At December 31, 2008, the Mutual Company owned approximately 52% of the Common Stock of the Company. Harleysville Group Inc. and its wholly owned subsidiaries 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 (which was merged into Harleysville Worcester Insurance Company in 2007), and Harleysville Ltd., a real estate partnership that owns the home office.
Harleysville Group has written down to fair value, any equity security that has declined below cost by (i) more than 20% and maintained such decline for six months, or (ii) 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. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon industry-standard pricing methodologies based on observable market data. 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.
The application of certain of these critical accounting policies to the years ended December 31, 2008 and 2007 is discussed in greater detail below.
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 $0.6 million, $1.1 million and $1.0 million in 2008, 2007 and 2006, respectively.
Premiums earned increased $85.5 million, or 10.3%, for the year ended December 31, 2008 due to the increase in the pool participation percentage effective January 1, 2008. Of the $85.5 million increase, $67.7 million, or 9.8%, was in commercial lines and $17.8 million, or 12.4%, was in personal lines. Excluding the impact of the change in the pool participation percentage, premiums earned decreased $6.4 million, or 0.8%, for the year ended December 31, 2008. This decrease of $6.4 million in premiums earned is due to a decrease of $8.1 million, or 1.2%, in premiums earned for commercial lines and an increase of $1.7 million, or 1.2%, in premiums earned for personal lines.
In the third quarter of 2008, the Company recorded an impairment charge of $17.7 million on equity securities that it was planning to sell. There was an additional impairment charge of $30.9 million in the fourth quarter of 2008 on the equity securities, prior to their sale. The equity securities were sold in November 2008 to recover a portion of federal income taxes which were previously paid. In 2006, the Company sold all of its holdings of individual equity securities and invested in equity index funds. As a result of this transaction, the Company recognized a capital gain of approximately $40 million. Under existing federal income tax regulations, such taxes can be recovered in future periods to the extent capital losses are recognized. As a result of the decline in value of the equity index funds held by the Company during 2008, the duration of the impairment, the likelihood of near term recovery and the availability to carryback realized capital losses for federal income tax purposes upon their disposal, the Company determined that it was appropriate to sell the equity investments and recover a portion of the federal income taxes which were previously paid.
An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium, (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium, and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio 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 statutory combined ratios by line of business for the year ended December 31, 2008 as compared to the year ended December 31, 2007 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 2007.
The personal lines statutory combined ratio increased to 99.7% for the year ended December 31, 2008 from 92.7% for the year ended December 31, 2007. Excluding the impact of the pool transfer, the personal lines statutory combined ratio increased to 100.1% for the year ended December 31, 2008 from 92.7% for the year ended December 31, 2007. The increase in the personal lines combined ratio for the year ended December 31, 2008 primarily relates to the higher incidence of catastrophe losses during this year (7.7 points) compared to the catastrophe losses in the prior year (2.9 points) and non-catastrophe property loss activity. The higher than average catastrophe experience primarily relates to losses associated with a series of hail events in Minnesota during the second quarter.
A reduction in homeowners severity in accident years 2006 and prior was observed during 2008. A slight increase in claim severity and an increase in claim frequency in accident year 2007 was observed in this line during 2008 and led to the recognition of $1.2 million of adverse development during the year. In total, $0.7 million of favorable development was recognized in the homeowners line during 2008.
The tables below break out the change in the estimate of ultimate losses between December 31, 2007 and December 31, 2008 for the 2007, 2006, 2005 and 2004 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, 2007 and December 31, 2008. 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, 2007 and December 31, 2008
These tables illustrate that the changes to the Company’s estimates of ultimate loss for prior accident years between December 31, 2007 and December 31, 2008 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. Broadly speaking, 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.
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, 2008. 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.
called for a final settlement of the guaranteed reserves based on reported reserves as of December 31, 2007. A final settlement is now to occur based on guaranteed reserves as of December 31, 2017. The extension has no material impact on the Company’s financial statements.
The income tax expense for the year ended December 31, 2008 includes the tax benefit of $9.4 million associated with tax-exempt income compared to $7.2 million in the prior year.
Premiums earned decreased $5.8 million for the year ended December 31, 2007. The decrease was primarily composed of a decrease in premiums earned for commercial lines of $3.7 million and a decrease of $2.1 million in personal lines premiums earned. The decrease in premiums earned for commercial lines was primarily due to a decrease in commercial auto premiums earned due to fewer policy counts and a decrease in earned premiums assumed from involuntary pools. The decline in premiums earned for personal lines was primarily due to fewer policy counts. The reduction in personal lines volume was driven primarily by a reduction of personal automobile business from the continued implementation of more stringent underwriting processes, partially offset by an increase in homeowners business due to higher average premiums.
There were impairment charges of $1.4 million in 2007 and no impairment charges in 2006.
Harleysville Group’s statutory combined ratio decreased to 96.7% for the year ended December 31, 2007 from 98.6% for the year ended December 31, 2006. Such decrease was due to improved underwriting results in commercial lines, partially offset by a lower underwriting gain in personal lines.
The commercial lines statutory combined ratio decreased to 97.5% for the year ended December 31, 2007 from 100.3% for the year ended December 31, 2006. The decrease is primarily due to declines in the combined ratio for all lines of business. Favorable prior accident year development as well as improved underwriting results in the current accident year contributed to the decreases in the commercial auto and commercial multi-peril lines of business. The decrease in the commercial auto combined ratio was primarily due to the recognition of favorable development of $10.2 million in 2007, while favorable development of $5.1 million was recognized in 2006. The decrease in the commercial multi-peril combined ratio was due to improved underwriting results in the current accident year. The decrease in the workers compensation combined ratio was primarily due to improved underwriting results in the current accident year.
In 2007, Harleysville Group recognized net favorable development of $22.0 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 prior accident years.
A reduction in commercial automobile severity was broadly observed during 2007 and led to the recognition of $10.2 million of favorable development in this line in 2007.
Underwriting expenses, including amortization of deferred policy acquisition costs, decreased $7.2 million for the year ended December 31, 2007 compared to the prior year. The decrease in underwriting expenses was primarily due to a decrease in head count resulting from on-going expense reduction initiatives, and lower incentive compensation, pension expense and severance charges.
Other income increased $0.2 million for the year ended December 31, 2007 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, partially offset by a decrease of $2.2 million in claim handling fees received in connection with the National Flood Insurance Program, related primarily to flood claims from Hurricane Katrina.
SFAS No. 128, “Earnings per Share.” The FSP 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 deferred stock units issued under employee compensation programs containing such dividend participation features would be considered participating securities subject to the “two-class method” in computing EPS rather than the “treasury stock method.” The FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008 and for interim periods within those years. All prior-period EPS data presented is to be adjusted retrospectively to conform to the provisions of this FSP. Early application is not permitted. The impact of adopting this staff position on Harleysville Group’s results of operations and financial condition is not expected to be material.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” to identify the sources of accounting principles and provide a framework for selecting the principles to be used in the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. SFAS No. 162 is effective November 15, 2008. The Company’s adoption did not result in any significant financial statement impact.
Net cash provided by operating activities was $197.0 million and $171.5 million for 2008 and 2007, respectively. The 2008 amount includes $82.6 million received in connection with the increase in pool participation effective January 1, 2008, offset by a decrease of $57.1 million primarily due to a decrease in underwriting cash flow due to greater catastrophe loss payments and an increase in non-catastrophe property loss payments.
Net cash used by investing activities was $80.9 million and $92.7 million for 2008 and 2007, respectively. The change is primarily due to lower net purchases of investments due to the increase in cash used by financing activities, partially offset by the increase in cash provided by operating activities.
Financing activities used net cash of $116.4 million and $78.7 million for 2008 and 2007, respectively. The increase is primarily due to an increase in the purchase of treasury stock in 2008 and an increase in dividends paid.
The SIV investments consist predominantly of asset-backed and mortgaged-backed securities. Each of the SIVs listed above represents a senior claim on the assets of the issuer. The Cheyne holding was restructured and replaced with the Gryphon Funding Ltd. pass-thru note. This security is now classified as other invested assets on the balance sheet. The Stanfield Victoria holdings are in technical default and are currently under the supervision of receivers appointed to protect the interests of senior creditors. In September 2008, a Sigma Finance Inc. Medium Term Note, a SIV holding, was downgraded to Ca by Moody’s as the result of a notice of default served on Sigma by one of its counterparties. Sigma entered into receivership in October 2008 and the security was written down to zero as of December 31, 2008. In 2008, impairment losses of $1.7 million on Gryphon, $1.5 million on Stanfield Victoria and $7.7 million on Sigma were recognized due to a significant deterioration in the credit worthiness of the issuer. In 2007, an impairment loss of $0.8 million was recognized on Gryphon.
In April 2008, a cash distribution of approximately 17% of the principal due on Cheyne Finance LLC was received in connection with the restructuring of the security. An additional cash distribution of approximately 7% of the principal due was received in August 2008 in connection with the restructuring of the security, which was exchanged for the Gryphon Funding Ltd. note in July 2008. In December 2008, a cash distribution of approximately 15% of the principal due on the Stanfield Victoria holdings was received.
As a holding company, the Company’s principal source of cash for the payment of dividends is dividends from its insurance subsidiaries. The Company’s insurance subsidiaries are subject to state laws that restrict their ability to pay dividends. The Company’s insurance subsidiaries declared and paid dividends to the Company of $109.9 million in 2008. Dividends of $53.2 million which were declared in 2007 were also paid to the Company in 2008.
Applying the current regulatory restrictions as of December 31, 2008, $58.9 million would be available for distribution to the Company by its subsidiaries after November 24, 2009 without prior regulatory approval. See the Business-Regulation section of this Annual Report on 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.
If certain catastrophic events occur, they could have a significant impact on our operating results and financial condition.
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
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.
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, which was originally extended in 2005 and extended again in 2007, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2014. 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.
The severe downturn in the public debt and equity markets, reflecting uncertainties associated with the mortgage crisis, worsening economic conditions, widening of credit spreads, bankruptcies and government intervention in large financial institutions, has resulted in significant realized and unrealized losses in our investment portfolio. Depending on market conditions going forward, we could incur substantial additional realized and unrealized losses in future periods, which could have an adverse impact on our results of operations, financial condition, debt and financial strength ratings and ability to access capital markets.
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 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.
Our subsidiaries are permitted under the terms of our debt agreement for our $100 million notes due 2013 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.
If our use of predictive modeling is not effective, our business could be 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 adversely affected.
If our technology initiatives are not successful, or the benefits are not realized, our business could be adversely affected.
Our businesses are increasingly dependent on technology. Our inability to anticipate or manage problems with technology, or fully realize the expected benefits from investments in technology, could adversely affect our ability to write business and could adversely impact our financial results.
As of December 31, 2008, the Mutual Company owned approximately 52% 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. Further, Section 203 of the Delaware General Corporation Law provides that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock, subject to certain exceptions. Section 203 may discourage a potential change of control transaction. Our Board of Directors is divided into three classes (A, B and C). The current three-year terms of Class A, B and C directors expire in 2010, 2009 and 2011, respectively. This classification of our Board of Directors could have the effect of discouraging a potential change in control transaction.
Held to maturity, at amortized cost (fair value $250,798 and $317,091)
Premiums earned from affiliate (ceded to affiliate, $761,751, $753,806 and $742,752)
Losses and loss settlement expenses (ceded to affiliate, $524,735, $490,058 and $482,783)
In connection with the amendment to the intercompany pooling agreement between the Company’s insurance subsidiaries and Harleysville Mutual Insurance Company (the Mutual Company) and its property and casualty insurance subsidiary, Harleysville Pennland Insurance Company (Pennland), fixed maturity investments and liabilities of $109,438,000 were transferred from the Mutual Company and Pennland to the Company’s insurance subsidiaries. See Note 2 of the Notes to Consolidated Financial Statements.
Harleysville Group is approximately 52% owned by Harleysville Mutual Insurance Company (the Mutual Company).
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 declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. 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 and the prospects for the fair value to recover in the near term, and Harleysville Group’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value.
The severe downturn in the public debt and equity markets, reflecting uncertainties associated with the mortgage crisis, worsening economic conditions, widening of credit spreads, bankruptcies and government intervention in large financial institutions, has resulted in significant realized and unrealized losses in our investment portfolio. Depending on market conditions going forward, we could incur additional realized and unrealized losses in future periods.
Harleysville Group has several share-based compensation plans. Harleysville Group accounts for the plans under the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), which replaced SFAS No. 123 and superceded APB Opinion No. 25, using the modified prospective application provisions. SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements.
Implementing SFAS No. 123(R) on January 1, 2006 did not have a material effect on income before cumulative effect of accounting change and basic or diluted earnings per share before cumulative effect of accounting change in the year ended December 31, 2006. A cumulative effect of change in accounting benefit of $942,000, net of tax of $507,000, was recorded in the first quarter of 2006 related to the accounting for the Long Term Incentive Plan (LTIP). The LTIP had a cash component and a stock component which awarded 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 Opinion No. 25, this plan had been accounted for using the intrinsic method. Under SFAS No. 123(R), the cash component was accounted for under the liability method and the stock component was accounted for as an equity instrument.
In March 2008, the FASB issued SFAS No. 161, “Disclosure about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities and specifically requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of, and gains and losses on, derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The provisions of SFAS No. 161 are effective for the Company beginning January 1, 2009. The Company is currently evaluating the effect, if any, that the adoption of SFAS No. 161 will have on its financial statements.
The insurance subsidiaries participate in a reinsurance pooling agreement with the Mutual Company and its property and casualty insurance subsidiary, Harleysville Pennland Insurance Company (Pennland), whereby such subsidiaries and Pennland cede to the Mutual Company all of their insurance business and assume from the Mutual Company 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 80% for 2008 and 72% for 2007 and 2006.
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 loss settlement expenses 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.
Harleysville Group has off-balance-sheet credit risk related to approximately $74,000,000 and $78,000,000 of premium balances due to the Mutual Company from agents and insureds at December 31, 2008 and 2007, respectively.
For investments that have quoted market prices in active markets, the Company uses the quoted market price as fair value and includes these investments in Level 1 of the fair value hierarchy. The Company classifies U.S. Treasury securities and publicly traded equity securities as Level 1. When quoted market prices in active markets are not available, the Company uses a pricing service to estimate fair value. The fair value estimates obtained from this pricing service are included in Level 2 of the fair value hierarchy. The Company classifies its fixed maturity securities other than U.S. Treasury securities and private placements as Level 2. Private placement fixed maturity securities, non-publicly traded equity securities and investments in receivership are classified as Level 3. Fair value of the investments in receivership is based on cash flow analysis and other valuation techniques.
When the independent pricing service provides a fair value estimate, the Company uses that estimate. At December 31, 2008, 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.
Management reviews, on an ongoing basis, the reasonableness of the methodologies employed by the independent pricing service. As part of the monthly review process, management examines the prices obtained from the independent pricing service. This process routinely involves reviewing any available recent transaction activity reported via various investment research tools. Additionally, the Company tracks changes in credit ratings of all fixed maturity securities on a monthly basis and performs a more in-depth, quarterly evaluation of fixed income securities that are rated below single A by Moody’s and/or S&P. If as a result of its review, management does not believe that a price received with respect to any particular security is a reasonable estimate of the fair value of the security, it will discuss this with the independent pricing service to resolve the discrepancy. Management then determines the appropriate level of classification of each investment within the fair value hierarchy in accordance with SFAS 157, based on its evaluation of the inputs used in determining the fair value.
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, 2008. These assets are measured on a recurring basis. The assets previously included within security lending collateral are included in the fixed maturities available for sale, as the Company terminated its security lending program in September 2008.
The following tables present additional information about assets measured at fair value on a recurring basis for which significant unobservable inputs (Level 3) were used to determine fair value.
The Cheyne Finance LLC security included in security lending collateral at December 31, 2007 was restructured in the third quarter of 2008 and is now classified as other invested assets. The other invested assets are carried at cost and are tested for impairment on a quarterly basis. During 2008, the securities were written down to fair value and an impairment charge of $557,000 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, 2008 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, 2008 and 2007 amounted to $31,228,000 and $32,097,000 respectively.
Of the total fixed maturity securities with an unrealized loss at December 31, 2008, securities with a fair value of $470.4 million and an unrealized loss of $26.0 million are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $49.8 million and an unrealized loss of $2.4 million are classified as held to maturity on the balance sheet and are carried at amortized cost.
In the third quarter of 2008, the Company recorded an impairment charge of $17,700,000 on equity securities that it was planning to sell. There was an additional impairment charge of $30,900,000 in the fourth quarter of 2008 on the equity securities, prior to their sale. The equity securities were sold in November 2008 to recover a portion of
sheet. The Stanfield Victoria holdings are in technical default and are currently under the supervision of receivers appointed to protect the interests of senior creditors. In September 2008, a Sigma Finance Inc. Medium Term Note, a SIV holding, was downgraded to Ca by Moody’s as the result of a notice of default served on Sigma by one of its counterparties. Sigma entered into receivership in October 2008 and the security was written down to zero as of December 31, 2008. In 2008, impairment losses of $1,700,000 on Gryphon, $1,600,000 on Stanfield Victoria and $7,700,000 on Sigma were recognized due to a significant deterioration in the credit worthiness of the issuer. In 2007, an impairment loss of $830,000 was recognized on Gryphon.
Rental expense under leases with non-affiliates amounted to $2,494,000, $2,732,000 and $3,033,000 for 2008, 2007 and 2006, respectively. Operating lease commitments were not material at December 31, 2008.
portion of the line in accident years prior to 2005 was observed during 2008 and contributed to the recognition of adverse development for those accident years in 2008. In total, $1,200,000 in favorable development was recognized in the commercial multi-peril line during 2008.
A reduction in personal automobile severity in accident years 2006 and prior was observed during 2008. A slight increase in severity in accident year 2007 was observed in this line during 2008 and led to the recognition of $900,000 of adverse development during the year. In total, $7,500,000 of favorable development was recognized in the personal auto line during 2008.
The fair value of the notes was $94,188,000 and $97,882,000 at December 31, 2008 and 2007, 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 $6,406,000, $6,808,000 and $6,760,000 in 2008, 2007 and 2006 respectively.
Reclassification adjustment for (gains) losses included in net income, net of (taxes) benefits of $20,944, $(353) and $(14,202)
Under SFAS No. 123(R), the compensation expense for the various share-based compensation plans that has been charged against income before income taxes and cumulative effect of accounting change was $5,899,000, $4,723,000 and $4,529,000 for 2008, 2007 and 2006, respectively with a corresponding income tax benefit of $1,964,000, $1,555,000 and $1,467,000 for 2008, 2007 and 2006, respectively.
Harleysville Group has an Equity Incentive Plan (EIP) for key employees. Awards may be made in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units or any combination of the above. The EIP was amended in 1997, 2006 and 2007 and limited future awards to an aggregate of 1,000,000 shares, plus the remaining shares under the 1997 plan, of Harleysville Group Inc.’s common stock. Such shares may be authorized and unissued shares or treasury shares. The plan provides that stock options may become exercisable from six months to 10 years from the date of grant with an exercise price not less than fair market value on the date of grant. Options granted normally vest 33 1/3% at the end of one year, 33 1/3% at the end of two years and 33 1/3% at the end of three years from the date of grant. SARs have not been material. Restricted stock awards have vesting periods of three to five years and vest 100% at the end of the period. Restricted stock units have vesting periods of three to five years and vest 100% at the end of the period.
In determining the expense to be recorded for stock options, the fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. The significant assumptions utilized in applying the Black-Scholes option pricing model are the risk-free interest rate, expected term, dividend yield, and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. The expected term of an option award is based on historical experience of similar awards. The dividend yield is determined by dividing the per share- dividend by the grant date stock price. The expected volatility is based on the volatility of the Company’s stock price
over a historical period comparable to the expected term. The weighted average assumptions used in applying the Black-Scholes valuation model are shown below:
For share options and restricted stock and restricted stock unit awards granted under the plan, the Company recognized compensation expense of $5,105,000, $3,550,000 and $3,109,000 in 2008, 2007 and 2006, respectively. As of December 31, 2008 the Company’s total unrecognized compensation cost related to nonvested share-based compensation arrangements (including share options, restricted stock and restricted stock unit awards) granted under the plan was $6,246,000. The cost is expected to be recognized over a weighted average period of 2.2 years.
The weighted-average fair value of options granted under the employee stock purchase plan was $7.14, $6.74 and $6.11 for 2008, 2007 and 2006, respectively. The total intrinsic value of options exercised under the plan was $241,000, $297,000 and $581,000 for 2008, 2007 and 2006, respectively. Compensation expense of $288,000, $281,000 and $336,000 related to grants under the plan was recognized in 2008, 2007 and 2006, respectively. As of December 31, 2008, there was $11,000 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 2005 Non-Employee Directors’ Deferred Stock Unit Plan provided for the grant of up to 110,000 fully vested deferred stock units to outside directors of Harleysville Group Inc. and the Mutual Company. Each stock unit represents the right to receive, without payment to the Company, one share of common stock of Harleysville Group Inc. The plan was amended and restated in 2007 to provide for the grant of awards in the form of stock options, deferred stock units and restricted stock and was renamed the Amended and Restated Directors’ Equity Compensation Plan. The aggregate number of shares which may be issued under the plan is 500,000, which may be either authorized and unissued shares or treasury shares. At each April Board of Directors meeting, each non-employee director shall receive a number of deferred stock units equal to the result of dividing $50,000 by the fair market value of a share of HGI common stock.
The weighted-average grant date fair value of the 2005-2007 plan stock award was $19.64 per share. Compensation expense of $434,000, and $823,000 was recognized related to the stock component of the LTIP for 2007 and 2006, respectively. As of December 31, 2008, 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 2006.
The LTIP also has a cash component. This component is accounted for under the liability method of SFAS No. 123(R). Compensation expense of $407,000 and $616,000 was recognized related to the cash component of the LTIP for 2007 and 2006, respectively. As of December 31, 2008, there was no unrecognized compensation cost related to the cash component.
Cash received from option exercises under all share-based payment arrangements for 2008, 2007 and 2006 was $9,410,000, $9,034,000 and $20,050,000, respectively. The actual tax benefit realized for the tax deductions from option exercises of the share-based payment arrangements was $1,945,000, $1,439,000 and $3,281,000, respectively, for 2008, 2007 and 2006.
Harleysville Group has incentive bonus plans. The plans were amended in 2006 to include virtually all employees. Cash bonuses are earned on a formula basis depending upon the performance of Harleysville Group and the Mutual Company in relation to certain targets. Harleysville Group’s expense for such plans was $6,111,000, $5,920,000 and $6,901,000 for 2008, 2007 and 2006, respectively.
Amounts in accumulated other comprehensive income expected to be recognized as components of net periodic pension cost in 2009 are as follows: net actuarial loss $1,775,000.
The expected 2009 contribution to the pension plan is $4,305,000, of which $3,368,000 is Harleysville Group’s expected portion.
Harleysville Group has profit-sharing plans covering qualified employees. Harleysville Group’s expense under the plans was $3,868,000, $4,264,000 and $3,956,000 for 2008, 2007 and 2006, respectively. The plan was amended, effective April 1, 2006, to require a Company core contribution, equal to 5% of salary, to be automatically contributed to all eligible employees’ accounts on a biweekly basis regardless of the employees’ salary deferral amounts into the plan. Harleysville Group’s expense for the Company core contribution was $3,822,000, $3,738,000 and $2,866,000 in 2008, 2007 and 2006, respectively.
As an underwriter of property and casualty insurance, Harleysville Group has three reportable segments, which consist of the investment function, the personal lines of insurance and the commercial lines of insurance. Using independent agents, Harleysville Group markets personal lines of insurance to individuals, and commercial lines of insurance to small and medium-sized businesses.