The application of certain of these critical accounting policies to the years ended December 31, 2004 and 2003 is discussed in greater detail below.
Harleysville Group has off-balance-sheet credit risk related to approximately $71.0 million of premium balances due to Mutual from agents and insureds at December 31, 2004 and 2003, 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 has attempted to reduce the potential impact of future catastrophes by achieving greater geographic distribution of risks, reducing exposure in catastrophe-prone areas and through reinsurance, including an agreement with Mutual. Effective January 1, 1997, Harleysville Group entered into a reinsurance agreement with Mutual whereby Mutual, in return for a reinsurance premium, reinsured accumulated catastrophe losses up to $14.4 million in a quarter for 2004, 2003 and 2002. This reinsurance coverage was in excess of a retention of $3.6 million in a quarter for 2004, 2003 and 2002. 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 $8.6 million, $8.4 million and $7.8 million, and losses incurred of $0.7 million, $4.2 million and $0.3 million for 2004, 2003 and 2002, respectively. The premiums for this reinsurance were established in consultation with an independent actuarial firm.
Harleysville Group provides certain management services to Mutual and other affiliates. Harleysville Group received a fee of $6.8 million, $7.2 million and $6.8 million in 2004, 2003 and 2002, 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 holds securities with unrealized losses at December 31, 2004 as follows:
There are eight positions that comprise the unrealized loss in equity investments at December 31, 2004. All have had volatile price movements and have not been significantly below cost for significant continuous amounts of time. Harleysville Group has been monitoring these securities and it is possible that some may be written down in the future.
After the events of September 11, 2001, air travel and the value of these airlines’ EETC securities declined. The EETCs are all “A tranche” holdings, which means they are in a senior credit position to the underlying airplane collateral value as compared to B and C tranche holders. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. Recent estimates indicate that in a distressed sale scenario, the value of the collateral would be approximately the same as the EETCs’ cost. The American Airline EETC’s currently carry an investment grade debt rating and the market value of both issues has improved over the past year. Harleysville Group is participating in certain EETC creditor committees and is monitoring developments. It is possible that these EETCs may be written down in the income statement in the future, depending upon developments involving both the issuers and world events which impact the level of air travel.
An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium; (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium; and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio decreased to 105.9% for the year ended December 31, 2004, from 123.2% for the year ended December 31, 2003. Such decrease was due to improved underwriting results in both commercial lines and personal lines, primarily resulting from the lower loss development and lower catastrophe losses.
The net $12.5 million of 2004 adverse development in the provision for insured events in prior years was primarily in the following lines: commercial multi-peril ($7.1 million), commercial automobile ($8.4 million), and other commercial liability lines ($3.9 million), partially offset by favorable development in workers compensation ($3.0 million) and homeowners ($4.3 million). The adverse development reflects loss severity that was higher than expected and was primarily from accident years 1998 to 2001, partially offset by favorable development in the 2003 accident year.
The $119.1 million of 2003 adverse development in the provision for insured events in prior years was primarily in the following lines: commercial automobile ($29.3 million), workers compensation ($48.8 million), commercial multi-peril ($31.8 million) and personal automobile ($11.5 million). Of the adverse development, $100.8 million was attributable to the 1998 to 2002 accident years and the balance was attributable to earlier accident years.
Harleysville Group had publicly noted adverse loss trends in its workers compensation line for several quarters during 2002 and 2003. These trends are consistent with the experience of other companies writing this coverage, many of which have, during this time, made substantial additions to their reserves for insured events in prior years in this line of insurance. The change in loss development patterns in 2003 was influenced by a number of factors. A reorganization of Harleysville Group’s claims operations resulted in more proactive claims management which, in turn, provided more contemporaneous loss estimates. In addition, weak economic conditions have hampered the ability to return injured workers to employment thus extending the estimated length of disabilities and medical loss cost trends have increased. The favorable development in workers compensation in 2004 reflects a moderation in severity.
The 2003 adverse development in commercial and personal automobile primarily was due to higher loss severity trends that became evident in the third and fourth quarters when case reserve increases were recognized. The higher loss severity trends continued in 2004 for commercial automobile. The case reserve increases for commercial automobile included the impact of adverse litigation trends. Harleysville Group had previously publicly noted an increase in litigation on bodily injury cases and a slowing of the rate of settlement. The combination of all of these factors resulted in the increased estimate of ultimate losses.
Net catastrophe losses decreased $10.4 million and losses ceded under the aggregate catastrophe reinsurance agreement with Mutual decreased $3.5 million for the year ended December 31, 2004. The decrease was due to less severe catastrophes in 2004.
Effective for one year from July 1, 2004, the Company’s subsidiaries and Mutual and its wholly-owned subsidiaries renewed its catastrophe reinsurance which provides coverage ranging from 85.0% to 95.0% of up to $155 million in excess of a retention of $30 million for any given catastrophe excluding terrorism for commercial lines. Harleysville Group’s 2004 pooling share of this coverage would range from 85.0% to 95.0% of up to $111.6 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 $142.2 million for any catastrophe involving an insured loss equal to or greater than $185 million. Harleysville Group’s 2004 pooling share of this maximum recovery would be $102.4 million for any catastrophe involving an insured loss of $133.2 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.
Realized investment losses improved $17.5 million for the year ended December 31, 2003, primarily resulting from lesser losses recognized on investments that were trading below cost on an other-than-temporary basis.
The greater underwriting loss was primarily due to greater loss severity, an increase in the provision for insured events in prior years and higher catastrophe losses. The 2003 provision for insured events in prior years was $119.1 million of adverse development compared to $4.6 million of favorable development in 2002.
Statutory pension expense totaled $18.2 million in 2003 and $1.7 million in 2002, and added 2.2 points and 0.2 points to the combined ratios for 2003 and 2002, respectively. However, GAAP pension expense totaled $4.7 million in 2003 and $3.5 million in 2002 and thus had a lesser impact on GAAP earnings comparisons.
The commercial lines statutory combined ratio increased to 123.6% for the year ended December 31, 2003 from 99.5% for the year ended December 31, 2002. The increase is primarily due to the adverse development in the provision for insured events in prior years, greater loss severity and greater catastrophe losses, particularly in commercial multi-peril insurance.
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 2004 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s nine insurance subsidiaries at December 31, 2004 ranged from 498% to 609%.
The following summarizes Harleysville Group’s contractual obligations at December 31, 2004.
You should consider carefully the following risks, as well as the other information contained in this 2004 Report on Form 10-K. If any of the following events described in the risk factors below actually occur, our business, financial condition and results of operations could be adversely affected. You should refer to the other information set forth in this 2004 Report on Form 10-K including our consolidated financial statements and the related notes.
If certain catastrophic events occur, they could have a significant impact on our financial and operational condition.
Our insurance subsidiaries have experienced, and are expected in the future to experience, catastrophe losses. It is possible that a catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the operating results and financial condition of our insurance subsidiaries, thereby limiting the ability of our insurance subsidiaries to pay dividends to us. In the last 6 years, the largest catastrophe to affect our results of operations was Hurricane Floyd in the third quarter of 1999, which resulted in $15.1 million of losses.
We are heavily regulated in the states in which we operate and if we violate those regulations or if the regulations unreasonably restrict our ability to do business, it could have an adverse effect on our business.
If demand for property and casualty insurance decreases, it could have an adverse impact on our business.
The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may adversely affect our investment portfolio.
Although we have paid cash dividends in the past, we may not be able to pay cash dividends in the future.
In addition, many state insurance laws require prior notification to the state insurance department of a change of control of a non-domiciliary insurance company licensed to transact insurance in that state. Although these pre-notification statutes do not authorize the state insurance departments to disapprove the change of control, they authorize regulatory action - including a possible revocation of our authority to do business - in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change of control of us may require prior notification in the states that have pre-acquisition notification laws.
Held to maturity, at amortized cost (fair value $517,434 and $463,953)
Held to maturity, at amortized cost (fair value $1,966 and $3,532)
Available for sale, at fair value (amortized cost $128,183 and $202,222)
Property and equipment are carried at cost less accumulated depreciation. Depreciation is calculated primarily on the straight-line basis over the estimated useful lives of the assets (40 years for buildings and three to 15 years for equipment).
Because this 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 reinsurance pooling agreement provides for the right of offset, and the amount of credit risk with Mutual was not material at December 31, 2004 and 2003. Mutual has an A. M. Best rating of “A-” (Excellent).
Harleysville 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 2004, 2003 and 2002. This reinsurance coverage was in excess of a retention of $3,600,000 for 2004, 2003 and 2002. 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 $8,597,000, $8,441,000 and $7,791,000, and losses incurred of $664,000, $4,181,000 and $334,000 for 2004, 2003 and 2002, respectively.
Intercompany balances are created primarily from the pooling arrangement (settled quarterly), allocation of common expenses, collection of premium balances and payment of claims (settled monthly). No interest is charged or received on intercompany balances due to the timely settlement terms and nature of the items. Interest expense on the loan from Mutual described in Note 7 was $395,000, $341,000 and $483,000 in 2004, 2003 and 2002, respectively.
Harleysville Group has off-balance-sheet credit risk related to approximately $71,000,000 of premium balances due to Mutual from agents and insureds at December 31, 2004 and 2003, respectively.
After the events of September 11, 2001, air travel and the value of these airlines’ EETC securities declined. The EETCs are all “A tranche” holdings, which means they are in a senior credit position to the underlying airplane collateral value as compared to B and C tranche holders. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. Recent estimates indicate that in a distressed sale scenario, the value of the collateral would be approximately the same as the EETCs’ cost. At December 31, 2004, the American Airlines EETCs carry an investment grade debt rating and the market value of both issues has improved over the past year. Harleysville Group is participating in certain EETC creditor committees and is monitoring developments. It is possible that these EETCs may be written down in the income statement in the future, depending upon developments involving both the issuers and world events which impact the level of air travel.
Income taxes (benefit) on realized investment gains (losses) were $4,433,000, $(322,000) and $(6,441,000) for 2004, 2003 and 2002, respectively.
At December 31, 2004, Harleysville Group held cash collateral of $139,486,000 related to securities on loan with a market value of $135,986,000. Harleysville Group’s policy is to require initial collateral of 102% of the market value of loaned securities plus accrued interest, which is required to be maintained daily by the borrower at no less than 100% of such market value plus accrued interest over the
life of the loan. Acceptable collateral includes cash and money market instruments, government securities, “A” rated corporate obligations, “AAA” rated asset-backed securities or GICs and Funding Agreements from issuers rated “A” or better.
Harleysville Group has not held or issued derivative financial instruments during the periods presented.
Property and equipment consisted of land and buildings with a cost of $30,607,000 and $30,310,000, and equipment, including software, with a cost of $14,433,000 and $15,262,000 at December 31, 2004 and 2003, respectively. Accumulated depreciation related to such assets was $24,149,000 and $21,748,000 at December 31, 2004 and 2003, respectively.
Rental expense under leases with non-affiliates amounted to $3,073,000, $2,960,000 and $2,469,000 for 2004, 2003 and 2002, respectively. Operating lease commitments were not material at December 31, 2004.
The EDC obligation is secured by Lake States’ building. Interest is payable semiannually at a variable rate (2.35% at December 31, 2004) equal to the market interest rate that would allow the bonds to be remarketed at par value. The bonds are subject to redemption prior to maturity in 2006 at levels dependent upon the occurrence of certain events.
Interest paid was $6,174,000, $5,436,000 and $5,599,000 in 2004, 2003 and 2002, respectively.
Harleysville Group has a net operating loss (NOL) carryforward of $24,858,000 at December 31, 2004 which expires in 2023.
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 55,354, 41,984 and 43,174 shares issued under the plan for which $79,000, $76,000 and $76,000 of expense was recognized in 2004, 2003 and 2002, respectively.
The expected 2005 contribution to the pension plan is $12,144,000 of which $8,015,000 is Harleysville Group’s expected portion.
Harleysville Group has profit-sharing plans covering qualified employees. Harleysville Group’s expense under the plans was $1,839,000, $874,000 and $1,573,000 for 2004, 2003 and 2002, respectively.
We have audited the accompanying consolidated balance sheets of Harleysville Group Inc. and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 2004, 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 11, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.