(1) The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with the Mutual Company and Pennland. Harleysville Group’s participation was 80% for 2008 through 2011 and 72% for 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3(a) of the Notes to Consolidated Financial Statements.
Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the control of Harleysville Group Inc. (the Company) and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on the Company and its wholly owned property and casualty insurance subsidiaries (collectively, Harleysville Group). There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results, including premium levels and underwriting results, could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; the insurance product pricing environment; changes in applicable law; government regulation and changes therein that may impede the ability to charge adequate rates; performance of and instability in the financial markets; investment losses; fluctuations in interest rates; significant catastrophe events in the geographic regions where we do business; decreased demand for property and casualty insurance; availability and price of reinsurance; the A. M. Best group rating of Harleysville Group; and the status of labor markets in which the Company operates. In addition, see “Management’s Discussion and Analysis - Risk Factors.”
Variations in premium income are subject to a number of factors, including:
limitations on premium rates arising from the competitive marketplace or regulation;
limitations on available business arising from a need to maintain the quality of underwritten risks;
the Company’s ability to maintain its A (Excellent) group rating by A.M. Best; and
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 deferred acquisition costs are not recoverable, they are written off and further analyses are performed to determine if an additional liability would need to be accrued.
The application of certain of these critical accounting policies to the years ended December 31, 2011 and 2010 is discussed in greater detail below.
On September 28, 2011, the Company and Harleysville Mutual Insurance Company (the Mutual Company) entered into an agreement and plan of merger (the Merger Agreement) with Nationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide would merge into the Company. Nationwide would acquire all of the publicly held shares of common stock of the Company for $60.00 per share in cash, and the Mutual Company would merge into Nationwide and the policyholders and members of the Mutual Company would become policyholders and members of Nationwide. The Mutual Company has also entered into a voting agreement with Nationwide (the Voting Agreement) under which the Mutual Company agreed to vote its 53% voting interest in the Company in favor of the Merger. The Merger Agreement restricts the Company from engaging in certain activities and taking certain actions without Nationwide’s prior approval, including among others, the payment of stockholder dividends.
The Company’s property and casualty subsidiaries participate in a pooling agreement with the Mutual Company and its property and casualty insurance subsidiary, Harleysville Pennland Insurance Company (Pennland). The pooling agreement provides for the allocation of premiums, losses, loss settlement expenses and underwriting expenses between Harleysville Group and the Mutual Company. Harleysville Group is not liable for any losses incurred by the Mutual Company or Company subsidiaries Harleysville Preferred Insurance Company (Preferred) and Harleysville Insurance Company of New Jersey (HNJ) prior to January 1, 1986, the date the pooling agreement became effective, or for certain business assumed by the Mutual Company effective January 1, 2010. Harleysville Group’s participation in the pool has been 80% since January 1, 2008.
2011 and following will be retained 100 percent by the Mutual Company. The financial results of this business for prior accident years will continue to be shared between the Company’s property and casualty subsidiaries, the Mutual Company and Pennland under the existing pool participations. Harleysville Group paid cash of $33 million on January 3, 2011 associated with the transfer of the unearned premium liability on the workers compensation business as of January 1, 2011. Harleysville Group’s unearned premium liability decreased by $40 million and Harleysville Group received a ceding commission of $7 million for expenses that were incurred to generate the business transferred to the Mutual Company, which ceding commission reduced deferred policy acquisition costs.
Harleysville Ltd. is a subsidiary of the Company and leases the home office to the Mutual Company, which shares the facility with Harleysville Group. Rental income under the lease was $4.5 million, $4.4 million and $4.2 million for 2011, 2010 and 2009, respectively, and is included in other income after elimination of intercompany amounts of $3.2 million, $3.0 million and $2.9 million in 2011, 2010 and 2009, respectively. The lease had a five-year term expiring December 31, 2009 and included a formula for additional rent for any additions, improvements or renovations. The lease was renewed for one-year periods expiring December 31, 2012, December 31, 2011 and December 31, 2010 under its prior terms. The Mutual Company is responsible for the building operating expenses including maintenance and repairs. The pricing of the lease was based upon an appraisal obtained from an independent real estate appraiser.
Harleysville Group provides certain management services to the Mutual Company and other affiliates. Harleysville Group received a fee of $8.5 million, $5.8 million and $5.1 million in 2011, 2010 and 2009, respectively, for its services under these management agreements. Effective January 1, 2010, the management agreement was amended to include voluntary assumed reinsurance business written by the Mutual Company. The level of fees has been approved by each state insurance department having jurisdiction. Under related agreements, Harleysville Group serves as the paymaster for the Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense.
Harleysville Group borrowed $18.5 million from the Mutual Company in connection with the acquisition of 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 $0.1 million, $0.1 million, and $0.3 million in 2011, 2010 and 2009, respectively.
Premiums earned decreased $61.8 million, or 7.1%, for the year ended December 31, 2011 compared to the prior year primarily due to the change to the pooling agreement effective January 1, 2011, whereby premiums earned on workers compensation business is retained 100% by the Mutual Company. Excluding 2010 premiums earned on workers compensation business, premiums earned increased 2.1% for the year ended December 31, 2011 compared to the prior year.
Premiums earned for commercial lines decreased $83.8 million, or 12.4%, compared to the prior year primarily due to the change to the pooling agreement described in the preceding paragraph. Excluding 2010 premiums earned on workers compensation business, premiums earned decreased 0.9% for the year ended December 31, 2011 compared to the prior year. Premiums earned for personal lines increased $22.0 million, or 11.6%, compared to the prior year primarily due to higher average premiums and greater policy counts.
Investment income decreased $7.9 million for the year ended December 31, 2011, primarily due to a lower investment yield on fixed income securities and lower average invested assets, partially offset by greater dividends on equity securities. Average invested assets were lower due to negative operating cash flow in 2011 and use of the proceeds from the sale of these investments to pay dividends in 2011 and 2010, and repurchase shares in 2010.
Net realized investment gains increased $74.9 million for the year ended December 31, 2011, compared to the prior year primarily due to gains on the sale of equity securities in 2011. In October 2011, the Company sold virtually all of its equity securities, at a gain of $62 million, in order to reduce potential volatility in statutory surplus. Prior to this sale, the Company recognized impairment charges of $3.6 million on equity securities. Impairment charges of $0.4 million were also recognized on fixed maturity securities the Company sold in 2011. There were no credit-related impairment charges in 2010.
The personal lines statutory combined ratio increased to 129.3% for the year ended December 31, 2011 from 103.5% for the year ended December 31, 2010. The increase in the personal lines combined ratio for the year ended December 31, 2011 is primarily due to higher catastrophe and non-catastrophe weather losses affecting property coverages during 2011. The unusually severe weather described for commercial lines also impacted personal lines during 2011. Catastrophe losses in the personal lines represented 18.3 points of the combined ratio in calendar year 2011 compared to 9.7 points in calendar year 2010. The personal automobile line of business also contributed to the overall increase in the personal lines combined ratio in 2011. The increase in the personal automobile combined ratio from 104.9% for the year ended December 31, 2010 to 119.4% for the year ended December 31, 2011 is primarily due to higher than expected frequency and severity in accident years 2010 and 2011.
As with the Paid Loss Development Method, various indications of ultimate loss may be produced from the Incurred Loss Development Method. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections.
Immature Accident Periods: The Paid Loss Development Method is generally given less consideration than the Incurred Loss Development Method for less mature accident periods since the relatively low magnitude of losses paid at early evaluations tends to result in less reliable indications from the Paid Loss Development Method. For long-tail lines of business, neither the Incurred nor the Paid Loss Development methods may receive significant consideration for the most recent accident period. This is due to the fact that the relatively low magnitude of losses either incurred or paid at early evaluations tends to result in less reliable indications from these methods.
The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the year ended December 31, 2011 by line of business:
In 2011, Harleysville Group recognized net favorable development of $32.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across casualty lines in accident years 2003 through 2008, partially offset by adverse development in accident years 2009 and 2010.
A decrease in other commercial lines severity, primarily in accident years 2007 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $2.8 million of favorable prior year development was recognized in this line during 2011.
A decrease in homeowners severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $0.9 million of favorable prior year development was recognized in this line during 2011.
A reduction in personal automobile severity in accident years 2008 and prior was widely observed during 2010. Claim frequency in accident year 2009 increased, which led to $0.5 million of adverse development during the year. In total, $4.4 million of favorable prior year development was recognized in this line during 2010.
The tables below break out the change in the estimate of ultimate losses between December 31, 2010 and December 31, 2011 for the 2010, 2009, 2008 and 2007 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, 2010 and December 31, 2011. 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.
These tables illustrate that the changes to the Company’s estimates of ultimate loss for prior accident years between December 31, 2010 and December 31, 2011 are primarily driven by the severity component of loss. In this context, the term “severity” does not refer to an actuarial assumption, rather, it refers to “severity” as a descriptive statistic derived from the ratio of estimated ultimate loss to estimated ultimate claim counts. In general, as estimates of the ultimate number of claims were relatively stable for the prior accident periods, the changes in estimates of ultimate loss are characterized as resulting from a reduction in severity.
In general, those lines of business with a relatively low underlying volume of data, such as other commercial lines and other personal lines, are subject to greater variability in both claim severity and claim count development.
The following table presents the liability for unpaid losses and loss settlement expenses by 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, 2011. The range of estimates around the actuarial central estimates is statistically determined in order to provide information regarding the variability of the actuarial central 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 range is determined using the Monte Carlo Simulation method. This method uses the Company’s actual historical loss data to estimate the mean and standard deviation of a statistical distribution for future loss development. There have been no adjustments made to the historical data. The Company’s application of the Monte Carlo Simulation assumes that loss development factors are normally distributed with a mean and standard deviation derived from the historical data.
Reinsurance recoverables were $245.9 million and $219.1 million at December 31, 2011 and 2010, respectively. Of these amounts, $137.7 million and $102.3 million, respectively, or 56% and 47%, respectively, of the recoverables were due from governmental bodies, regulatory agencies or quasi governmental pools and reinsurance facilities where, Harleysville Group believes, there is limited credit risk. The remainder of the reinsurance recoverables are principally due from reinsurers rated A- or higher by the A.M. Best Company. Ceded reinsurance contracts do not relieve Harleysville Group’s primary obligation to its policyholders. Consequently, an exposure exists with respect to reinsurance recoverables to the extent that any reinsurer is unable to meet its obligation or disputes the liabilities assumed under the reinsurance contract. From time to time, Harleysville Group may encounter such disputes with its reinsurers. In addition, the creditworthiness of our reinsurers could deteriorate in the future due to adverse events affecting the reinsurance industry, such as a large number of major catastrophes.
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. 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, 2011.
Net realized investment gains decreased $1.7 million for the year ended December 31, 2010, compared to the prior year. There were no credit-related impairment charges in 2010 and credit-related impairment charges of $1.5 million on non-equity securities in 2009. The 2009 impairment charges consisted of $0.5 million on bonds which were sold in 2010 and $1.0 million on structured investment vehicles.
Harleysville Group’s statutory combined ratio increased to 102.5% for the year ended December 31, 2010 from 99.8% for the year ended December 31, 2009. The increase in the combined ratio was primarily due to greater catastrophe losses and greater non-catastrophe property losses in 2010, partially offset by greater favorable development in 2010. Net catastrophe losses increased to $35.7 million (4.1 points) for 2010 from $6.2 million (0.7 points) for 2009. The 2010 catastrophe losses were primarily due to a series of severe winter storms in the first quarter and several wind and hail events during the second and third quarters.
The statutory combined ratios by line of business for the year ended December 31, 2010 as compared to the year ended December 31, 2009 are shown below:
The personal lines statutory combined ratio increased to 103.5% for the year ended December 31, 2010 from 96.8% for the year ended December 31, 2009. The increase in the personal lines combined ratio for the year ended December 31, 2010 primarily relates to a higher incidence of personal lines catastrophe losses during 2010 (9.7 points) compared to the catastrophe losses in 2009 (1.0 points). Catastrophe losses in the homeowners line of business were significantly higher during 2010 (20.1 points) compared to 2009 (1.6 points).
Other income increased $2.8 million for the year ended December 31, 2010 compared to the prior year primarily due to an increase in fee income received in connection with the National Flood Insurance Program and an increase in management fees received from the Mutual Company.
The income tax expense for the year ended December 31, 2010 included the tax benefit of $13.2 million associated with tax-exempt income compared to $11.1 million in the prior year.
In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income.” Under the amendments
in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In December 2011, the FASB amended this guidance to postpone the requirement to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income where the components of net income and the components of other comprehensive income are presented and reinstate previous guidance related to such reclassifications. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively. Early adoption is permitted. The adoption of this ASU will not have a material impact on the Company’s results of operations or financial position.
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 generally 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 believes it 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.
Operating activities used net cash of $77.4 million and provided net cash of $98.2 million for 2011 and 2010, respectively. The 2011 amount includes $33.0 million paid in connection with the change to the intercompany pooling agreement effective January 1, 2011. The remaining decrease of $142.6 million is due to a decrease in underwriting cash flow, primarily from an increase in paid losses from greater catastrophe losses and a decrease in premiums due to the change in the pooling agreement.
Following the execution of the Merger Agreement, the Company determined that it was prudent to sell its equity securities portfolio holdings to reduce risks that could negatively impact the Company’s ability to meet various financial covenant closing conditions set forth in the Merger Agreement. Such sales occurred in the fourth quarter of 2011.
Financing activities used net cash of $27.1 million and $95.6 million for 2011 and 2010, respectively. The decrease is primarily due to a decrease in dividends paid and a decrease in the purchase of treasury stock in 2011.
liquidity exists within Harleysville Group and the Mutual Company. Maintaining a regular maturity schedule in readily marketable securities is an essential part of addressing liquidity. This regular maturity schedule is maintained in all interest rate environments. After-tax yield will be maximized consistent with safety and liquidity considerations by investment in taxable or tax-exempt securities, depending on Harleysville Group’s tax position.
As a holding company, the Company’s principal source of cash for the payment of stockholder 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 dividends of $19.3 million and paid dividends of $43.4 million in 2011 ($24.1 million of which had been declared in 2010). The Company’s insurance subsidiaries declared dividends of $89.0 million and paid dividends of $94.3 million in 2010 ($29.5 million of which had been declared in 2009).
Applying the current regulatory restrictions as of December 31, 2011, $65.1 million would be available for distribution to the Company by its subsidiaries in 2012 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 9 of the Notes to Consolidated Financial Statements.
The following summarizes Harleysville Group’s contractual obligations at December 31, 2011:
an insurance subsidiary pays a number of smaller catastrophic loss claims that, individually, fall below the subsidiary’s retention level.
Although we do not write health insurance, rules affecting health care services can affect other insurance that we write, including workers compensation and commercial and personal automobile and liability insurance. We cannot determine whether or in what form additional health care reform legislation may be adopted by the U.S. Congress or any state legislature. We also cannot determine the nature and effect, if any, that the adoption of health care legislation or regulations, or changing interpretations, at the federal or state level would have on us.
In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law. Among other things, the Dodd-Frank Act established a Federal Insurance Office within the U.S. Department of the Treasury and empowered it to gather data and information regarding the insurance industry and insurers. We cannot predict what impact, if any, the Dodd-Frank Act or any other such legislation will have on us.
If demand for property and casualty insurance decreases, it could have a material adverse impact on our business.
legislative and regulatory changes and judicial decisions that affect insurers’ liabilities.
The capital and credit markets experienced extreme volatility and disruption in the recent past. The volatility and disruption in the markets exerted downward pressure on the availability of liquidity and credit capacity for certain issuers. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by continued disruptions in the capital and credit markets.
Continued deterioration in the public debt and equity markets could lead to investment losses.
In addition to being assigned financial strength ratings, the Company is also assigned credit ratings. We consider our credit ratings from Moody’s and Standard & Poor’s to be most important with regard to our ability to access capital markets. Our current credit rating from Moody’s is Baa2 with a positive outlook while our Standard & Poor’s credit rating is BBB- with a positive outlook. We cannot be sure we will maintain our current investment grade credit ratings. An unfavorable change in our Moody’s or Standard & Poor’s credit rating to below investment grade could make it more expensive for us to access capital markets.
Delay in the consummation of the Mergers could have an adverse effect on our stock price, financial condition, results of operations or business prospects.
employees may experience uncertainty regarding their future roles with the merged company, which might adversely affect the Company’s ability to retain, recruit and motivate key personnel;
the Company may be unable to grow its business or implement new business initiatives given the pendency of the Merger transactions; and
third parties with business relationships with the Company may seek to terminate or renegotiate their relationships with the Company as a result of the Merger.
The Merger Agreement also restricts the Company from engaging in certain activities and taking certain actions without Nationwide’s approval, which could prevent us from pursuing opportunities that may arise prior to the closing of the Merger or termination of the agreement.
If the Merger is not completed, for any reason, including reasons beyond our control, our ongoing business is likely to be adversely affected and we will be subject to the following risks, among others:
we may have to pay significant costs relating to the Merger without receiving the benefits of the Merger;
any resulting negative customer perception could adversely affect our ability to compete for, or to win, new and renewal business in the marketplace; and
We have incurred and will continue to incur substantial transaction and Merger-related costs in connection with the Merger.
We face significant competition from other regional and national insurance companies, agents and from self-insurance, which may result in lower revenues.
Although we have paid cash dividends in the past, we are currently restricted, under the Merger Agreement, from paying cash dividends, and we may not be able to pay cash dividends in the future.
We have a history of paying dividends to our stockholders when sufficient cash is available. However, under the Merger Agreement we are restricted from paying cash dividends to our stockholders without the consent of Nationwide, and did not pay a fourth quarter 2011 dividend. Further, any payment of future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section.
and C). The current three-year terms of Class A, B and C directors expire in 2013, 2012 and 2014, respectively. This classification of our Board of Directors could have the effect of discouraging a potential change in control transaction.
Consolidated Statements of Income for Each of the Years in the Three-year Period Ended December 31, 2011
Harleysville-Atlantic Insurance Company (Atlantic) - merged into Worcester in December 2011
Harleysville Insurance Company of Ohio (HIC Ohio) - merged into Worcester in December 2011
Harleysville Group is approximately 53% 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. Unrealized gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. A fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value.
In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, “Fair Value Measurements and Disclosures.” ASU 2010-06 applies to all entities that are required to make disclosures about recurring or non-recurring fair value measurements. ASU 2010-06 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories was for interim and annual periods beginning after December 15, 2009. The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category was for interim and annual periods beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s results of operations or financial position.
In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force).” This ASU amends FASB Accounting Standards Codification (ASC) Topic 944, Financial Services-Insurance, to address which costs related to the acquisition of new or renewal insurance contracts qualify for deferral. The ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employee’s compensation and fringe benefits related to certain activities for successful contract acquisitions, or (3) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs - Capitalized Advertising Costs. An insurance entity would expense as incurred all other costs related to the acquisition of new or renewal insurance contracts. The amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2011, and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity’s annual reporting period. The Company will adopt this guidance prospectively. During 2012, the Company estimates that pre-tax expenses will increase by approximately $20 million (unaudited), as a lower amount of acquisition costs will be capitalized and amortization of the greater December 31, 2011 balance will continue.
In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU result in common fair value measurement and disclosure in U.S. GAAP and IFRSs. The amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include: (1) those that clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements; and (2) those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurement. For public entities, the amendments in this ASU are effective during interim and annual periods beginning after December 15, 2011, and are to be applied prospectively. Early application by public entities is not permitted. The adoption of this ASU will not have a material impact on the Company’s results of operations or financial position.
In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment.” The amendments in this ASU permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in ASC Topic 350, Intangibles-Goodwill and Other. Previous guidance under this topic required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount. If the fair value of the reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. This ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this ASU will not have a material impact on the Company’s results of operations or financial position.
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 pooling agreement provides for allocation of premiums, losses and loss settlement expenses and underwriting expenses between Harleysville Group and the Mutual Company. Harleysville Group is not liable for any losses incurred by its subsidiaries, Harleysville Preferred Insurance Company and Harleysville Insurance Company of New Jersey, and the Mutual Company prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool has been 80% since January 1, 2008. Effective January 1, 2010, the pooling agreement was amended to exclude reinsurance premiums, losses, loss settlement expenses and underwriting expenses voluntarily assumed by the Mutual Company.
Because this pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the reinsurance pooling agreement provides for the right of offset, and the amount of credit risk with the Mutual Company was not material at December 31, 2011 and 2010. The Mutual Company has an A. M. Best rating of “A” (Excellent).
Harleysville Ltd. leases the home office to the Mutual Company, which shares the facility with Harleysville Group. Rental income under the lease was $4,469,000, $4,402,000 and $4,194,000 for 2011, 2010, and 2009, respectively, and is included in other income after elimination of intercompany amounts of $3,175,000, $2,994,000 and $2,852,000 in 2011, 2010 and 2009, respectively.
Harleysville Group has off-balance-sheet credit risk related to approximately $97,300,000 and $99,600,000 of premium balances due to the Mutual Company from agents and insureds at December 31, 2011 and 2010, respectively.
On December 30, 2010, Harleysville Group Inc. acquired Mainland Insurance Company (Mainland) from the Mutual Company for $4,825,000 in cash. On December 31, 2010, HIC New York was merged into Mainland and Mainland’s name was changed to Harleysville Insurance Company of New York (HIC New York). Mainland was a shell property and casualty insurance company with no premiums or outstanding insurance obligations. The acquisition and Merger were completed to facilitate the redomestication of HIC New York to Pennsylvania in order to improve the efficiency of the corporate structure. Supplemental cash flow information for the acquisition is as follows:
Level 3 - Inputs that are unobservable, reflecting the Company’s own assumptions.
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 and equity mutual funds as Level 1. When quoted market prices in active markets are not available, the Company relies on a pricing service to estimate fair value. The Company classifies its fixed maturity securities other than U.S. Treasury securities and private placements as Level 2. Private placement fixed maturity securities and non-publicly traded equity securities are classified as Level 3.
In instances when the independent pricing service is unable to provide a fair value estimate, the Company attempts to obtain a non-binding fair value estimate from a number of broker/dealers and reviews any fair value estimate reported by an independent business news service. In instances where only one broker/dealer provides a fair value estimate for a fixed maturity security, the Company uses that estimate. In instances where the Company is able to obtain fair value estimates from more than one broker/dealer, the Company generally uses the lowest or next to lowest fair value estimate. In instances where neither the independent pricing service nor a broker/dealer is able to provide a fair value estimate, the fair value is based on cash flow analysis and other valuation techniques which utilize significant unobservable inputs and the Company classifies the fixed maturity investment as a Level 3 investment. Level 3 investments represent less than 1% of the Company’s total investment portfolio.
The following tables presents 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 amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2011 and 2010 amounted to $32,658,000 and $32,581,000 respectively.
Of the total fixed maturity securities with an unrealized loss at December 31, 2011, securities with a fair value of $10,963,000 and an unrealized loss of $22,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $5,969,000 and an unrealized loss of $26,000 are classified as held to maturity on the balance sheet and are carried at amortized cost.
Harleysville Group has not directly held or issued derivative financial instruments during the periods presented.
In the ordinary course of business, Harleysville Group cedes insurance to, and assumes insurance from, insurers to limit its maximum loss exposure through diversification of its risks. See Note 3(a) for discussion of reinsurance with the Mutual Company. Reinsurance contracts do not relieve Harleysville Group of primary liability as the originating insurer. After excluding reinsurance transactions with the Mutual Company under the pooling arrangement in the assumed and ceded amounts below, the effect of Harleysville Group’s share of other reinsurance on premiums written and earned is as follows:
Rental expense under leases with non-affiliates amounted to $2,619,000, $2,514,000 and $2,793,000 for 2011, 2010 and 2009, respectively. Operating lease commitments were not material at December 31, 2011.
Activity in the liability for unpaid losses and loss settlement expenses is summarized as follows:
In 2011, Harleysville Group recognized net favorable development of $32,061,000 in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across casualty lines in accident years 2003 through 2008, partially offset by adverse development in accident years 2009 and 2010.
A decrease in workers compensation severity, primarily in accident years 2003 through 2008, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $11,800,000 of favorable prior year development was recognized in this line during 2011.
A decrease in commercial multi-peril severity was widely observed during 2011, which led to the recognition of favorable development in most accident years prior to 2009. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these years. In aggregate, $10,600,000 of favorable prior year development was recognized in this line during 2011.
A decrease in personal automobile severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $70,000 of favorable prior year development was recognized in this line during 2011.
A slight decrease in other personal lines severity was observed during 2011, primarily in accident year 2009. In aggregate, $300,000 of favorable prior year development was recognized in other personal lines during 2011.
A reduction in other personal lines severity was observed during 2010, especially in accident year 2005. Severity in accident years 2008 and 2009 was observed to marginally increase, which led to the recognition of approximately $100,000 of adverse development in each accident year. In total, $677,000 of favorable development was recognized in other personal lines during 2010.
Interest paid was $5,876,000, $5,887,000 and $6,054,000 in 2011, 2010 and 2009 respectively.
Net cash paid for federal income taxes in 2011, 2010 and 2009 was $1,046,000, $11,100,000 and $9,100,000 respectively.
The actual income tax rate differed from the statutory federal income tax rate applicable to income before income taxes as follows:
As of December 31, 2011 and 2010, Harleysville Group had no material unrecognized tax benefits or accrued interest and penalties. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense. Federal tax years 2007 through 2010 were open for examination as of December 31, 2011.
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, 2007 and 2010 and limits future awards to an aggregate of 3,500,000 shares of the Company’s common stock, plus the remaining shares under the plan in existence in 1997. 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, subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder. SARs have not been material. Time-based restricted stock awards have vesting periods of three to five years and vest 100% at the end of the period. Time-based restricted stock units have vesting periods of three to five years and vest 100% at the end of the period. Some restricted stock and restricted stock unit awards have performance-based vesting requirements and can vest anywhere from 0% to 200% of the number of target shares, depending upon the achievement of such performance goals. Performance-based restricted stock and restricted stock units have vesting periods of three to five years. All of the restricted stock awards and restricted stock unit awards are subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder.
Harleysville Group Inc. is authorized to issue up to 3,150,000 shares of common stock under the terms of the Amended and Restated Employee Stock Purchase Plan (ESPP). Such shares may be authorized and unissued shares or treasury shares. 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. Subscription periods run from January 15 through July 14, or July 15 through January 14 in each year. In accordance with the terms of the Merger Agreement with Nationwide described in Note 2 of the Notes to Consolidated Financial Statements, no new subscription period will be commenced after the date of the Merger Agreement (September 28, 2011). In April 2010, the ESPP was amended to establish a 1,000 share purchase limitation per participant per subscription period.
The weighted-average fair value of options granted under the ESPP was $6.29, $6.08 and $7.07 for 2011, 2010 and 2009, respectively. The total intrinsic value of options exercised under the plan was $340,000, $340,000 and $212,000 for 2011, 2010 and 2009, respectively. Compensation expense of $280,000, $277,000 and $348,000 related to grants under the plan was recognized in 2011, 2010 and 2009, respectively. As of December 31, 2011, there was $12,000 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.
Amounts in accumulated other comprehensive income expected to be recognized as components of net periodic pension cost in 2012 are as follows: net actuarial loss $6,785,000.
The following is a summary of the fair value of major categories of plan assets as of December 31, 2011 and December 31, 2010:
As of December 31, 2011 and 2010, the pension plan also includes net assets of $143,000 and $214,000, respectively, primarily related to accrued investment income receivable at that date.
The expected 2012 contribution to the pension plan is $12,703,000, of which $11,580,000 is Harleysville Group’s expected portion.
The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price:
Harleysville Group is also subject to other non-insurance claims proceedings, lawsuits and claims arising in the normal course of business. The Company does not believe that the ultimate liability associated with these claims will have a material adverse effect on its financial condition or results of operations. However, adverse outcomes are possible and could negatively impact the Company’s financial condition and results of operations in the future.
We have audited the accompanying consolidated balance sheets of Harleysville Group Inc. and Subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011. 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.