Harleysville 10Q 2008 Q2 Quarterly report

Harleysville (HGIC) Inactive 10-Q2008 Q2 Quarterly report

Content analysis

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

——————

FORM 10-Q

——————

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission File Number 0-14697

HARLEYSVILLE GROUP INC.

(Exact name of registrant as specified in its charter)

Delaware	51-0241172
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

355 Maple Avenue, Harleysville, PA 19438-2297

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (215) 256-5000

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer ¨	Accelerated filer ý
Non-accelerated filer ¨ (Do not check if a smaller reporting company)	Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No ý.

At August 4, 2008 28,687,690 shares of common stock of Harleysville Group were outstanding.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

INDEX

		Page Number
Part I	Financial Information
Item 1.	Financial Statements
	Consolidated Balance Sheets - June 30, 2008 and December 31, 2007		3
	Consolidated Statements of Income - For the three months ended June 30, 2008 and 2007		4
	Consolidated Statements of Income - For the six months ended June 30, 2008 and 2007		5
	Consolidated Statement of Shareholders’ Equity - For the six months ended June 30, 2008		6
	Consolidated Statements of Cash Flows - For the six months ended June 30, 2008 and 2007		7
	Notes to Consolidated Financial Statements		8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 3.	Quantitative and Qualitative Disclosure About Market Risk		31
Item 4.	Controls and Procedures		32
Part II	Other Information		33
Item 1A.	Risk Factors		33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		33
Item 4.	Submission of Matters to a Vote of Security Holders		33
Item 6.	Exhibits		34

Item 1. Financial Statements

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

	June 30, 2008			December 31, 2007
		(Unaudited)
Assets
Investments:
Fixed maturities:
Held to maturity, at amortized cost (fair value $288,777 and $317,091)	$	286,884		$	313,629
Available for sale, at fair value (amortized cost $1,915,334 and $1,715,219)		1,926,604			1,740,045
Equity securities, at fair value (cost $127,742 and $66,433)		121,087			76,297
Short-term investments, at cost, which approximates fair value		118,417			107,941
Fixed maturity securities on loan:
Held to maturity, at amortized cost (fair value $2,290 and $2,419)		2,276			2,414
Available for sale, at fair value (amortized cost $58,231 and $116,047)		59,152			118,147
Total investments		2,514,420			2,358,473
Cash		145			412
Receivables:
Premiums		152,679			146,238
Reinsurance		203,400			167,671
Accrued investment income		27,330			26,220
Total receivables		383,409			340,129
Deferred policy acquisition costs		115,133			101,954
Prepaid reinsurance premiums		41,562			38,721
Property and equipment, net		12,843			13,475
Deferred income taxes		56,882			38,544
Securities lending collateral		57,850			122,053
Due from affiliate		2,301			7,197
Other assets		57,221			51,487
Total assets	$	3,241,766		$	3,072,445
Liabilities and Shareholders’ Equity
Liabilities:
Unpaid losses and loss settlement expenses (affiliate $304,610 and $149,826)	$	1,766,884		$	1,546,690
Unearned premiums (affiliate $76,925 and $28,555)		509,264			450,186
Accounts payable and accrued expenses		64,029			74,686
Securities lending obligation		63,096			123,542
Debt (affiliate $18,500 and $18,500)		118,500			118,500
Total liabilities		2,521,773			2,313,604
Shareholders’ equity:
Preferred stock, $1 par value, authorized 1,000,000 shares; none issued
Common stock, $1 par value, authorized 80,000,000 shares; issued 34,052,693 and 33,656,253 shares; outstanding 29,411,034 and 30,322,905 shares		34,052			33,656
Additional paid-in capital		223,435			213,654
Accumulated other comprehensive income (loss)		(719	)		20,599
Retained earnings		597,309			578,705
Treasury stock, at cost, 4,641,659 and 3,333,348 shares		(134,084	)		(87,773	)
Total shareholders’ equity		719,993			758,841
Total liabilities and shareholders’ equity	$	3,241,766		$	3,072,445

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

For the three months ended June 30, 2008 and 2007

(dollars in thousands, except per share data)

	2008		2007
Revenues:
Premiums earned from affiliate (ceded to affiliate, $189,663 and $187,311)	$	229,835	$	207,395
Investment income, net of investment expense		28,565		27,947
Realized investment gains, net		183		678
Other income (affiliate $1,544 and $1,594)		2,937		6,321
Total revenues		261,520		242,341
Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $141,142 and $122,774)		170,733		131,411
Amortization of deferred policy acquisition costs		56,698		51,953
Other underwriting expenses		20,429		18,299
Interest expense (affiliate $143 and $266)		1,625		1,789
Other expenses		1,130		1,340
Total expenses		250,615		204,792
Income before income taxes		10,905		37,549
Income taxes		1,543		11,114
Net income	$	9,362	$	26,435
Per common share:
Basic net income	$	.32	$	.84

Diluted net income	$	.31	$	.82

Cash dividend	$	.25	$	.19

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

For the six months ended June 30, 2008 and 2007

(dollars in thousands, except per share data)

	2008			2007
Revenues:
Premiums earned from affiliate (ceded to affiliate, $379,559 and $372,552)	$	459,208		$	412,773
Investment income, net of investment expense		57,763			55,344
Realized investment gains (losses), net		(49	)		1,302
Other income (affiliate $3,163 and $3,246)		6,453			9,819
Total revenues		523,375			479,238
Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $268,075 and $241,691)		318,043			262,562
Amortization of deferred policy acquisition costs		113,654			103,849
Other underwriting expenses		41,340			36,580
Interest expense (affiliate $333 and $530)		3,297			3,554
Other expenses		2,290			2,613
Total expenses		478,624			409,158
Income before income taxes		44,751			70,080
Income taxes		11,247			20,743
Net income	$	33,504		$	49,337
Per common share:
Basic net income	$	1.13		$	1.56

Diluted net income	$	1.11		$	1.54

Cash dividend	$	.50		$	.38

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

For the six months ended June 30, 2008

(dollars in thousands)

	Common Stock			Additional Paid-in Capital		Accumulated Other Comprehensive Income (Loss)			Retained Earnings			Treasury Stock			Total
	Shares	Amount		Additional Paid-in Capital		Accumulated Other Comprehensive Income (Loss)			Retained Earnings			Treasury Stock			Total

Balance at December 31, 2007	33,656,253	$	33,656	$	213,654	$	20,599		$	578,705		$	(87,773	)	$	758,841
Net income										33,504						33,504
Other comprehensive income, net of tax:
Unrealized investment losses, net of reclassification adjustment							(21,375	)								(21,375	)
Defined benefit pension plans:
Recognized net actuarial loss							57									57
Other comprehensive loss																(21,318	)
Comprehensive income																12,186
Issuance of common stock:
Incentive plans	382,285		382		3,911											4,293
Dividend reinvestment plan	14,155		14		492											506
Tax benefit from stock compensation					2,333											2,333
Stock compensation					3,045											3,045
Purchase of treasury stock, 1,308,311 shares													(46,311	)		(46,311	)
Cash dividends paid										(14,900	)					(14,900	)
Balance at June 30, 2008	34,052,693	$	34,052	$	223,435	$	(719	)	$	597,309		$	(134,084	)	$	719,993

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

For the six months ended June 30, 2008 and 2007

(in thousands)

	2008			2007

Cash flows from operating activities:
Net income	$	33,504		$	49,337
Adjustments to reconcile net income to net cash provided by operating activities:
Change in receivables, unearned premiums and prepaid reinsurance balances		(32,761	)		(2,886	)
Change in affiliate balance		4,896			8,262
Increase in unpaid losses and loss settlement expenses		66,659			33,434
Deferred income taxes		(6,858	)		6,169
Increase in deferred policy acquisition costs		(1,841	)		(2,078	)
Amortization and depreciation		2,758			1,958
(Gain) loss on sale of investments		49			(1,302	)
Other, net		(21,674	)		(9,987	)
		44,732			82,907
Cash provided by the change in the intercompany pooling agreement		82,640			¾
Net cash provided by operating activities		127,372			82,907
Cash flows from investing activities:
Fixed maturity investments:
Purchases		(150,266	)		(179,084	)
Sales or maturities		146,932			116,127
Equity securities:
Purchases		(61,327	)		(18,796	)
Sales		18			18,308
Net sales (purchases) of short-term investments		(10,476	)		4,464
Sale of property and equipment, net		54			5,158
Net cash used by investing activities		(75,065	)		(53,823	)
Cash flows from financing activities:
Issuance of common stock		4,801			3,877
Dividends paid (to affiliate, $7,747 and $6,296)		(14,900	)		(12,132	)
Purchase of treasury stock		(44,808	)		(22,537	)
Excess tax benefits from share-based payment arrangements		2,333			1,627
Net cash used by financing activities		(52,574	)		(29,165	)
Decrease in cash		(267	)		(81	)
Cash at beginning of period		412			227
Cash at end of period	$	145		$	146

Supplemental schedule of noncash investing and financing activities:

In connection with the amendment to the intercompany pooling agreement between the Company’s insurance subsidiaries and Harleysville Mutual Insurance Company (Mutual), fixed maturity investments and liabilities of $109,438,000 were transferred from Mutual to the Company’s insurance subsidiaries. See Note 2 of the Notes to Consolidated Financial Statements.

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1 – Basis of Presentation

The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments which are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations, and cash flows for the interim periods. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year.

These financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2007 included in the Company’s 2007 Annual Report filed with the Securities and Exchange Commission on Form 10-K.

The affiliate transaction disclosures on the face of the financial statements are in regards to transactions with Harleysville Mutual Insurance Company (Mutual). Mutual owns approximately 52% of the outstanding common stock of Harleysville Group Inc. As used herein, “Harleysville Group” refers to Harleysville Group Inc. and its subsidiaries.

2 - Change in Pooling Agreement

The Company’s property and casualty subsidiaries participate in a pooling agreement with Mutual. The pooling agreement provides for the allocation of premiums, losses and loss settlement expenses and underwriting expenses between Harleysville Group and Mutual. Harleysville Group is not liable for any losses incurred by its subsidiaries, Harleysville Preferred Insurance Company (Preferred) and Harleysville Insurance Company of New Jersey (HNJ), and Mutual prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool had been 72% since January 1, 1998.

Effective January 1, 2008, the Company’s property and casualty subsidiaries and Mutual and its property and casualty subsidiary, Harleysville Pennland Insurance Company, amended their intercompany pooling agreement to increase Harleysville Group’s share of the pool from 72% to 80%. Harleysville Group received cash and investments of $192.1 million associated with the transfer of liabilities from Mutual to Harleysville Group in connection with the pool change. The Company’s liabilities increased $203.4 million and the Company reimbursed Mutual $11.3 million, through a ceding commission, for expenses that were incurred to generate the additional business assumed by the Company’s property and casualty subsidiaries, which ceding commission was deferred as policy acquisition costs.

These liabilities consist of the following at January 1, 2008 (in thousands):

3 – Share-Based Payments

Harleysville Group has several share-based compensation plans. Harleysville Group accounts for the plans under the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)).

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Harleysville Group Inc. has the following share-based compensation plans:

-	The Equity Incentive Plan (EIP) provides for awards to key employees in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units or any combination of the above.

The Employee Stock Purchase Plan provides that 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. There are two subscription periods during each year.

-	The Directors’ Equity Compensation Plan provides for the grant of equity-based awards to non-employee directors of Harleysville Group Inc. and Mutual. These awards can be in the form of stock options, deferred stock units or restricted stock.

-	The Long Term Incentive Plan (LTIP) provided for share and cash awards to key employees based on the total shareholder return of the Company’s stock relative to the total shareholder return of a group of insurance company stocks for the three year period January 1, 2005 through December 31, 2007.

Under SFAS No. 123(R), the compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $1,994,000 and $1,459,000 for the three months ended June 30, 2008 and 2007, respectively, with a corresponding income tax benefit of $668,000 and $485,000, respectively. Under SFAS No. 123(R), the compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $3,045,000 and $2,469,000 for the six months ended June 30, 2008 and 2007, respectively, with a corresponding income tax benefit of $1,007,000 and $816,000, respectively.

During the six months ended June 30, 2008, 346,340 stock options were granted at a Black Scholes weighted average value of $7.52 per option. The options vest 33 1/3% per year over a three year period. Restricted stock grants of 83,302 shares and restricted stock unit grants of 22,040 units were also made during the six months ended June 30, 2008. The weighted average fair value of the restricted stock grants was $35.83 per share. The weighted average fair value of the grant of the restricted stock units was $38.92 per unit. These awards vest over a period of three to four years. All of the restricted stock units awarded and 10,480 of the restricted stock shares awarded include performance conditions.

During the six months ended June 30, 2007, 277,150 stock options were granted at a Black Scholes weighted average value of $11.03. The options vest 33 1/3% per year over a three year period. Restricted stock grants of 102,422 shares and restricted stock unit grants of 17,440 units were also made during the six months ended June 30, 2007. The weighted average fair value of the restricted stock grants was $34.55 per share. The weighted average fair value of the grant of the restricted stock units was $34.76 per unit. These awards vest over a period of three to five years.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

As of June 30, 2008, the Company’s total unrecognized compensation cost related to nonvested share-based compensation arrangements and the weighted average period over which the compensation cost is expected to be recognized is as follows:

				Weighted Average
	Unrecognized Compensation Cost			Period of Recognition
	(in thousands)			(in years)

Equity incentive plan awards		$	8,938		2.47
Employee stock purchase plan		$	14		.04

4 – Investments

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of this statement did not have an impact on Harleysville Group’s results of operations or financial condition. Harleysville Group has adopted FASB Staff Position No. 157-2, which allowed us to defer the effective date of SFAS No. 157 for certain non-financial assets and liabilities to January 1, 2009.

SFAS No. 157 establishes a fair value hierarchy which gives the highest priority to quoted prices in active markets and the lowest priority to unobservable inputs which are based on the Company’s own assumptions. The three levels of the hierarchy are as follows:

Level 1 - Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.

Level 2 - Inputs other than Level 1 that are based on observable market data. These include: quoted prices for similar assets in active markets, quoted prices for identical assets in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from or corroborated by observable market data.

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 as Level 1. When quoted market prices in active markets are not available, the Company relies on a pricing service, which uses pricing models to determine fair value. The Company classifies its fixed maturity securities other than U.S. Treasury securities and private placements as Level 2. Security lending collateral investments which are not in receivership are also classified as Level 2. Private placement fixed maturity securities, non-publicly traded equity securities and security lending collateral investments in receivership are classified as Level 3. Fair value of the security lending collateral investments in receivership is based on cash flow analysis and other valuation techniques.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

The following is a summary of the fair value measurements of applicable Company assets by level within the fair value hierarchy as of June 30, 2008. These assets are measured on a recurring basis.

			Fair Value Measurements at Reporting Date Using
	June 30, 2008			Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)

Fixed maturities available for sale	$	1,985,756	$	69,550	$	1,916,047	$	159
Equity securities		121,087		121,070		¾		17
Security lending collateral		57,850		¾		49,073		8,777
Total	$	2,164,693	$	190,620	$	1,965,120	$	8,953

	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
	Fixed Maturities Available for Sale				Equity Securities			Security Lending Collateral
	(in thousands)
Balance at January 1, 2008		$	171			$	17	$	6,898
Total gains (losses) (realized/unrealized)
Included in earnings			¾				¾		(2,128	)
Included in other comprehensive income			¾				¾		138
Purchases, issuances and settlements			(12	)			¾		(1,339	)
Transfer into Level 3			¾				¾		5,208
Balance at June 30, 2008		$	159			$	17	$	8,777

The amount of total losses for the six month period included in earnings (realized investment gains (losses), net) attributable to the change in unrealized losses relating to assets still held at June 30, 2008								$	(2,128	)

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

5 – Earnings Per Share

The computation of basic and diluted earnings per share is as follows:

		For the three months ended June 30,				For the six months ended June 30,
		2008		2007		2008		2007
	(in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net income		$	9,362	$	26,435	$	33,504	$	49,337
Denominator for basic earnings per share -- Weighted average shares outstanding			29,370		31,659		29,715		31,644
Effect of stock incentive plans			391		431		382		454
Denominator for diluted earnings per share			29,761		32,090		30,097		32,098
Basic earnings per share		$	.32	$	.84	$	1.13	$	1.56
Diluted earnings per share		$	.31	$	.82	$	1.11	$	1.54

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:

		For the three months ended June 30,				For the six months ended June 30,
		2008		2007		2008		2007
	(in thousands)
Number of options			¾		273		¾		192

6 – Reinsurance

Premiums earned are net of amounts ceded of $25,909,000 and $50,897,000 for the three and six months ended June 30, 2008, respectively, and $22,782,000 and $44,400,000 for the three and six months ended June 30, 2007, respectively. Losses and loss settlement expenses are net of amounts ceded of $21,538,000 and $29,119,000 for the three and six months ended June 30, 2008, respectively, and $14,232,000 and $24,116,000 for the three and six months ended June 30, 2007, respectively. Such amounts ceded do not include the reinsurance transactions with Mutual under the pooling arrangement (described below) which are reflected on the face of the income statements, but do include reinsurance with unaffiliated reinsurers.

Pursuant to the terms of a reinsurance pooling agreement with Mutual, each of the insurance subsidiaries of Harleysville Group Inc. cedes premiums, losses and underwriting expenses on all of their respective business to Mutual which, in turn, retrocedes to such subsidiaries a specified portion of premiums, losses and underwriting expenses of Mutual and such subsidiaries. Because this agreement does not relieve Harleysville Group Inc.’s insurance subsidiaries of primary liability as originating insurers, there is a concentration of credit risk arising from business ceded to Mutual. However, the reinsurance pooling agreement provides for the right of offset. Mutual has an A. M. Best rating of “A-” (Excellent).

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

7 - Cash Flows

There were cash tax payments of $23,000,000 and $10,250,000 and cash interest payments of $3,227,000 and $3,408,000 in the first six months of 2008 and 2007, respectively.

8 - Segment Information

The performance of the personal lines and commercial lines is evaluated based upon underwriting results as determined under statutory accounting practices (SAP).

Financial data by segment is as follows:

		For the three months ended June 30,					For the six months ended June 30,
		2008			2007		2008			2007
	(in thousands)
Revenues:
Premiums earned
Commercial lines		$	189,746		$	171,662	$	379,258		$	341,875
Personal lines			40,089			35,733		79,950			70,898
Total premiums earned			229,835			207,395		459,208			412,773
Net investment income			28,565			27,947		57,763			55,344
Realized investment gains (losses)			183			678		(49	)		1,302
Other			2,937			6,321		6,453			9,819
Total revenues		$	261,520		$	242,341	$	523,375		$	479,238
Income before income taxes:
Underwriting gain (loss):
Commercial lines		$	(13,406	)	$	1,245	$	(22,937	)	$	3,337
Personal lines			(7,041	)		2,109		(5,344	)		3,683
SAP underwriting gain (loss)			(20,447	)		3,354		(28,281	)		7,020
GAAP adjustments			2,422			2,378		14,452			2,762
GAAP underwriting gain (loss)			(18,025	)		5,732		(13,829	)		9,782
Net investment income			28,565			27,947		57,763			55,344
Realized investment gains (losses)			183			678		(49	)		1,302
Other			182			3,192		866			3,652
Income before income taxes		$	10,905		$	37,549	$	44,751		$	70,080

The GAAP adjustment of $14,452,000 for the six months ended June 30, 2008 includes the impact of deferring the ceding commission paid in January 2008 of $11,338,000 related to the change in the intercompany pooling agreement as described in Note 2 of the Notes to Consolidated Financial Statements. The impact on commercial lines was $9,376,000 and the impact on personal lines was $1,962,000.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

9 – Comprehensive Income

Comprehensive income (loss) for the three and six months ended June 30, 2008 and 2007 consisted of the following (all amounts are net of taxes):

		For the three months ended June 30,						For the six months ended June 30,
		2008			2007			2008			2007
	(in thousands)
Net income		$	9,362		$	26,435		$	33,504		$	49,337
Other comprehensive income (loss):
Unrealized gains (losses) on securities:
Unrealized investment holding losses arising during period			(28,750	)		(16,566	)		(21,407	)		(12,705	)
Less:
Reclassification adjustment for (gains) losses included in net income			(119	)		(441	)		32			(923	)
Net unrealized investment losses			(28,869	)		(17,007	)		(21,375	)		(13,628	)
Defined benefit pension plans:
Recognized net actuarial loss			28			181			57			362
Other comprehensive loss			(28,841	)		(16,826	)		(21,318	)		(13,266	)
Comprehensive income (loss)		$	(19,479	)	$	9,609		$	12,186		$	36,071

Accumulated other comprehensive income (loss) at June 30, 2008 and December 31, 2007 consisted of the following amounts (which are net of tax):

	June 30, 2008			December 31, 2007
	(in thousands)
Unrealized investment gains	$	2,110		$	23,485
Defined benefit pension plan - net actuarial loss		(2,829	)		(2,886	)
Accumulated other comprehensive income (loss)	$	(719	)	$	20,599

10 – Pension

Harleysville Group Inc. has a frozen pension plan that covers employees hired before January 1, 2006. The Company adopted SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” as of December 31, 2006. As a result, the Company’s share of the net actuarial loss included in net periodic pension cost for the six months ended June 30, 2008 and 2007 has been included as an adjustment to other comprehensive income. The net periodic pension cost for the plan including Mutual consists of the following components:

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

		For the three months ended June 30,						For the six months ended June 30,
		2008			2007			2008			2007
	(in thousands)
Components of net periodic pension cost:
Interest cost		$	2,817		$	2,755		$	5,634		$	5,510
Expected return on plan assets			(3,098	)		(2,972	)		(6,196	)		(5,945	)
Recognized net actuarial loss			68			427			136			855
Net periodic pension cost:
Entire plan		$	(213	)	$	210		$	(426	)	$	420
Harleysville Group portion		$	(69	)	$	137		$	(137	)	$	274

Harleysville Group’s expected portion of the 2008 contribution to the pension plan is $2,222,000. Contributions of $1,278,000 were made in the first six months of 2008.

11 – Shareholders’ Equity

Various states have adopted the National Association of Insurance Commissioners (NAIC) 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.

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 2007 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s eight insurance subsidiaries at December 31, 2007 ranged from 543% to 677%.

12 – Income Taxes

Effective January 1, 2007, Harleysville Group adopted FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” As of June 30, 2008, 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 2004 through 2007 were open for examination as of June 30, 2008.

13 – Property and Equipment

In the second quarter of 2007, the Company sold its office building in Traverse City, Michigan and recognized a pre-tax gain of $2,700,000 which is included in other income.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

14 – New Accounting Standards

In June 2008, the FASB issued FASB Staff Position (FSP) EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” This FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, should be included in the earnings allocation in computing earnings per share (EPS) under the two-class method described in SFAS No. 128, “Earnings per Share.” The FSP redefines participating securities to include unvested share-based payment awards that contain non-forfeitable dividends or dividend equivalents as participating securities to be included in the computation of EPS pursuant to the “two-class method.” Outstanding unvested restricted stock and deferred stock units issued under employee compensation programs containing such dividend participation features would be considered participating securities subject to the “two-class method” in computing EPS rather than the “treasury stock method.” The FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008 and for interim periods within those years. All prior-period EPS data presented is to be adjusted retrospectively to conform to the provisions of this FSP. Early application is not permitted. The impact of adopting this staff position is currently being evaluated.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Item 2.

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

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 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 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; 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 A. M. Best rating of Harleysville Group; and the status of labor markets in which the Company operates.

Overview

The Company’s net income is primarily determined by three elements:

·	net premium income

·	investment income

·	amounts paid or reserved to settle insured claims

Variations in premium income are subject to a number of factors, including:

·	limitations on premium rates arising from the competitive marketplace or regulation

·	limitation on available business arising from a need to maintain the quality of underwritten risks

·	the Company’s ability to maintain its A- (“excellent”) rating by A.M. Best

·	the ability of the Company to maintain a reputation for efficiency and fairness in claims administration

Variations in investment income are subject to a number of factors, including:

·	general interest rate levels

·	specific adverse events affecting the issuers of debt obligations held by the Company

·	changes in the prices of equity securities generally and those held by the Company specifically

Loss and loss settlement expenses are affected by a number of factors, including:

·	the quality of the risks underwritten by the Company

·	the nature and severity of catastrophic losses

·	the availability, cost and terms of reinsurance

·	underlying settlement costs, including medical and legal costs

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The Company seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside of the control of the Company.

Critical Accounting Policies and Estimates

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require Harleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements for the year ended December 31, 2007 included in the Company’s 2007 Annual Report filed with the Securities and Exchange Commission on Form 10-K). Harleysville Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and estimation. The judgments, or the methodology on which the judgments are made, are reviewed quarterly with the Audit Committee.

Liability for Losses and Loss Settlement Expenses. The liability for losses and loss settlement expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have not yet been reported to Harleysville Group. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss settlement expense reserves are determined utilizing historical information by line of insurance as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Estimates of the liabilities are reviewed and updated on a regular basis using the most recent information on reported claims and a variety of actuarial techniques. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operations.

Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.

Harleysville Group has written down to fair value, any equity security that has declined below cost by (i) more than 20% and maintained such decline for six months or (ii) by 50% or more in the quarter in which either such decline occurred. In some cases, securities that have declined by a lesser amount or for a shorter period of time are written down if the evaluation indicates the decline is other than temporary. Fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities but Harleysville Group does not own a material amount of non-traded securities.

Policy Acquisition Costs. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

investment income over the claim 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.

Contingencies. Besides claims related to its insurance products, Harleysville Group is subject to proceedings, lawsuits and claims in the normal course of business. Harleysville Group assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will not differ from those assessments.

The application of certain of these critical accounting policies to the periods ended June 30, 2008 and 2007 is discussed in greater detail below.

Results of Operations

The Company’s property and casualty subsidiaries participate in a pooling agreement with Mutual. The pooling agreement provides for the allocation of premiums, losses and loss settlement expenses and underwriting expenses between Harleysville Group and Mutual. Harleysville Group is not liable for any losses incurred by Mutual, Preferred and HNJ prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool had been 72% since January 1, 1998.

Effective January 1, 2008, the Company’s property and casualty subsidiaries and Mutual and its property and casualty subsidiary, Harleysville Pennland Insurance Company, amended their intercompany pooling agreement to increase Harleysville Group’s share of the pool from 72% to 80%. Harleysville Group received cash and investments of $192.1 million associated with the transfer of liabilities from Mutual to Harleysville Group in connection with the pool change. The Company’s liabilities increased $203.4 million and the Company reimbursed Mutual $11.3 million, through a ceding commission, for expenses that were incurred to generate the additional business assumed by the Company’s property and casualty insurance subsidiaries, which ceding commission was deferred as policy acquisition costs.

These liabilities consist of the following at January 1, 2008 (in thousands):

When the Company’s property and casualty insurance subsidiaries’ pooling participation increases, there is a larger retrocession of this pooled business from Mutual. Through this retrocession, Harleysville Group is assuming a larger share of premiums, losses and loss settlement expenses and underwriting expenses for current and future periods originating both from its subsidiaries and Mutual. An increase in Harleysville Group’s pooling participation results in a larger share of the pooled liabilities being assumed by Harleysville Group. Cash and investments are received by Harleysville Group equal to this greater share of loss reserves, unearned premiums and other insurance liabilities (primarily commissions and premium taxes) less a ceding commission based on acquisition costs related to unearned premiums. An increase in pool participation also increases Harleysville Group’s leverage and exposure to prior period development.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Premiums earned increased $22.4 million, or 10.8%, during the three months ended June 30, 2008 compared to the same period in the prior year primarily due to the increase in the pool participation percentage effective January 1, 2008. Of the $22.4 million increase, $18.1 million, or 10.5%, was in commercial lines and $4.3 million, or 12.2%, was in personal lines. Excluding the impact of the change in the pool participation percentage, premiums earned decreased $0.5 million, or 0.3%, during the three months ended June 30, 2008 compared to the same period in the prior year. This decrease of $0.5 million in premiums earned is due to a decrease of $0.9 million, or 0.5%, in premiums earned for commercial lines and an increase of $0.4 million, or 1.0%, in premiums earned for personal lines.

Premiums earned increased $46.4 million, or 11.2%, during the six months ended June 30, 2008 compared to the same period in the prior year primarily due to the increase in the pool participation percentage effective January 1, 2008. Of the $46.4 million increase, $37.4 million, or 10.9%, was in commercial lines and $9.0 million, or 12.8%, was in personal lines. Excluding the impact of the change in the pool participation percentage, premiums earned increased $0.5 million, or 0.1%, during the six months ended June 30, 2008 compared to the same period in the prior year. This increase of $0.5 million in premiums earned is due to a decrease of $0.5 million, or 0.2%, in premiums earned for commercial lines and an increase of $1.0 million, or 1.5%, in premiums earned for personal lines.

The decrease in premiums earned for commercial lines in both the three and six month periods of 2008 compared to the prior year was due to a decrease in both direct premiums earned and premiums assumed from involuntary pools, primarily in the commercial auto line of business. The increase in premiums earned for personal lines in both the three and six month periods of 2008 compared to the prior year was primarily due to an increase in homeowners business due to higher average premiums.

Investment income increased $0.6 million and $2.4 million for the three and six months ended June 30, 2008 as compared to the same periods in the prior year, primarily due to a higher level of invested assets, partially offset by a lower investment yield on fixed income securities and a greater percentage of fixed income securities invested in tax-exempt securities.

Realized investment gains decreased $0.5 million and $1.4 million for the three and six months ended June 30, 2008 as compared to the same periods in the prior year. The decreases resulted primarily from impairment charges. There were impairment charges of $1.0 million and $2.1 million in the three and six months ended June 30, 2008, respectively, and impairment charges of $0.4 million and $0.5 million in the three and six months ended June 30, 2007, respectively, as the declines of investments below cost were deemed to be other than temporary.

Harleysville Group holds securities with unrealized losses at June 30, 2008 as follows:

						Length of Unrealized Loss
		Fair Value		Unrealized Loss		Less Than 12 Months		Over 12 Months
	(in thousands)
Fixed maturities: Obligations of states and political subdivisions		$	230,661	$	4,393	$	4,259	$	134
Corporate securities			292,106		11,224		5,482		5,742
Mortgage-backed securities			84,999		758		383		375
Total fixed maturities		$	607,766	$	16,375	$	10,124	$	6,251
Equity securities		$	68,484	$	8,973	$	8,973	$	¾
Security lending collateral		$	34,406	$	2,290	$	1,751	$	539

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Of the total fixed maturity securities with an unrealized loss at June 30, 2008, securities with a fair value of $527.3 million and an unrealized loss of $14.8 million are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $80.5 million and an unrealized loss of $1.6 million are classified as held to maturity on the balance sheet and are carried at amortized cost.

There are $534.6 million in fixed maturities at fair value with continuous unrealized losses for less than 12 months. The $10.1 million of unrealized losses on such securities and the $2.3 million unrealized loss on the security lending portfolio primarily relates to securities which carry an investment grade debt rating and have declined in fair value due to a widening of credit spreads. Of the $6.3 million of unrealized losses on fixed maturity securities with continuous unrealized losses for more that 12 months, $2 million was related to securities which carry a debt rating which is below investment grade. The remaining unrealized loss of $4.3 million was primarily due to a widening of credit spreads. Harleysville Group currently has the ability and intent to hold these securities at least until recovery.

The unrealized loss in equity investments at June 30, 2008 is primarily due to the decline in the overall equity markets in 2008. Approximately 38% of the unrealized loss on equity securities at June 30, 2008 related to two exchange traded funds in the banking sector. Harleysville Group has been monitoring these securities and it is possible that some may be written down in the income statement in the future.

Income before income taxes decreased $26.6 million for the three months ended June 30, 2008 compared to the same prior year period. Income before income taxes decreased $25.3 million for the six months ended June 30, 2008 compared to the same prior year period. The decreases were primarily due to underwriting losses in the 2008 periods, compared to underwriting gains in the prior year periods, partially offset by increases in investment income. The underwriting losses in the 2008 periods were primarily due to greater catastrophe losses.

An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium; (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium; and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio increased to 107.7% for the three months ended June 30, 2008 from 96.5% for the three months ended June 30, 2007 and increased to 102.2% for the six months ended June 30, 2008 from 97.2% for the six months ended June 30, 2007. The statutory combined ratio for the six months ended June 30, 2008 includes a benefit of 0.7% due to the impact of the transfer of liabilities in connection with the pool change. This benefit results from the statutory treatment of the ceding commission paid on the unearned premiums transferred on January 1, 2008. Excluding the impact of the pool transfer, the statutory combined ratio increased to 102.9% for the six months ended June 30, 2008. Such increases in the combined ratio were due to higher catastrophe losses in both the three and six month periods ended June 30, 2008. Net catastrophe losses increased to $25.1 million for the three months ended June 30, 2008 from $4.5 million for the three months ended June 30, 2007. Net catastrophe losses increased to $28.1 million for the six months ended June 30, 2008 from $6.6 million for the six months ended June 30, 2007. The 2008 catastrophe losses were primarily due to tornadoes and hail storms impacting Arkansas and Minnesota during the second quarter.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The statutory combined ratios by line of business for the three and six months ended June 30, 2008, as compared to the three and six months ended June 30, 2007, are shown below. The statutory combined ratios for the six months ended June 30, 2008 are shown both including and excluding the impact of the pool transfer. The combined ratios excluding the pool transfer are shown, as they are prepared on a basis that is comparable to the combined ratios for the six months ended June 30, 2007.

	For the three months ended June 30,				For the six months ended June 30,
	2008		2007		2008	2008	2007
					Including the Impact of the Pool Transfer	Excluding the Impact of the Pool Transfer
Commercial:
Automobile		98.1%		93.2%	95.0%	95.9%		92.9%
Workers compensation		111.9%		111.7%	111.0%	111.7%		112.1%
Commercial multi-peril		107.1%		99.2%	104.1%	104.8%		99.7%
Other commercial		113.0%		81.0%	97.2%	97.9%		82.7%
Total commercial		106.1%		97.5%	101.8%	102.5%		97.7%
Personal:
Automobile		90.2%		97.4%	93.1%	94.0%		100.9%
Homeowners		142.0%		90.3%	116.5%	117.6%		91.1%
Other personal		114.6%		60.8%	92.5%	92.4%		78.1%
Total personal		115.7%		92.0%	103.9%	104.8%		95.1%
Total personal and commercial		107.7%		96.5%	102.2%	102.9%		97.2%

The commercial lines statutory combined ratio increased to 106.1% and 101.8% for the three and six months ended June 30, 2008 from 97.5% and 97.7% for the three and six months ended June 30, 2007. Excluding the impact of the pool transfer, the commercial lines statutory combined ratio increased to 102.5% for the six months ended June 30, 2008 from 97.7% for the six months ended June 30, 2007. These increases are primarily due to higher than average catastrophe experience affecting property coverages during the three months ended June 30, 2008. The higher than average catastrophe experience primarily relates to losses associated with tornadoes in Arkansas.

The personal lines statutory combined ratio increased to 115.7% and 103.9% for the three and six months ended June 30, 2008 from 92.0% and 95.1% for the three and six months ended June 30, 2007. Excluding the impact of the pool transfer, the personal lines statutory combined ratio increased to 104.8% for the six months ended June 30, 2008 from 95.1% for the six months ended June 30, 2007. These increases are primarily due to higher than average catastrophe experience affecting property coverages during the three months ended June 30, 2008. The higher than average catastrophe experience primarily relates to losses associated with a series of hail events in Minnesota. The statutory combined ratios for the personal automobile line of business decreased for both the three and six months ended June 30, 2008. These decreases were primarily related to the recognition of favorable prior year development of $3.0 million and $5.1 million for the three and six months ended June 30, 2008 compared to favorable development of $1.6 million and $3.1 million for the three and six months ended June 30, 2007.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The following table presents the liability for unpaid losses and loss settlement expenses by major line of business:


	June 30, 2008		December 31, 2007
	(in thousands)
Commercial:
Automobile	$	336,272	$	308,564
Workers compensation		384,223		337,286
Commercial multi-peril		599,121		524,274
Other commercial		122,917		100,664
Total commercial		1,442,533		1,270,788
Personal:
Automobile		82,711		81,222
Homeowners		40,564		27,925
Other personal		2,609		1,877
Total personal		125,884		111,024
Total personal and commercial		1,568,417		1,381,812
Plus reinsurance recoverables		198,467		164,878
Total liability	$	1,766,884	$	1,546,690

The following table presents the increase (decrease) in the liability for unpaid losses and loss settlement expenses attributable to insured events of prior years for the six months ended June 30, 2008 by line of business:

	Total			Accident Years
	Total			2007			2006			2005 and Prior Years
	(in thousands)
Commercial:
Automobile	$	(6,791	)	$	593		$	(18	)	$	(7,366	)
Workers compensation		5			803			(2,096	)		1,298
Commercial multi-peril		(866	)		(567	)		(822	)		523
Other commercial		(100	)		1,507			(1,809	)		202
Total commercial		(7,752	)		2,336			(4,745	)		(5,343	)
Personal:
Automobile		(5,074	)		816			(1,328	)		(4,562	)
Homeowners		(523	)		718			(352	)		(889	)
Other personal		512			205			248			59
Total personal		(5,085	)		1,739			(1,432	)		(5,392	)
Total net development	$	(12,837	)	$	4,075		$	(6,177	)	$	(10,735	)

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

There was $12.8 million of net favorable development in the provision for insured events in prior years for the six months ended June 30, 2008, ($5.2 million in the second quarter of 2008), of which $7.7 million was in commercial lines and $5.1 million was in personal lines. The favorable development primarily related to the 2003 through 2006 accident years as a result of lower than expected claim severity experienced in the workers compensation and commercial and personal automobile lines of business, partially offset by adverse development in accident year 2007 and accident years prior to 2003.

There was $14.8 million of net favorable development in the provision for insured events in prior years for the six months ended June 30, 2007, ($6.7 million in the second quarter of 2007), of which $8.6 million was in commercial lines and $6.2 was in personal lines. The favorable development primarily related to the 2003 through 2006 accident years as a result of lower than expected claim severity broadly experienced across all casualty lines, partially offset by adverse development in accident years prior to 2003.

The following table presents workers compensation claim count information for the total pooled business in which Harleysville Group participates and payment amounts which are Harleysville Group’s pooling share of the total pooled amounts.

	For the six months ended June 30, 2008				For the year ended December 31, 2007
	(dollars in thousands)
Number of claims pending, beginning of period			5,328				5,481
Number of claims reported			4,324				8,531
Number of claims settled or dismissed			(3,961	)			(8,684	)
Number of claims pending, end of period			5,691				5,328
Losses paid		$	29,471			$	59,322
Loss settlement expenses paid		$	6,874			$	13,091

Workers compensation losses primarily consist of indemnity and medical costs for injured workers.

Harleysville Group records the actuarial best estimate of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or before June 30, 2008. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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 as of June 30, 2008:

	Case		IBNR		LAE Liability		IBNR (Incl. LAE)		Total Liability
	(in thousands)
Commercial:
Automobile	$	119,367	$	158,882	$	58,023	$	216,905	$	336,272
Workers compensation		159,351		174,071		50,801		224,872		384,223
Commercial multi-peril		169,817		262,496		166,808		429,304		599,121
Other commercial		30,587		63,640		28,690		92,330		122,917
Total commercial		479,122		659,089		304,322		963,411		1,442,533
Personal:
Automobile		39,943		28,119		14,649		42,768		82,711
Homeowners		12,869		21,484		6,211		27,695		40,564
Other personal		1,224		1,116		269		1,385		2,609
Total personal		54,036		50,719		21,129		71,848		125,884
Total net liability		533,158		709,808		325,451		1,035,259		1,568,417
Reinsurance recoverables		149,210		48,836		421		49,257		198,467
Total gross liability	$	682,368	$	758,644	$	325,872	$	1,084,516	$	1,766,884

Reinsurance receivables were $203.4 million and $167.7 million at June 30, 2008 and December 31, 2007, respectively. Of these amounts, $107.0 million and $92.1 million, or 53% and 55%, respectively, of the receivables were due from governmental bodies, regulatory agencies or quasi governmental pools and reinsurance facilities where, Harleysville Group believes, there is virtually no credit risk. The remainder of the reinsurance receivables are principally due from reinsurers rated A- or higher by A.M. Best. 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 June 30, 2008.

The property and casualty industry has had substantial aggregate loss experience from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures. Harleysville Group has not experienced significant losses from such claims.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Effective for one year from July 1, 2008, the Company’s subsidiaries and Mutual and its wholly owned subsidiaries renewed its catastrophe reinsurance treaty under which they are purchasing higher coverage limits while decreasing their co-participation. Annual retentions and limits on the expiring and new treaties are set forth below:

	EXPIRING TREATY FOR 2007-2008		NEW TREATY FOR 2008-2009
	Retention: $50 million		Retention: $50 million
	Coverage for Losses		Coverage for Losses
	85% of losses between $50 and $90 million		90% of losses between $50 and $90 million
	80% of losses between $90 and $160 million		80% of losses between $90 and $375 million
	75% of losses between $160 and $300 million

The maximum recovery under the new treaty is $264.0 million; under the expiring treaty it was $195.0 million. Harleysville Group’s current pooling share of this maximum recovery would be $211.2 million, compared to a maximum recovery of $156.0 million under the expiring treaty. Both the new treaty and the expiring treaty include reinstatement provisions providing for coverage for a second catastrophe and requiring payment of additional premium in the event a first catastrophe occurs.

Other income decreased $3.4 million for the three and six months ended June 30, 2008, as compared to the same prior year periods. The decrease primarily resulted from a $2.7 million gain on the sale of the Company’s office building in Traverse City, Michigan in the second quarter of 2007.

The income tax expense for the three and six months ended June 30, 2008 includes a tax benefit of $2.3 million and $4.5 million associated with tax-exempt income compared to $1.8 million and $3.6 million in the same prior year periods.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Liquidity and Capital Resources

Operating activities provided $127.4 million and $82.9 million of net cash for the six months ended June 30, 2008 and 2007, respectively. The 2008 amount includes $82.6 million received in connection with the increase in the pool participation percentage effective January 1, 2008, offset by a decrease of $38.1 million primarily due to a decrease in underwriting cash flow and an increase in federal income tax payments.

Investing activities used $75.1 million and $53.8 million of net cash for the six months ended June 30, 2008 and 2007, respectively. The change is primarily due to higher net purchases of investments due to the increase in net cash provided by operating activities, partially offset by the increase in cash used by financing activities.

Net cash used by financing activities was $52.6 million and $29.2 million for the six months ended June 30, 2008 and 2007, respectively. The increase is primarily due to an increase in the purchase of treasury stock and an increase in dividends paid.

Harleysville Group’s investment strategy is designed to complement and support the insurance operations. Harleysville Group considers projected cash flow (premiums, investment income, reinsurance programs, liability payout patterns, general expenses, large seasonal obligations, intercompany transfers, etc.) to assure that sufficient liquidity exists within Harleysville Group and Mutual. 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.

Harleysville Group participates in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time in return for a fee. At June 30, 2008, Harleysville Group had received, and had the obligation to return, cash collateral of $63.1 million. The cash collateral received was invested, as described below, in investments with a fair value at June 30, 2008 of $57.9 million, related to securities on loan with a fair value of $61.4 million. Harleysville Group’s policy is to require initial collateral of 102% of the fair value of loaned securities plus accrued interest, which is required to be maintained daily by the borrower at no less than 100% of such fair value plus accrued interest over the life of the loan. Cash collateral received can be further invested in 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. Since August 30, 2007, acceptable collateral was restricted to prohibit investment in sub-prime asset-backed securities, structured investment vehicles and asset-backed commercial paper, and all reinvestment of cash collateral is overnight only. The cash collateral Harleysville Group received was invested as follows at June 30, 2008: 30% of the collateral was held in cash and cash equivalents (maturities of three months or less, excluding any securities in receivership) and 70% of the collateral was held in securities which may fluctuate in value and have variable interest rates and maturities of up to three years. These securities are classified as available for sale. The securities on loan to others have been segregated from the other invested assets on the balance sheet. In addition, the assets and liabilities have been grossed up to reflect the investment of the collateral received under the securities lending program and the obligation to return this collateral upon the return of the loaned securities.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

At June 30, 2008, Harleysville Group held the following fixed maturity investments in its securities lending collateral portfolio:

	Stated Maturity Date		Cost		Fair Value		Unrealized Loss
	(in thousands)
Structured Investment Vehicles (SIVs)
Cheyne Finance LLC, Medium Term Note SER 144A	02/10/2009	$	4,445	$	4,445		¾
Stanfield Victoria LLC, Medium Term Note SER 144A	08/25/2008		2,166		2,166	$	¾
Stanfield Victoria LLC, Medium Term Note SER 144A	08/05/2008		2,166		2,166		¾
Liberty Lighthouse, Medium Term Note SER 144A	03/16/2010		2,577		2,491		(86	)
Sigma Finance Inc, Medium Term Note	01/16/2009		7,731		6,186		(1,545	)
Total SIVs		$	19,085	$	17,454	$	(1,631	)

Other Investments
CIT Group Inc., Medium Term Note SER A	05/14/2009	$	2,577	$	2,455	$	(122	)
CIT Group Inc., Medium Term Note	11/04/2008		2,578		2,574		(4	)
Hertz Vehicle Financing LLC ABS	02/25/2010		2,578		2,550		(28	)
Monumental Global Funding III, Medium Term Note	05/24/2010		2,578		2,503		(75	)
Monumental Global Funding II, Medium Term Note	09/22/2009		2,577		2,565		(12	)
Pacific Life Global Funding Note SER 144A	08/09/2009		2,578		2,562		(16	)
SLM Corp. Medium Term Note SER 144A	03/16/2009		8,248		7,847		(401	)
Wachovia Bank NA Corp. CD	07/11/2008		2,674		2,673		(1)
Open End Repo Agreements			14,667		14,667		¾
Total Other Investments		$	41,055	$	40,396	$	(659	)

Total Securities Lending Portfolio		$	60,140	$	57,850	$	(2,290	)

The fixed maturity investments in the SIVs consist predominantly of asset-backed and mortgage-backed securities. Each of the SIVs listed above represents a senior claim on the assets of the issuer. The Cheyne and Stanfield Victoria holdings are in technical default and are currently under the supervision of receivers appointed to protect the interests of senior creditors. In 2008, an impairment loss of $1.1 million was recognized on the Cheyne holding and an impairment loss of $1.0 million was recognized on the Stanfield Victoria holdings due to a significant deterioration in the credit worthiness of the issuer. An impairment loss of $0.8 million was recognized on the Cheyne holding in the fourth quarter of 2007.

Due to illiquid market conditions and deteriorating fundamentals in the housing industry, the value of some of the underlying assets that secure our position as a senior creditor in the SIVs is uncertain at this time. Depending upon developments involving the performance of the assets held by the SIVs, it is possible that the SIV holdings listed above may be written down in the income statement in the future.

During the first quarter of 2008, the Atlas Capital Funding Corp. Medium Term Note, which was held at December 31, 2007, was converted into a Wachovia Bank Certificate of Deposit with the same maturity date. In February 2008, we sold both of the Liquid Funding LTD Medium Term Notes maturing on November 4, 2008 and September 29, 2008 for losses of $15,000 and $10,000, respectively.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

In April 2008, the Sigma Finance Medium Term Note was downgraded by Moody’s from Aaa to A2 and by Standard & Poor’s from AAA to AA-. As of June 30, 2008, this security was priced at 80% of par based on recent market activity. However, information contained in Sigma Finance’s monthly business report indicated that the ratio of eligible assets to total debt outstanding was 112% at June 30, 2008, and the security is still of investment grade. Therefore, the Company believes that this security is not other-than-temporarily impaired as the Company currently has the ability and intent to hold this security at least until recovery.

In April 2008, a cash distribution of approximately 17% of the principal due on Cheyne Finance LLC was received in connection with the restructuring of the security.

Harleysville Group Inc. maintained $3.3 million of cash and marketable securities at June 30, 2008 which is available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. In June 2007, the Company’s Board of Directors authorized a stock repurchase plan under which up to 1.6 million shares of its outstanding common stock could be repurchased through an open market purchase program. The Company was authorized to repurchase shares from Mutual, which owned 53% of the Company’s stock at that time, at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and the public float as of the authorization date. This program was completed on July 18, 2007. On August 1, 2007, the Board of Directors authorized the Company to repurchase an additional 1.6 million shares of its outstanding common stock for a two year period under terms similar to the first repurchase authorization. This program was completed on May 16, 2008. On May 20, 2008, the Board of Directors authorized the Company to repurchase up to an additional 1.5 million shares of its outstanding common stock for a two year period under terms similar to the first repurchase authorization. As of June 30, 2008, 43,750 shares had been repurchased under this third authorization, leaving 1,456,250 shares authorized to be repurchased. An additional 814,373 shares were repurchased through August 4, 2008. Harleysville Group has no other material commitments for capital expenditures as of June 30, 2008.

As a holding company, the Company’s principal source of cash 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 payable to the Company of $90 million in June 2008, $0.4 million of which had been paid to the Company as of June 30, 2008. Of the $117.6 million dividends declared by the Company’s insurance subsidiaries in June 2007, $1.4 million was unpaid at June 30, 2008.

On August 18, 2006, Harleysville Group Inc. entered into a credit agreement with HSBC Bank USA, National Association, as Administrative Agent, and participating lenders relating to a five year $100 million revolving credit facility. The credit facility was available for general corporate purposes. There were no borrowings under the credit facility. The Company was in compliance with all applicable covenants. Effective January 8, 2008, the Company terminated this agreement because the Company felt it was no longer needed.

The timing of future cash payments associated with unpaid losses and loss settlement expenses and contractual obligations pursuant to debt agreements is not expected to be materially different from that disclosed in the Company’s Annual Report on Form 10-K for fiscal year 2007.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

RISK FACTORS

The business, results of operations and financial condition, and therefore the value of Harleysville Group’s securities, are subject to a number of risks. Some of those risks are set forth in the Company’s annual report on Form 10-K for fiscal year 2007, filed with the Securities and Exchange Commission on March 7, 2008. There has been no material change from risk factors as previously disclosed in the Company’s annual report for fiscal year 2007.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Item 3.

Quantitative and Qualitative Disclosure

About Market Risk

Harleysville Group’s market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of Harleysville Group’s investment portfolio as a result of fluctuations in prices and interest rates. Harleysville Group attempts to manage its interest rate risk by maintaining an appropriate relationship between the average duration of the investment portfolio and the approximate duration of its liabilities. No material changes to Harleysville Group’s market risk have occurred since December 31, 2007.

Harleysville Group has maintained approximately the same duration of its investment portfolio to its liabilities from December 31, 2007 to June 30, 2008. During the first quarter of 2008, the Company increased its holdings of equity securities by approximately $60 million.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Item 4.

Controls and Procedures

(a)

Evaluation of disclosure controls and procedures. Our management, under the supervision and with the participation of the chief executive officer and the chief financial officer, has evaluated the effectiveness of our controls and procedures related to our reporting and disclosure obligations as of June 30, 2008, which is the end of the period covered by this quarterly report on Form 10-Q. Based on that evaluation, the chief executive officer and chief financial officer have concluded that these disclosure controls and procedures are effective to provide that (a) material information relating to us, including our consolidated subsidiaries, is made known to these officers by other employees of us and our consolidated subsidiaries, particularly material information related to the second quarter of 2008, for which this periodic report is being prepared; and (b) this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the rules and forms of the Securities and Exchange Commission.

(b)

Change in internal control over financial reporting. There was no change in the Company’s internal control over financial reporting that occurred during the second quarter of 2008 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

Item 1A.

Risk Factors

For a discussion of material changes in risk factors applicable to the Company, as previously disclosed in the Company’s Form 10-K for the fiscal year ended 2007, see page 30 “Risk Factors.”

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases Of Equity Securities (1)

Period	Total Number of Shares Purchased (2)	Average Price Paid Per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Program

April 1 - April 30, 2008	46,807	$36.69	46,807	545,632
May 1 - May 31, 2008	545,632	$36.80	545,632	1,500,000
June 1 - June 30, 2008	43,750	$34.35	43,750	1,456,250

(1)

In June 2007, the Board of Directors authorized the Company to repurchase up to 1.6 million shares of its outstanding common stock for a two year period in the open market or in privately negotiated transactions. The Company is authorized to repurchase shares from Harleysville Mutual Insurance Company (Mutual), which owned 53% of the Company’s stock at that time, at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and the public float as of the authorization date. This program was completed on July 18, 2007. On August 1, 2007, the Board of Directors authorized the Company to repurchase an additional 1.6 million shares of its outstanding common stock for a two year period in the open market or in privately negotiated transactions. The Company is authorized to repurchase shares from Mutual at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and the public float as of the authorization date. This program was completed on May 16, 2008. On May 20, 2008, the Board of Directors authorized the Company to repurchase an additional 1.5 million shares of its outstanding common stock for a two year period in the open market or in privately negotiated transactions. The Company is authorized to repurchase shares from Mutual at fair market value terms on the date of purchase and from the public float in amounts that are proportional to the respective ownership percentages of Mutual and public float as of the authorization date.

(2)

Represents the total number of shares repurchased during the period, of which 592,439 of these shares were settled for cash on or before June 30, 2008.

Item 4.

Submission of Matters to a Vote of Security Holders

The annual meeting of stockholders of Harleysville Group Inc. was held on April 23, 2008 (the “Annual Meeting” or “Meeting”), with the following result:

The total number of shares represented at the Annual Meeting in person or by proxy was 28,713,307 of the 30,386,769 shares of common stock outstanding and entitled to vote at the Meeting.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

(Continued)

On the resolution to elect W. Thacher Brown, Mirian M. Graddick-Weir and William W. Scranton, III as class “C” Directors to serve until the expiration of their respective terms and until their successors are duly elected, the nominees for Director received the number of votes set forth opposite their respective names:

	Number of Votes
	For		Withheld

W. Thacher Brown		28,367,398		345,909
Mirian M. Graddick-Weir		28,363,864		349,443
William W. Scranton, III		28,365,744		347,563

There were no abstentions or broker non-votes recorded. On the basis of the above vote, W. Thacher Brown, Mirian M. Graddick-Weir and William W. Scranton, III were elected as class “C” Directors to serve until the expiration of their respective terms and until their successors are duly elected. The other directors who continued in office after the election were: Barbara A. Austell, Michael L. Browne, G. Lawrence Buhl, William Gray, Jerry S. Rosenbloom and William E. Storts.

The resolution to approve the Amended and Restated Employee Stock Purchase Plan was adopted, 27,344,153 votes for the resolution, 163,238 votes against the resolution and 374,099 abstentions. There were 831,817 broker non-votes.

The resolution that the selection of KPMG LLP as the Company’s independent registered public accounting firm be ratified was adopted 28,610,114 votes for the resolution, 91,417 votes against the resolution and 11,776 abstentions.

Item 6.

Exhibits

4.1*

Amended and Restated Employee Stock Purchase Plan

31.1*

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*

Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1*

Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2*

Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

____________________________________________

*Filed herewith.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Harleysville Group Inc.


Date: August 8, 2008	By:	/s/ ARTHUR E. CHANDLER
		Arthur E. Chandler Senior Vice President and Chief Financial Officer (duly elected officer and principal financial officer)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	7th grade Avg

Unpaid losses and loss settlement expenses (net of reinsurance)

Unearned premiums (net of reinsurance)

Other liabilities

Less: ceding commission paid