricing service to obtain fair value estimates for its fixed maturity holdings because of the detailed process it uses in arriving at a fair value estimate. For fixed maturity securities that have quoted prices in active markets, market quotations are provided. For fixed maturity securities that do not trade on a daily basis, the independent pricing service prepares estimates of fair value using a wide array of observable inputs including relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. The observable market inputs that our independent pricing service utilizes include, listed in approximate order of priority: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. Additionally, the independent pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
When the independent pricing service provides a fair value estimate, the Company uses that estimate. At December 31, 2009, the independent pricing service provided a fair value estimate for all of the investments classified as level 1 investments within the fair value hierarchy and approximately 98% of the investments classified as level 2 estimates within the fair value hierarchy. The fair value of all level 2 securities is based on observable market inputs.
In instances when the independent pricing service is unable to provide a fair value estimate, the Company attempts to obtain a non-binding fair value estimate from a number of broker/dealers and reviews any fair value estimate reported by an independent business news service. In instances where only one broker/dealer provides a fair
value estimate for a fixed maturity security, the Company uses that estimate. In instances where the Company is able to obtain fair value estimates from more than one broker/dealer, the Company generally uses the lowest or next to lowest fair value estimate. In instances where neither the independent pricing service nor a broker/dealer is able to provide a fair value estimate, the fair value is based on cash flow analysis and other valuation techniques which utilize significant unobservable inputs and the Company classifies the fixed maturity investment as a level 3 investment. Level 3 investments represent less than 1% of the Company’s total investment portfolio.
The following is a summary of the fair value measurements of applicable Company assets by level within the fair value hierarchy as of December 31, 2009 and 2008. These assets are measured on a recurring basis.
The other invested assets on the balance sheet are carried at cost and are tested for impairment on a quarterly basis. During 2009, the securities were written down to fair value and an impairment charge of $299,000 was included in earnings for the year. Fair value is determined based on cash flow analysis and other valuation techniques, based on unobservable inputs (Level 3).
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2009 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, 2009 and 2008 amounted to $31,411,000 and $31,228,000 respectively.
Of the total fixed maturity securities with an unrealized loss at December 31, 2009, securities with a fair value of $218,242,000 and an unrealized loss of $3,230,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $6,398,000 and an unrealized loss of $60,000 are classified as held to maturity on the balance sheet and are carried at amortized cost.
In April 2007, bonds with an amortized cost of $1,882,000 were transferred from the held to maturity category to the available for sale category due to a significant deterioration in the credit worthiness of the issuer. An impairment loss of $118,000 was recognized on this security. The security was sold in the third quarter of 2007 at a gain of $76,000.
Losses and loss settlement expenses are net of reinsurance recoveries of $53,563,000, $62,821,000 and $34,091,000 for 2009, 2008 and 2007, respectively.
Assumed and ceded written premiums for 2009 include $6,200,000 and assumed and ceded earned premiums for 2009 include $920,000 for Harleysville Group’s share of flood insurance business the Mutual Company assumed from another carrier, which is ceded 100% to the National Flood Insurance Program.
Property and equipment consisted of land and buildings with a cost of $28,241,000 and $26,409,000, and equipment, including software, with a cost of $5,865,000 and $7,297,000 at December 31, 2009 and 2008, respectively. Accumulated depreciation related to such assets was $20,527,000 and $21,195,000 at December 31, 2009 and 2008, respectively.
Rental expense under leases with non-affiliates amounted to $2,793,000, $2,494,000 and $2,732,000 for 2009, 2008 and 2007, respectively. Operating lease commitments were not material at December 31, 2009.
A decrease in commercial automobile severity was observed during 2009 which led to the recognition of $20,525,000 of favorable development in this line during 2009. Approximately $1,100,000 of the favorable development experienced in this line during 2009 is related to the Company’s involuntary pools.
An increase in other personal lines severity was observed during 2009 which led to the recognition of $977,000 of adverse development during the year for all accident years.
A reduction in commercial automobile severity was observed during 2008 and led to the recognition of $19,500,000 of favorable development in this line in 2008. Approximately $1,600,000 of the favorable development experienced in this line during 2008 is related to the Company’s involuntary pools.
An increase in other personal lines severity was observed during 2008, primarily related to the emergence of a single $1,000,000 claim in the third quarter. In total, $1,600,000 of adverse development was recognized in other personal lines during 2008.
Harleysville Group recognized net favorable development in the provision for insured events of prior years of $22,000,000 in 2007, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2003 through 2006 partially offset by adverse development in the 2002 and prior accident years. The favorable development consisted of $12,500,000 in commercial lines and $9,500,000 in personal lines.
The fair value of the notes was $99,975,000 and $94,188,000 at December 31, 2009 and 2008, 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 $6,054,000, $6,406,000 and $6,808,000 in 2009, 2008 and 2007 respectively.
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 2009 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s eight insurance subsidiaries at December 31, 2009 ranged from 471% to 696%.
Net cash paid for federal income taxes in 2009, 2008 and 2007 was $9,100,000, $31,500,000 and $28,550,000 respectively.
A valuation allowance is required to be established for any portion of the deferred tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the benefit of the deferred tax asset will be realized through the generation of future income. Therefore, no such valuation allowance has been established.
The compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $6,300,000, $5,899,000 and $4,723,000 for 2009, 2008 and 2007, respectively with a corresponding income tax benefit of $2,083,000, $1,964,000 and $1,555,000 for 2009, 2008 and 2007, respectively.
In determining the expense to be recorded for the employee stock purchase plan, the fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
The weighted-average fair value of options granted under the employee stock purchase plan was $7.07, $7.14 and $6.74 for 2009, 2008 and 2007, respectively. The total intrinsic value of options exercised under the plan was $212,000, $241,000 and $297,000 for 2009, 2008 and 2007, respectively. Compensation expense of $348,000, $288,000 and $281,000 related to grants under the plan was recognized in 2009, 2008 and 2007, respectively. As of December 31, 2009, there was $13,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the plan. The cost is expected to be recognized over a period of one month.
The Long Term Incentive Plan (LTIP) provided 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 were 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. The most recent plan was in effect for the three year period 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 2005-2007 plan stock award was $19.64 per share. Compensation expense of $434,000 was recognized related to the stock component of the LTIP for 2007. As of December 31, 2009, there was no unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the LTIP. During 2008, 111,395 shares were issued in connection with plan years 2005-2007. During 2007, 95,704 shares were issued in connection with plan years 2004-2006. No shares were issued under the plan in 2009.
The LTIP also had a cash component. This component was accounted for under the liability method. Compensation expense of $407,000 was recognized related to the cash component of the LTIP for 2007. As of December 31, 2009, there was no unrecognized compensation cost related to the cash component.
Harleysville Group has incentive bonus plans which include virtually all employees. Cash bonuses are earned on a formula basis depending upon the performance of Harleysville Group and the Mutual Company in relation to certain targets. Harleysville Group’s expense for such plans was $7,732,000, $6,111,000 and $5,920,000 for 2009, 2008 and 2007, respectively.
Harleysville Group Inc. has a frozen pension plan that covers employees hired before January 1, 2006. 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.
Amounts in accumulated other comprehensive income expected to be recognized as components of net periodic pension cost in 2010 are as follows: net actuarial loss $3,009,000.
This category comprised entirely of a low-cost, index-based mutual fund that is designed to track the performance of the MSCI Broad Market Index
As of December 31, 2009, the pension plan also includes net liabilities of $773,000, primarily related to securities in transit at that date.
The expected 2010 contribution to the pension plan is $7,695,000, of which $5,477,000 is Harleysville Group’s expected portion.