Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to the Company’s growth and economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on Harleysville Group. There can be no assurance that future developments will be in accordance with management’s expectations so that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results including premium growth and underwriting results could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; catastrophe losses; competition in insurance product pricing; government regulation and changes therein which may impede the ability to charge adequate rates; performance of the financial markets; fluctuations in interest rates; availability and price of reinsurance; the Best’s rating of Harleysville Group; and the status of labor markets in which the Company operates.
Liabilities for Losses and Loss Settlement Expenses. The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have not yet been reported to Harleysville Group. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of statistical techniques. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operations.
Harleysville Group evaluates its investment portfolio quarterly to determine if a decline in fair value below cost is other than temporary. Harleysville Group has written down to fair value, without exception, any equity security that has declined below cost by more than 20% and maintained such decline for six months, or by 50% or more, in the quarter in which either such decline occurred. In some cases, securities that have declined by a lesser amount or for a shorter period of time are written down if the evaluation indicates the decline is other than temporary. For example, one equity security had declined for a short period of time but was written down in the fourth quarter of 2002 when the sale of the company at a value less than our cost was announced. Fair value of equity securities is based on the closing market value as reported by a national stock exchange or Nasdaq. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities but Harleysville Group does not own a material amount of non-traded securities.
The application of certain of these critical accounting policies to the years ended December 31, 2003 and 2002 is discussed in greater detail below.
The Company’s property and casualty subsidiaries participate in a pooling agreement with Mutual. The pooling agreement provides for the allocation of premiums, losses, loss settlement expenses and underwriting expenses between Harleysville Group and Mutual. Harleysville Group is not liable for any pooled losses occurring prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool has been 72% since January 1, 1998.
Because the pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to Mutual. However, the pooling agreement provides for the right of offset and the amount of credit risk with Mutual was not material at December 31, 2003 and 2002. Mutual has an A. M. Best rating of “A-” (Excellent).
Harleysville Group has off-balance-sheet credit risk related to approximately $71 million and $68 million of premium balances due to Mutual from agents and insureds at December 31, 2003 and 2002, 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 2003, 2002 and 2001. This reinsurance coverage was in excess of a retention of $3.6 million in a quarter for 2003, 2002 and 2001. 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 $8.4 million, $7.8 million and $7.0 million, and losses incurred of $4.2 million, $0.3 million and $8.0 million for 2003, 2002 and 2001, respectively. The premiums for this reinsurance were established in consultation with an independent actuarial firm.
Harleysville Group borrowed $18.5 million from Mutual in connection with the acquisition of Mid-America and HIC New York in 1991. It was a demand loan with a stated maturity in March 1998. In February 1998, the maturity was extended to March 2005 and the interest rate became LIBOR plus 0.65%, which was a commercially reasonable market rate in 1998. Interest expense on this loan was $0.3 million, $0.5 million and $0.9 million in 2003, 2002 and 2001, respectively.
Harleysville Group has no material relationships with current or former members of management other than compensatory plans and arrangements disclosed or described in the Company’s public filings.
There were impairment charges of $0.5 million and $29.1 million for the years ended December 31, 2003 and 2002, respectively. Harleysville Group had gross realized losses of $3.6 million in 2003 which were from the sales of securities which had not declined by more than 20% below their cost for more than six months at the time of their sale.
Harleysville Group holds securities with unrealized losses at December 31, 2003 as follows:
Substantially all of the unrealized loss on fixed maturity securities is associated with securities classified as available for sale and carried at fair value on the balance sheet.
There are six positions that comprise the unrealized loss in equity investments at December 31, 2003. They have had volatile price movements and have not been significantly below cost for significant continuous amounts of time and the securities that traded below cost for twelve months or longer have all traded above cost in early 2004.
There are $21.4 million in fixed maturity securities, at amortized cost, that at December 31, 2003, had been below amortized cost for over 12 months. These are comprised of airline enhanced equipment trust certificates (EETC) as follows:
Harleysville Group had publicly noted adverse loss trends in its workers compensation line for several quarters during 2002 and the trends were again worse than expected throughout 2003. These trends are consistent with the experience of other companies writing this coverage, many of which have, during the past two years, 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.
Net catastrophe losses increased $15.2 million and losses ceded under the aggregate catastrophe reinsurance agreement with Mutual increased $3.8 million for the year ended December 31, 2003. The increase was due to a greater number and more severe catastrophes in 2003, including $8.8 million of losses from Hurricane Isabel.
Losses ceded under the aggregate catastrophe reinsurance agreement with Mutual decreased by $7.6 million for the year ended December 31, 2002, as there were fewer severe storms than in the prior year.
Harleysville Group recognized favorable development in the provision for insured events of prior years of $4.6 million and $17.4 million in 2002 and 2001, respectively. Such development represents 0.6% and 2.2% of the net liability for unpaid losses and loss settlement expenses of $800.9 million and $792.6 million at December 31, 2001 and 2000, respectively. The favorable development for 2002 primarily related to lower-than-expected claim severity in both the commercial and personal lines of business. The favorable development for 2001 primarily related to lower-than-expected loss settlement expenses.
Net cash used by investing activities was $127.3 million and $100.9 million for 2003 and 2002, respectively. The change is primarily due to increased net purchases of investments due to the increase in cash provided by operating activities.
The National Association of Insurance Commissioners (NAIC) adopted risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company’s operations. These RBC standards have not affected the operations of Harleysville Group since each of the Company’s insurance subsidiaries has statutory capital and surplus in excess of RBC requirements.
Harleysville Group had off-balance-sheet credit risk related to $71 million of premium balances due to Mutual from agents and insureds at December 31, 2003.
We are required to maintain loss reserves for our estimated liability for losses and loss settlement expenses associated with reported and unreported claims for each accounting period. We regularly review our reserving techniques and our overall amount of reserves and, based on our estimated liability, raise or lower the levels of our reserves accordingly. If our estimates are incorrect and our reserves are inadequate, we are obligated to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. For every 1% change in our reserve, our pre-tax income is affected by approximately $10.6 million. Our reserve amounts are estimated based on what we expect our ultimate liability for losses and loss settlement expenses to be. These estimates are based on facts and circumstances of which we are
Results of property insurers are subject to weather and other events prevailing in any given year. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results for that year to be materially worse than for other years.
We compete with local, regional and national insurance companies, including direct writers of insurance coverage. Many of these competitors are larger than we are and many have greater financial, technical and operating resources. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent more than one insurance company.
We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, certain of our customers and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance.
We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors’ insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business
If our insurance subsidiaries are not able to pay adequate dividends to us, our ability to meet our obligations and pay dividends would be affected.
Our principal assets are the shares of capital stock of our insurance company subsidiaries. We rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations and for paying corporate expenses and dividends to shareholders. As described below, the payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as other regulatory restrictions. As a result, we may not be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our obligations or to allow us to pay dividends.
Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary for the preceding year. Our insurance subsidiaries paid no dividends to us in 2003, $12.0 million in 2002 and $10.0 million in 2001. An additional $11.6 million in aggregate dividends declared by our insurance subsidiaries have not yet been paid and remain as a receivable on the books of the Company at December 31, 2003. Applying the current regulatory restrictions as of December 31, 2003, $47.6 million would be available for distribution to us without prior approval during 2004. We anticipate no objections to the payment of the dividends described in the preceding two sentences.
We have a history of paying dividends to our shareholders when sufficient cash is available. However, 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.
Also, there can be no assurance that we will continue to pay dividends even if the necessary financial conditions are met and if sufficient cash is available for distribution.
Available for sale, at fair value (amortized cost $202,222 and $118,991)
Premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on a pro rata basis.
Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with, and are directly related to, the production of business, are deferred and amortized over the effective period of the related insurance policies 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 claims paying period, losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.
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 2003, 2002 and 2001. This reinsurance coverage was in excess of a retention of $3,600,000 for 2003, 2002 and 2001. 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 $8,441,000, $7,791,000 and $7,035,000, and losses incurred of $4,181,000, $334,000 and $7,951,000 for 2003, 2002 and 2001, respectively.
Harleysville Ltd. leases the home office to Mutual, which shares the facility with Harleysville Group. Rental income under the lease was $3,606,000, $3,531,000 and $3,512,000 for 2003, 2002 and 2001, respectively, and is included in other income after elimination of intercompany amounts of $2,207,000, $2,161,000 and $2,149,000 in 2003, 2002 and 2001, 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 $341,000, $483,000 and $936,000 in 2003, 2002 and 2001, respectively.
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2003 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.
Realized gross gains (losses) from investments and the change in difference between fair value and cost of investments, before applicable income taxes, are as follows:
Income tax benefit on realized investment losses were $(322,000), $(6,441,000) and $(1,075,000) for 2003, 2002 and 2001, respectively.
Deferred income taxes applicable to net unrealized investment gains included in shareholders’ equity were $36,142,000 and $29,161,000 at December 31, 2003 and 2002, respectively.
At December 31, 2003, Harleysville Group held cash collateral of $221,454,000 related to securities on loan with a market value of $215,696,000. 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.
Property and equipment consisted of land and buildings with a cost of $30,310,000 and $30,511,000, and equipment, including software, with a cost of $15,262,000 and $15,569,000 at December 31, 2003 and 2002, respectively. Accumulated depreciation related to such assets was $21,748,000 and $18,524,000 at December 31, 2003 and 2002, respectively.
Harleysville Group recognized adverse development in the provision for insured events of prior years of $119,059,000 in 2003 primarily due to greater-than-expected claims severity in both commercial and personal lines. The adverse development consisted of $108,322,000 in commercial lines and $10,737,000 in personal lines.
Harleysville Group recognized favorable development in the provision for insured events of prior years of $4,648,000 and $17,350,000 in 2002 and 2001, respectively. The favorable development for 2002 primarily relates to lower-than-expected claim severity in the commercial and personal lines of business. The favorable development for 2001 primarily relates to lower-than-expected loss settlement expenses. The 2001 favorable development includes $14,772,000 of reductions in loss settlement expenses. Such reductions are related to benefits from initiatives to reduce costs of adjusting claims and to the favorable development on losses.
A source of cash for the payment of dividends is dividends from subsidiaries. Harleysville Group Inc.’s insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2003, $47,567,000 would be available for distribution to Harleysville Group Inc. during 2004 without prior approval.
These RBC standards require the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2003 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s nine insurance subsidiaries at December 31, 2003 ranged from 478% to 609%.
Cash paid (refunded) for federal income taxes in 2003, 2002 and 2001 was $(3,465,000), $13,250,000 and $13,158,000, respectively.
Harleysville Group has an operating loss carryforward of $47,840,000 at December 31, 2003 which expires in 2023.
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 or any combination of the above. The EIP was amended in 1997 and limited future awards to an aggregate of 4,260,946 shares of Harleysville Group Inc.’s common stock. The plan provides that stock options may become exercisable from six months to 10 years from the date of grant with an option price not less than fair market value on the date of grant. The options normally vest 50% at the end of one year and 50% at the end of two years from the date of grant. SARs have not been material.
The Harleysville Group Inc. Year 2000 Directors’ Stock Option Program provides for the granting of options to eligible directors to purchase a maximum of 123,500 shares of common stock. Options are granted at exercise prices equal to fair market value on the date of grant. The options vest immediately, although no option is exercisable until six months after the date of grant. The options have a term of 10 years.
The following table summarizes information about fixed stock options at December 31, 2003:
The per share weighted-average fair value of options granted during 2003, 2002 and 2001 was $6.79, $9.04 and $8.45, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2003, 2002 and 2001, respectively: dividend yield of 2.84%, 2.21% and 2.12%; expected volatility of 38.99%, 37.34% and 34.89%; risk-free interest rate of 2.55%, 4.60% and 4.77%; and an expected life of 5.25 years.
Harleysville Group Inc. is authorized to issue up to 1,650,000 shares of common stock under the terms of the 1995 Employee Stock Purchase Plan as amended in 2003. Virtually all employees are eligible to participate in the plan, under which a participant may elect to have up to 15% of base pay withheld to purchase shares. The purchase price of the stock is 85% of the lower of the beginning-of-the-subscription-period or end-of-the-subscription-period fair market value. Each subscription period runs from January 15 through July 14, or July 15 through January 14. Under the plan, Harleysville Group Inc. issued 95,048, 92,175 and 93,637 shares to employees in 2003, 2002 and 2001, respectively.
Harleysville Group has incentive bonus plans. Cash and common stock bonuses are earned on a formula basis depending upon the performance of Harleysville Group and Mutual in relation to certain targets. There are 600,000 shares of common stock available under the Long Term Incentive Plan and 165,848 of these shares have been issued in 2003. Harleysville Group’s expense (benefit) for such plans was $(1,999,000), $7,291,000 and $1,808,000 for 2003, 2002 and 2001, respectively.
To develop the expected long-term rate of return on assets assumption, the company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension plan portfolio. This resulted in the selection of the 9.0% long-term rate of return on assets assumption.
The expected 2004 contribution to the pension is $10,000,000 of which $6,600,000 is Harleysville Group’s expected portion.
The following options to purchase shares of common stock were not included in the computation of diluted earnings (loss) per share because the exercise price of the options was greater than the average market price:
An additional 1,184,903 options to purchase shares of common stock were not included in the computation of diluted earnings per share for 2003 because their inclusion would have had an antidilutive effect.
We have audited the accompanying consolidated balance sheets of Harleysville Group Inc. and Subsidiaries as of December 31, 2003 and 2002, 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, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harleysville Group Inc. and Subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.