The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with Mutual. 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 so that the effect of future developments on Harleysville Group will be those anticipated by management. 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 Best’s rating of Harleysville Group; and the status of labor markets in which the Company operates.
Positive variations in premium income are subject to a number of factors, including
specific adverse events affecting the issuers of debt obligations held by the Company
Loss and loss settlement expenses are affected by a number of factors, including
Liabilities for Losses and Loss Settlement Expenses. The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have not yet been reported to Harleysville Group. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of actuarial techniques. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operations.
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. Fair value of equity securities is based on the closing market value as reported by a national securities 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.
Policy Acquisition Costs. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim 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.
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, 2005 and 2004. Mutual has an A. M. Best rating of “A-” (Excellent).
Harleysville Group provides certain management services to Mutual and other affiliates. Harleysville Group received a fee of $6.7 million, $6.8 million and $7.2 million in 2005, 2004 and 2003, respectively, for its services under these management agreements. Under related agreements, Harleysville Group serves as the paymaster for Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense based upon time allocation. The level of fees has been approved by each state insurance department having jurisdiction.
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 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 $0.7 million, $0.4 million and $0.3 million in 2005, 2004 and 2003, respectively.
Harleysville Group has off-balance-sheet credit risk related to approximately $73.0 million and $71.0 million of premium balances due to Mutual from agents and insureds at December 31, 2005 and 2004, respectively. Mutual 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, 2005 as follows:
The fixed maturity investments with continuous unrealized losses for less than twelve months were primarily due to the impact of the higher market interest rates rather than a decline in credit quality. There are $213.5 million in fixed maturity securities, at fair value, that at December 31, 2005, had been below amortized cost for over twelve months. Of the $6.9 million of unrealized losses on such securities, $6.2 million relates to securities which carry investment grade ratings and have declined in fair value roughly in line with market interest rate changes. The remaining $0.7 million of unrealized losses are comprised of airline enhanced equipment trust certificates (EETC) as follows:
Income before income taxes increased $23.3 million for the year ended December 31, 2005 compared to the prior year. The increase was primarily due to the increase in investment income and a lower underwriting loss, partially offset by lower realized investment gains.
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
The following table presents the increase (decrease) in the liability for unpaid losses and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2005 by line of business.
A reduction in commercial automobile severity in accident years 2004 and 2003 was observed during 2005 and led to the recognition of favorable development for those accident years in 2005. An increase in commercial automobile severity in accident years prior to 2003 was observed during 2005 and led to the recognition of adverse development for those accident years in 2005. In total, $3.0 million in favorable development was recognized in the commercial automobile line during 2005.
A reduction in commercial multi-peril severity in accident years 2004 and 2003 was observed during 2005 and led to the recognition of favorable development for those accident years in 2005. An increase in commercial multi-peril severity in accident years prior to 2003 was observed during 2005 and led to the recognition of adverse development for those accident years in 2005. In total, $3.7 million in favorable development was recognized in the commercial multi-peril line during 2005.
The following table presents case and incurred but not reported (IBNR) reserves by line of business and a statistically determined range of estimates of the ultimate unpaid losses and loss settlement expenses incurred for each line of business as of December 31, 2005. 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 statistical analysis is completed only on a basis that is net of reinsurance recoverables, as this appropriately reflects Harleysville Group’s risk profile based on the type and quality of its reinsurance. 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 total commercial lines range and total personal lines range were developed as separate simulations using the means and standard deviations of the individual lines as inputs. Therefore, the 90% confidence interval for all lines of business is smaller than the straight sum of the individual lines of business 90% intervals.
Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Harleysville Group’s reorganization of its claims operation in recent years has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. Litigation on bodily injury liability cases is higher for the past four years while the rate of settlement is slower. These changed patterns give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury liability claims. There are uncertainties regarding future loss cost trends particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2005.
Net catastrophe losses decreased $2.8 million for the year ended December 31, 2005, primarily due to less severe catastrophes impacting Harleysville Group in 2005.
Effective for one year from July 1, 2005, the Company’s subsidiaries and Mutual and its wholly-owned subsidiaries renewed its catastrophe reinsurance which provides coverage ranging from 85% to 100% of up to $205 million in excess of a retention of $30 million for any given catastrophe excluding terrorism for commercial lines. Harleysville Group’s 2005 pooling share of this coverage would range from 85% to 100% of up to $147.6 million in excess of a retention of $21.6 million for any given catastrophe. Pursuant to the terms of the treaty, the maximum recovery would be $196.5 million for any catastrophe involving an insured loss equal to or greater than $235 million. Harleysville Group’s 2005 pooling share of this maximum recovery would be $141.5 million for any catastrophe involving an insured loss of $169.2 million or greater. The treaty includes reinstatement provisions providing for coverage for a second catastrophe and requiring payment of an additional premium in the event of a first catastrophe occurring. Harleysville Group and Mutual have purchased property per risk excess of loss reinsurance which covers certain terrorism losses and provides for recovery of up to $8.5 million in excess of $1.5 million of terrorism losses for any one risk under certain circumstances. The maximum recovery by Harleysville Group on a terrorism loss occurrence is $8.6 million.
The income tax expense for the year ended December 31, 2005 includes the tax benefit of $10.2 million associated with tax-exempt income compared to $10.7 million in the prior year.
Harleysville Group and Mutual agreed on August 2, 2005 to terminate the reinsurance agreement whereby Mutual reinsures certain accumulated catastrophe losses as described in Note 2 of Notes to Consolidated Financial Statements. The agreement was terminated on December 31, 2005. The coverage will not be replaced as it is no longer deemed necessary based on our current catastrophe risk profile. Harleysville Group ceded to Mutual premiums earned of $8.8 million and $8.6 million and losses incurred of $(0.2) million and $0.7 million for the years ended December 31, 2005 and 2004, respectively related to this agreement.
Investment income increased $0.6 million for the year ended December 31, 2004, resulting from an increase in invested assets, partially offset by a lower yield on the fixed maturity investment portfolio.
Realized investment gains (losses) improved $13.6 million for the year ended December 31, 2004, primarily resulting from gains on the sale of equity securities.
There were impairment charges of $0.3 million and $0.5 million for the years ended December 31, 2004 and 2003, respectively. Harleysville Group had gross realized losses of $2.0 million in 2004 which were from the sales of securities which had not declined by more than 20% below their cost for more than six months at the time of their sale.
The lesser underwriting loss was primarily due to lesser loss frequency in the current accident year, lower catastrophe losses and a decrease in the provision for insured events in prior years. 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.
The commercial lines statutory combined ratio decreased to 106.7% for the year ended December 31, 2004 from 123.6% for the year ended December 31, 2003. The decrease is primarily due to the lesser adverse development in the provision for insured events in prior years, lesser loss frequency and lesser catastrophe losses.
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 No. 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 fiscal year beginning after June 15, 2005. The impact of adopting SFAS No. 123(R) on 2005 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, 2005. The Long-Term Incentive Plan (LTIP) has a component which awards shares based on the total shareholder return of the Company’s stock relative to the total shareholder return of a group of insurance company stocks. Under APB No. 25 and SFAS No. 123, this component has been accounted for using the intrinsic method. Under SFAS No. 123(R), it will be accounted for as an equity instrument. Accordingly, the Company currently expects, based on preliminary calculations, to record a cumulative effect benefit of approximately $1.0 million, net of tax, in the first quarter of 2006. The impact that any future share-based payment transactions will have on our financial position or results of operations is not yet known.
Liquidity is a measure of the ability to generate sufficient cash to meet cash obligations as they come due. Harleysville Group’s primary sources of cash are premium income, investment income and maturing investments. Cash outflows can be variable because of uncertainties regarding settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, Harleysville Group maintains investment and reinsurance programs generally
intended to provide adequate funds to pay claims without forced sales of investments. Harleysville Group models its exposure to catastrophes and has the ability to pay claims without selling held to maturity securities even for events having a low (less than 1%) probability. Even in years of greater catastrophe frequency, Harleysville Group has been able to pay claims without liquidating any investments. Harleysville Group has also considered scenarios of declines in revenue and increases in loss payments, and has the ability to meet cash requirements under such scenarios without selling held to maturity securities. Harleysville Group’s policy with respect to fixed maturity investments is to purchase only those that are of investment grade quality.
Net cash provided by operating activities was $165.1 million and $115.7 million for 2005 and 2004, respectively. The increase in net cash provided by operating activities during 2005 is primarily from greater underwriting cash flow primarily due to lower paid losses.
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, 2005, Harleysville Group held cash collateral of $150.9 million related to securities on loan with a market value of $146.4 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 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 gross and 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. 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 actuarial methods to project our ultimate liability, there is no method that can always exactly predict our ultimate liability for losses and loss settlement expenses.
Our insurance subsidiaries seek to reduce the impact on our business of a catastrophe through geographic diversification and through the purchase of reinsurance covering various categories of catastrophes, which generally excludes terrorism. Nevertheless, reinsurance may prove inadequate if:
insurance, including workers compensation, may also have an adverse effect on our business. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry.
Historically, the results of the property and casualty insurance industry have been subject to significant fluctuations over time due to competition and due to unpredictable developments, including:
Many reinsurers experienced significant losses related to Hurricanes Katrina, Rita and Wilma during 2005. While it is expected that reinsurers will increase rates for business in states impacted by these storms, they may also increase rates for business in other areas of the country, including the markets in which we write.
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, which was extended in 2005, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2007. 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.
Certain changes in the accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies could have a material adverse impact on our reported net income.
If our investments lose value, our revenues and earnings will be adversely affected.
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 policyholder obligations. Currently, our rating from A. M. Best is “A-”, the 4th of A. M. Best’s 16 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.
Our subsidiaries are permitted under the terms of our indebtedness to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by our subsidiaries to us. We cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund payments on these notes when due.
As of December 31, 2005, the Mutual Company owned approximately 56% of our outstanding common stock. The Mutual Company’s stock ownership and ability, by reason of such ownership, to elect our board of directors, provides it with significant influence over potential change of control transactions.
Held to maturity, at amortized cost (fair value $430,877 and $517,434)
Held to maturity, at amortized cost (fair value $7,010 and $1,966)
Harleysville Group underwrites property and casualty insurance in both the personal and commercial lines of insurance. The personal lines of insurance include both auto and homeowners, and the commercial lines include auto, commercial multi-peril and workers compensation. The business is marketed primarily in the eastern and midwestern United States through independent agents.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, including loss and loss settlement expenses, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses, including the determination of other-than-temporary declines in investments, during the reporting period. Actual results could differ from these estimates.
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 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 Mutual 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.
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 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 fiscal year beginning after June 15, 2005. The impact of adopting SFAS No. 123(R) on 2005 net income and earnings per share is not currently expected to be materially different from the pro forma amounts disclosed above which includes all share-based payment transactions through December 31, 2005. The Long-Term Incentive Plan (LTIP) has a component which awards shares based on the total shareholder return of the Company’s stock relative to the total shareholder return of a group of insurance company stocks. Under APB No. 25 and SFAS No. 123, this component has been accounted for using the intrinsic method. Under SFAS No. 123(R), it will be accounted for as an equity instrument. Accordingly, the Company currently expects, based on preliminary calculations, to record a cumulative effect benefit of approximately $1.0 million, net of tax, in the first quarter of 2006. The impact that any future share-based payment transactions will have on our financial position or results of operations is not yet known.
Harleysville Group and Mutual are parties to a reinsurance agreement whereby Mutual, in return for a reinsurance premium, reinsured accumulated catastrophe losses in a quarter up to $14,400,000 for 2005, 2004 and 2003. This reinsurance coverage was in excess of a retention of $3,600,000 for 2005, 2004 and 2003. The agreement excludes catastrophe losses resulting from earthquakes, terrorism or hurricanes and supplements the existing external catastrophe reinsurance program. Under this agreement, Harleysville Group ceded to Mutual premiums earned of $8,812,000, $8,597,000 and $8,441,000, and losses incurred of $(178,000), $664,000 and $4,181,000 for 2005, 2004 and 2003, respectively. Harleysville Group and Mutual terminated the agreement on December 31, 2005.
Harleysville Group Inc. received $6,697,000, $6,782,000 and $7,221,000 of management fee income in 2005, 2004 and 2003, respectively, under agreements whereby Harleysville Group Inc. provides management services to Mutual and other affiliates. Such amounts are included in other income.
Harleysville Group has off-balance-sheet credit risk related to approximately $73,000,000 and $71,000,000 of premium balances due to Mutual from agents and insureds at December 31, 2005 and 2004, respectively.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2005 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 $213.5 million in fixed maturity securities, at fair value, that at December 31, 2005, had been below amortized cost for over 12 months. Of the $6.9 million of unrealized losses on such securities, $6.2 million relates to securities which carry an investment grade debt rating and have declined in fair
Income taxes (benefit) on realized investment gains (losses) were $81,000, $4,433,000 and $(322,000) for 2005, 2004 and 2003, respectively.
Property and equipment consisted of land and buildings with a cost of $29,220,000 and $30,607,000, and equipment, including software, with a cost of $12,542,000 and $14,433,000 at December 31, 2005 and 2004, respectively. Accumulated depreciation related to such assets was $23,724,000 and $24,149,000 at December 31, 2005 and 2004, respectively.
Harleysville Group recognized adverse development in the provision for insured events of prior years of $12,462,000 and $119,059,000 in 2004 and 2003, respectively, primarily due to greater-than-expected claims severity in commercial lines. The adverse (favorable) development consisted of $16,368,000 and $108,322,000 in commercial lines in 2004 and 2003, respectively, and $(3,906,000) and $10,737,000 in personal lines in 2004 and 2003, respectively.
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.
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, 2005, $62,790,000 would be available for distribution to Harleysville Group Inc. during 2006 without prior approval.
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 2005 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s nine insurance subsidiaries at December 31, 2005 ranged from 495% to 606%.
The following table summarizes information about fixed stock options at December 31, 2005:
The per share weighted-average fair value of options granted during 2005, 2004 and 2003 was $6.36, $5.64 and $6.79, 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 2005, 2004 and 2003, respectively: dividend yield of 3.18%, 3.53% and 2.84%; expected volatility of 36.14%, 38.67% and 38.99%; risk-free interest rate of 4.05%, 3.36% and 2.55%; and an expected life of 6 years, 6 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 90,686, 116,294 and 95,048 shares to employees in 2005, 2004 and 2003, respectively.
Under Harleysville Group Inc.’s 1995 Agency Stock Purchase Plan, eligible independent insurance agencies may invest up to $12,500 in shares of common stock at 90% of the fair market value at the end of each six-month subscription period. There are 1,000,000 shares of common stock available under the plan. There were 44,629, 55,354 and 41,984 shares issued under the plan for which $71,000, $79,000 and $76,000 of expense was recognized in 2005, 2004 and 2003, respectively.
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 $4,916,000, $1,694,000 and $(1,999,000) for 2005, 2004 and 2003, respectively.
The accumulated benefit obligation for the entire plan was $184,752,000 at December 31, 2005. This differs from the projected benefit obligation of $185,553,000 because the changes to the supplemental executive retirement plan will not be recognized until the first quarter of 2006. The accumulated benefit obligation for the entire plan was $171,678,000 at December 31, 2004.
The expected 2006 contribution to the pension plan is $3,146,000 of which $2,076,000 is Harleysville Group’s expected portion.
The following benefit payments, which reflect expected future service primarily through March 31, 2006, are expected to be paid:
Harleysville Group has profit-sharing plans covering qualified employees. Harleysville Group’s expense under the plans was $2,565,000, $1,839,000 and $874,000 for 2005, 2004 and 2003, respectively.
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, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Harleysville Group Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 8, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.