EXHIBIT 13(B)
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
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;
natural 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; and the status of labor markets in which
the Company operates.
RESULTS OF OPERATIONS
Harleysville Group underwrites property and casualty insurance in both the
personal and commercial lines of insurance. The personal lines of insurance
include both auto and homeowners, and the commercial lines include auto,
commercial multi-peril and workers compensation. The business is marketed
primarily in the eastern and midwestern United States through independent
agents.
Historically, Harleysville Group's results of operations have been
influenced by factors affecting the property and casualty insurance industry in
general. The operating results of the United States property and casualty
insurance industry have been subject to significant variations due to
competition, weather, catastrophic events, regulation, general economic
conditions, judicial trends, fluctuations in interest rates and other changes in
the investment environment.
Page 2
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
Harleysville Group's premium growth and underwriting results have been, and
continue to be, influenced by market conditions. Insurance industry price
competition has often made it difficult both to obtain and to retain properly
priced personal and commercial lines business. It is management's policy to
maintain its underwriting standards, even at the expense of premium growth.
The key elements of Harleysville Group's business model are the sales of
properly priced and underwritten personal and commercial property and casualty
insurance through independent agents and the investment of the premiums in a
manner that assures claims and expenses can be paid while providing a return on
the capital employed. Loss trends and investment performance are critical
factors in influencing the success of the business model. These factors are
affected by the factors impacting the insurance industry in general as described
above and factors unique to Harleysville Group as described in the following
discussion.
TRANSACTIONS WITH AFFILIATES
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 net balance of Harleysville Group with
Mutual was not material at December 31, 2002 and 2001. Mutual has an A. M. Best
rating of "A" (Excellent).
Harleysville Group has off-balance-sheet credit risk related to
approximately $68 million and $64 million of premium balances due to Mutual from
agents and insureds at December 31, 2002 and 2001, 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.
Page 3
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
TRANSACTIONS WITH AFFILIATES (CONTINUED)
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 2002, 2001 and 2000. This reinsurance coverage was in
excess of a retention of $3.6 million in a quarter for 2002, 2001 and 2000. 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 $7.8 million, $7.0 million and $6.8 million, and losses incurred of
$0.3 million, $8.0 million and $4.4 million for 2002, 2001 and 2000,
respectively. The premiums for this reinsurance were established in
consultation with an independent actuarial firm.
Harleysville Ltd. is a subsidiary of the Company and leases the home office
to Mutual, which shares the facility with Harleysville Group. Rental income
under the lease was $3.5 million for both 2002 and 2001 and $3.4 million for
2000 and is included in other income after elimination of intercompany amounts
of $2.2 million in 2002 and $2.1 million in both 2001 and 2000. The lease has a
five-year term expiring December 31, 2004 and includes a formula for additional
rent for any additions, improvements or renovations. Mutual is responsible for
the building operating expenses including maintenance and repairs. The pricing
of the lease was based upon an appraisal obtained from an independent real
estate appraiser.
Harleysville Group provides certain management services to Mutual and other
affiliates. Harleysville Group received a fee of $6.8 million, $7.3 million and
$7.4 million in 2002, 2001 and 2000, respectively, for its services under these
management agreements. Under related agreements, Harleysville Group serves as
the paymaster for Harleysville companies, with each company being charged for
its proportionate share of salary and employee benefits expense based upon time
allocation. The level of fees has been approved by each state insurance
department having jurisdiction.
Page 4
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
TRANSACTIONS WITH AFFILIATES (CONTINUED)
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.
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 $0.5 million, $0.9 million and $1.3 million in 2002, 2001 and 2000,
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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The consolidated financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, which
require Harleysville Group to make estimates and assumptions (see Note 1 of the
Notes to Consolidated Financial Statements). 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.
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 been
incurred but 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 incurred but 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
Page 5
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED)
results. Reserves are closely monitored and are recomputed periodically 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.
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 reviews investments
that have experienced a decline in fair value below cost each quarter to
evaluate whether the decline is other than temporary. Such evaluations
consider, among other things, the magnitude and reasons for a decline and the
prospects for the fair value to recover in the near term. Future adverse
investment market conditions, or poor operating results of underlying
investments, could result in an impairment charge in the future.
Policy Acquisition Costs. 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. The
method followed in computing deferred policy acquisition costs limits the amount
of such deferred costs to their estimated realizable value, which gives effect
to the premium to be earned, related investment income, 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.
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 be consistent with those
assessments.
The application of certain of these critical accounting policies to the
years ended December 31, 2002 and 2001 is discussed in greater detail below.
Page 6
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001
Premiums earned increased $34.7 million, or 5% for the year ended December
31, 2002. The increase was primarily due to an increase in premiums earned for
commercial lines of $59.8 million, or 12%, partially offset by a decrease of
$25.1 million, or 11%, in personal lines premiums earned. The increase in
premiums earned for commercial lines primarily was due to higher rates and was
partially offset by fewer policy counts. The decline in policy counts was
primarily in the workers compensation line of business. The decrease in
premiums earned for personal lines primarily was due to fewer policy counts and
was partially offset by higher rates. The reduction in personal lines volume
was driven primarily by a planned reduction of business in certain less
profitable states and the implementation of other more stringent underwriting
processes. The trend of double-digit percentage growth in commercial lines
premiums earned is expected to continue in 2003 while the decline in personal
lines premiums earned is expected to be much lower in 2003 and may turn positive
later in 2003.
Investment income increased $0.7 million, or 1%, for the year ended
December 31, 2002, resulting from an increase in invested assets, partially
offset by a lower yield on the fixed maturity investment portfolio.
Realized investment losses increased $15.4 million for the year ended
December 31, 2002, primarily due to a $3.9 million decrease in gains on the sale
of fixed maturity securities and an $11.5 million increase in losses from equity
securities.
Page 7
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
During 2002, Harleysville Group recognized other-than-temporary impairment
charges as follows:
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------
(in thousands)
EQUITY SECURITIES:
- -----------------
WorldCom $2,444 $1,366 $ $
AOL Time Warner 3,641
AT&T 1,358
AT&T Wireless 1,162
Bristol-Myers 2,677
Corning Inc. 1,374
Solectron Corp. 1,205
Sun Microsystems 1,757
Tyco 2,480
Williams Cos. 3,559
Bank of NY 1,273
EMC Corp. 2,090
Schering-Plough 1,186
Household Intl. 670
------ ------- ------ ----
Total equity securities 2,444 20,579 4,549 670
------ ------- ------ ----
FIXED MATURITIES:
- ----------------
MCI Communications 665
United Airlines 206
------ -------- ------ ----
Total fixed maturities 665 206
------ ------- ------ ----
Total investments $2,444 $21,244 $4,549 $876
====== ======= ====== ====
During the third and fourth quarters, Harleysville Group began to sell
equity securities as part of a plan to carry back realized tax losses to recover
taxes previously paid. All but two of the equity securities recognized as
impaired were sold in a subsequent quarter of 2002.
Page 8
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
Harleysville Group had gross realized equity investment losses of $28.6
million in 2002, which consisted of impairment charges of $28.2 million and $0.4
million from equity securities that were sold. Harleysville Group had gross
realized fixed maturity losses of $2.7 million in 2002, which consisted of
impairment charges of $0.9 million, $1.8 million from sales of one issuer's
bonds with a cost of $8.3 million that had been below cost for approximately six
months at the time of sale.
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 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 these are not material.
Harleysville Group holds securities with unrealized losses at December 31,
2002 as follows:
LENGTH OF UNREALIZED LOSS
-------------------------------
UNREALIZED LESS THAN 6 TO 12 OVER 12
FAIR VALUE LOSS 6 MONTHS MONTHS MONTHS
---------- ---------- --------- -------- -------
(in thousands)
Equity securities $49,886 $9,871 $3,439 $3,351 $3,081
======= ====== ====== ====== ======
Fixed maturities:
Obligations of state
and political
subdivisions $21,064 $ 256 $ 256 $ $
Corporate bonds 31,655 4,206 35 19 $4,152
------- ------ ------ ------ ------
Total bonds $52,719 $4,462 $ 291 $ 19 $4,152
======= ====== ====== ====== ======
Substantially all of the fixed maturity securities are classified as
available for sale and are carried at fair value on the balance sheet.
Page 9
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
There are 24 positions that comprise the unrealized loss in equity
investments at December 31, 2002. While 10 of these positions have been below
cost for more than six months, they have had volatile price movements and have
not been significantly below cost for significant continuous amounts of time.
Harleysville Group has been monitoring these securities and it is possible that
some may be written down in the income statement in 2003.
There are $30.3 million in fixed maturity securities, at amortized cost,
that at December 31, 2002, had been below amortized cost for over 12 months.
These primarily are comprised of airline enhanced equipment trust certificates
(EETC) as follows:
FAIR MATURITY
COST VALUE DATES
------- ------- -----------
(in thousands)
American Airlines $14,472 $12,371 2011
United Airlines 7,012 5,311 2010-2012
Other airlines 2,842 2,693 2011-2015
Other 6,014 5,813 2004-2008
------- -------
$30,340 $26,188
======= =======
After the events of September 11, 2001, air travel and the value of these
airlines' EETC securities declined. The EETCs are all "A tranche" holdings,
which means they are in a senior credit position to the underlying airplane
collateral value as compared to B and C tranche holders. At the time of
issuance, the collateral was appraised at approximately twice the value of the A
tranche EETCs. At year end, major investment banks had estimated that in a
distressed sale scenario, the value of the collateral would be approximately the
same as the EETCs' cost. During the fourth quarter of 2002, United Airlines
declared bankruptcy. At December 31, 2002, all of the EETCs continued to carry
an investment grade rating. In the first quarter of 2003, the debt rating of
American Airlines was downgraded by Moody's to non-investment grade.
Harleysville Group is participating in certain EETC creditor committees and is
monitoring developments. It is possible that these EETCs may be written down in
the income statement in 2003, depending upon developments involving both the
issuers and the threats of terrorism and war. During the fourth quarter of
2002, a $0.2 million impairment charge was recognized for United Airlines bonds,
which were not EETCs and were not collateralized.
Page 10
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
Income before income taxes increased $4.7 million, or 9%, for the year
ended December 31, 2002 due to the higher investment income and a lower
underwriting loss, partially offset by the increased realized investment losses.
The 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. Harleysville
Group's statutory combined ratio improved to 101.9% for the year ended December
31, 2002 from 104.2% for the year ended December 31, 2001. Such decrease was
due to improved results in both commercial lines and personal lines. The
commercial lines combined ratio improved to 99.5% for the year ended December
31, 2002 from 100.0% for the year ended December 31, 2001. The personal lines
combined ratio improved to 108.1% for the year ended December 31, 2002 from
113.1% for the year ended December 31, 2001. The improvement in commercial
lines primarily was due to improved results in the commercial automobile and
commercial multi-peril lines of business, partially offset by worse results in
the workers compensation line of business, where losses have trended higher. The
improvement in personal lines primarily was due to benefits from higher pricing,
re-underwriting and agency management efforts, partially offset by higher loss
trends in the personal automobile lines. The year ended December 31, 2001 also
included estimated losses of $3.6 million resulting from the September 11, 2001
terrorist acts and a $2.6 million charge for guaranty fund and other assessments
resulting from the liquidation of Reliance Insurance Company. These charges
adversely affected the statutory combined ratio by 0.5 points and 0.4 points,
respectively.
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
Page 11
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
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.
Of the $4.6 million of favorable development in 2002, $2.9 million was from
commercial lines and was net of $6.7 million of favorable development in the
2001 accident year and $4.8 million of adverse development in the 1999 accident
year and smaller amounts of development in every other accident year. The net
liability for commercial lines unpaid losses and loss settlement expenses at
December 31, 2001 for the 2001 and 1999 accident years was $236.2 million and
$91.9 million, respectively. Favorable development in personal lines was $1.7
million for 2002 and was net of $3.8 million of favorable development in the
2001 accident year and $0.9 million of adverse development in the 1998 accident
year and smaller amounts of development in every other accident year. The net
liability for personal lines unpaid losses and loss settlement expenses at
December 31, 2001 for the 2001 and 1998 accident years was $71.5 million and
$11.7 million, respectively. Actuarial loss reserving techniques and
assumptions, which rely on historical information as adjusted to reflect current
conditions, have been consistently applied during the periods presented.
Changes in the estimate of the liability for unpaid losses and loss settlement
expenses were not actuarially significant and reflect actual payments and
evaluations of new information and data since the last reporting date. These
changes correlate with actuarial trends and primarily relate to
lower-than-expected claim severity.
Of the $17.4 million of favorable development in 2001, $14.8 million was
derived from a reduction in anticipated loss settlement expenses. During 2000,
Harleysville Group completed a plan to consolidate its claims operations from 23
general claims offices into a centralized direct reporting center and four
specialized regional claims centers, which resulted in the termination of 173
employees. At December 31, 2000, the liability for loss settlement expenses of
$151.0 million was established based on historical trends with consideration
given to benefits from staffing reductions that were expected from the claims
reorganization. When establishing this liability, Harleysville Group did not
have historical experience or data regarding such a reorganization that
indicated that additional benefits were likely to be realized. During 2001, the
actual loss settlement payments and actuarial data indicated, with increasing
certainty, that the benefits from the claims reorganization were greater than
originally anticipated due to the benefits of
Page 12
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
greater specialization of the staff and the favorable development was recognized
throughout 2001 as the experience developed. Of the $14.8 million favorable
development from loss settlement expenses, $13.5 million is from commercial
lines and is from all of the accident years roughly in proportion to the loss
reserves in those accident years. In addition to the $14.8 million of favorable
loss settlement expense development, there was $2.6 million of net favorable
loss development with no significant variances from a varied mix of accident
years and lines.
The net liability at December 31, 2002 for unpaid losses and loss
settlement expenses was $702.7 million for commercial lines and $154.5 million
for personal lines. Harleysville Group has recorded the actuarial best estimate
of the ultimate unpaid cost of all losses and loss settlement expenses incurred,
including losses for claims that have been incurred but 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. A statistically determined
range of estimates for commercial lines is $616.4 million to $822.1 million and
for personal lines is $129.7 million to $176.4 million. The range of estimates
around the actuarial best estimates is statistically determined in order to
provide information regarding the variability of the actuarial best estimates.
The ranges were determined using both paid and incurred loss development data
with a 1,000 trial simulation run against each set of data. Development factors
within each 12-month development period were assumed to be normally distributed
with the means equal to the estimated age-to-age factors, and the standard
deviations equal to the actual standard deviations of the data used. The
resulting ranges produced by the simulation were then used to create a
reasonable representation of a 90% confidence interval using the 5% point as the
low end of the range and the 95% point as the high end of the range.
Because of the nature of insurance claims, there are uncertainties inherent
in the estimates of ultimate losses. The aforementioned reorganization of the
claims operation has resulted in new people and processes involved in settling
claims.
Page 13
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2002 COMPARED TO 2001 (CONTINUED)
As a result, more recent statistical data reflects different patterns than in
the past. For example, the rate of settlement of liability cases is generally
slower than it had been before the reorganization. Harleysville Group believes
that this reflects the impact of more specialized claims settlement activity and
a related increase in litigation and has considered this in establishing its
best estimates. On the other hand, smaller, routine property claims are being
handled by a centralized claims unit that has led to faster settlement of such
claims. These changes resulting from the claims reorganization give 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 is likely to differ from the amount recorded at December 31, 2002. For
every 1% change in the estimate, the effect on pre-tax income would be $8.6
million.
The property and casualty industry has had substantial aggregate loss
experience from claims related to asbestos-related illnesses, environmental
remediation, product and construction defect liability, mold, and other
uncertain exposures. Harleysville Group has not experienced significant losses
from such claims.
Effective for one year from July 1, 2002, the pool in which Harleysville
Group and Mutual participate is reinsured under a catastrophe reinsurance treaty
that provides coverage ranging from 84.8% to 94.3% of up to $140 million in
excess of a retention of $30 million for any given catastrophe. Harleysville
Group's 2002 pooling share of this coverage would range from 84.8% to 94.3% of
up to $100.8 million in excess of a retention of $21.6 million for any given
catastrophe. Accordingly, pursuant to the terms of the treaty, the maximum
recovery would be $126.5 million for any catastrophe involving an insured loss
of $170 million or greater. Harleysville Group's 2002 pooling share of this
maximum recovery would be $91.1 million for any catastrophe involving an insured
loss of $122.4 million or greater. The treaty includes reinstatement provisions
for coverage for a second catastrophe and payment of an additional premium in
the event of a first catastrophe occurring. Most terrorism losses would not be
covered by the treaty. A separate property per risk reinsurance treaty covers
certain terrorism losses. The maximum recovery by Harleysville Group on such
terrorism losses would be $27 million.
Page 14
HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2001 COMPARED TO 2000
Premiums earned increased $41.6 million, or 6%, for the year ended December
31, 2001. The increase was due to an increase in premiums earned for commercial
lines of $55.5 million, partially offset by a decrease of $13.9 million in
personal lines premiums earned. The increase in premiums earned for commercial
lines primarily was due to higher rates, partially offset by fewer policy
counts. The decrease in premiums earned for personal lines primarily was due to
fewer policy counts, partially offset by higher rates.
Investment income decreased $1.3 million, or 1%, for the year ended
December 31, 2001 due to a lower yield on the investment portfolio.
Realized investment gains (losses) decreased $12.9 million for the year
ended December 31, 2001 primarily resulting from greater losses on the sale of
equity securities and an increase of $5.5 million in losses recognized on
investments that were trading below cost on an other-than-temporary basis. Such
increased losses were partially offset by greater gains on the sale of fixed
maturities.
Income before income taxes decreased $5.9 million, or 10%, for the year
ended December 31, 2001, due to the lower investment income and lower realized
investment gains (losses), partially offset by a lower underwriting loss.
Harleysville Group's statutory combined ratio improved to 104.2% for the year
ended December 31, 2001 from 106.1% for the year ended December 31, 2000. Such
decrease is primarily due to improved results in commercial lines, partially
offset by worse results in personal lines. The commercial lines combined ratio
improved to 100.0% for the year ended December 31, 2001 from 104.5% for the year
ended December 31, 2000. The personal lines combined ratio declined to 113.1%
for the year ended December 31, 2001 from 108.7% for the year ended December 31,
2000. The improvement in commercial lines primarily was due to benefits from
higher pricing, re-underwriting and agency management efforts, partially offset
by $3.6 million of net estimated losses ($.08 per basic share after taxes)
resulting from the September 11, 2001 terrorist acts. The decline in personal
lines profitability primarily was due to higher loss trends in the personal
automobile lines.
The year ended December 31, 2001 included a $2.6 million charge ($.06 per
basic share after taxes) for guaranty fund and other assessments resulting from
the liquidation of Reliance Insurance Company. This charge adversely affected
the statutory
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
2001 COMPARED TO 2000 (CONTINUED)
combined ratio by 0.4 points and the September 11 terrorist losses adversely
affected it by 0.5 points. The year ended December 31, 2000 included a pre-tax
charge of $1.1 million ($.03 per basic share after taxes) related to the
consolidation of selected non-claims support services and office functions
throughout the field operations. This restructuring charge adversely affected
the statutory combined ratio by 0.2 points for the year ended December 31, 2000.
Income before income taxes for the year ended December 31, 2000 also was reduced
by $1.9 million ($.04 per basic share after taxes) to reflect the effect of a
settlement of litigation between the North Carolina Rate Bureau and the
Commissioner of Insurance over personal automobile insurance rate levels dating
back to 1994. The settlement, which mandated a refund of premium be made to
policyholders, adversely affected the combined ratio by 0.3 points.
Losses ceded under the aggregate catastrophe reinsurance agreement with
Mutual increased by $3.6 million for the year ended December 31, 2001, as there
were more severe storms, particularly in the Midwest, than in the prior year.
Harleysville Group recognized $48.9 million of favorable development in the
provision for insured events of prior years in 2000, of which $20.2 million was
from loss settlement expenses and $28.7 million is from losses. At December 31,
1999, the liability for loss settlement expenses of $158.5 million was
established based on historical trends. The aforementioned claims
reorganization plan was being implemented and was not complete at that time. As
a result, Harleysville Group was unable to accurately estimate the benefits to
the ultimate loss settlement expenses associated with claims that occurred prior
to December 31, 1999. During 2000, the claims reorganization was completed and
staffing efficiencies were achieved and the estimate of the liability for loss
settlement expenses was adjusted in correlation with this information.
Of the $28.7 million of favorable loss development in 2000, $21.0 million
was from commercial lines and $7.7 million was from personal lines. For both of
these lines, the favorable development correlated with actuarial trends and
primarily was in the three most recent accident years. Within the commercial
lines, workers compensation claims developed favorably by $8.9 million primarily
due to benefits of reform legislation that was passed in Pennsylvania and
resulted in a reduction of medical cost trends from rules that controlled
medical fees and a reduction in indemnity costs through rules that resulted in
injured workers returning to work quicker. Such benefits affected almost all
accident years.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
NEW ACCOUNTING STANDARDS
In June 2001, SFAS No. 142, "Goodwill and Other Intangible Assets" was
issued. SFAS No. 142 requires that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead be tested for
impairment at least annually in accordance with the provisions of SFAS No. 142.
Harleysville Group adopted the provisions of SFAS No. 142 effective January 1,
2002, at which time Harleysville Group ceased to record amortization expense
related to its goodwill. The adoption of SFAS No. 142 resulted in a $0.8
million reduction in amortization expense in 2002 as compared to 2001.
Harleysville Group's goodwill balance was $23.4 million at December 31, 2002.
Harleysville Group completed its analysis of any potential impairment of the
goodwill during the second quarter of 2002 and no adjustment was necessary.
Other new accounting standards that have been issued did not, or are not
expected to, have a material impact on the consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measure of the ability to generate sufficient cash to meet
cash obligations as they come due. Harleysville Group's primary sources of cash
are premium income, investment income and maturing investments. Cash outflows
can be variable because of uncertainties regarding settlement dates for
liabilities for unpaid losses and because of the potential for large losses,
either individually or in the aggregate. Accordingly, Harleysville Group
maintains investment and reinsurance programs generally intended to provide
adequate funds to pay claims without forced sales of investments. Harleysville
Group models its exposure to catastrophes and has the ability to pay claims
without selling held to maturity securities even for events having a low (less
than 1%) probability. Even in years of greater catastrophe frequency,
Harleysville Group has been able to pay claims without liquidating any
investments. Harleysville Group has also considered scenarios of declines in
revenue and increases in loss payments, and has the ability to meet cash
requirements under such scenarios without selling held to maturity securities.
Harleysville Group's policy with respect to fixed maturity investments is to
purchase only those that are of investment grade quality.
Net cash provided by operating activities was $113.2 million and $45.8
million for 2002 and 2001, respectively. The increase in net cash provided by
operating activities primarily consists of an increase in cash provided by
underwriting activities.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
Net cash used by investing activities was $100.9 million and $36.4 million
for 2002 and 2001, respectively. The change is primarily due to increased net
purchases of investments due to the increase in cash provided by operating
activities.
Financing activities used net cash of $11.1 million in 2002 compared to
$9.6 million in 2001. The change was primarily due to an increase in dividends
paid, partially offset by an increase in the issuance of common stock.
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 December
31, 2002, Harleysville Group held cash collateral of $139.2 million related to
securities on loan with a market value of $135.5 million. 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.
The Company had $8.7 million of cash and marketable securities and $42.0
million of dividends receivable from its subsidiaries at December 31, 2002,
which are available for general corporate purposes including dividends, debt
service, capital contributions to subsidiaries, acquisitions and the repurchase
of stock. The Company's $75.0 million of notes payable are due in November 2003
and are expected to be refinanced. The Company has adopted a stock repurchase
plan under which the Company may purchase up to 500,000 shares of Harleysville
Group Inc. common stock. Mutual has authorized purchases of the common shares
of Harleysville Group Inc. in an equal amount. At March 6, 2003, the Company
and Mutual each have repurchased 1,250 of the shares authorized to be
repurchased. Harleysville Group has no material commitments for capital
expenditures as of December 31, 2002.
As a holding company, the Company's principal source of cash for the
payment of dividends is dividends from its subsidiaries. The Company's insurance
subsidiaries are subject to state laws that restrict their ability to pay
dividends.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
Applying the current regulatory restrictions as of December 31, 2002, $11.0
million would be available for distribution to the Company by its subsidiaries
without prior regulatory approval until October 1, 2003, after which $52.9
million would be available for distribution to Harleysville Group Inc. without
prior approval. See the Business-Regulation section of the Company's 2002 Form
10-K, which includes a reconciliation of net income and shareholders' equity as
determined under statutory accounting practices to net income and shareholders'
equity as determined in accordance with generally accepted accounting
principles. Also, see Note 10 of the Notes to Consolidated Financial Statements.
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.
The NAIC has adopted the Codification of Statutory Accounting Principles
with an effective date of January 1, 2001. The codified principles are intended
to provide a basis of accounting recognized and adhered to in the absence of,
conflict with, or silence of, state statutes and regulations. The impact of the
codified principles on the January 1, 2001 statutory capital and surplus of the
Company's insurance subsidiaries ranged from a decrease of $0.4 million to an
increase of $6.4 million and was an increase of $21.0 million on a consolidated
basis.
Harleysville Group had off-balance-sheet credit risk related to $68.0
million of premium balances due to Mutual from agents and insureds at December
31, 2002.
The following summarizes Harleysville Group's contractual obligations at
December 31, 2002.
LESS THAN AFTER
TOTAL 1 YEAR 1-3 YEARS 3 YEARS
------- --------- --------- -------
(in thousands)
Contractual obligations:
Debt $95,620 $75,475 $19,585 $560
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
In 2001, GE Reinsurance Corporation (GE Re) sought rescission of a
reinsurance agreement between Mutual and GE Re relating to certain automobile
insurance policies written in California through a managing general agent
beginning in 1999. On December 13, 2002, Mutual and GE Re settled this matter
by agreeing to a commutation and termination of the reinsurance agreement
effective December 31, 2002. The settlement agreement did not materially impact
Harleysville Group's financial statements.
IMPACT OF INFLATION
Property and casualty insurance premiums are established before the amount
of losses and loss settlement expenses, or the extent to which inflation may
affect such expenses, are known. Consequently, Harleysville Group attempts, in
establishing rates, to anticipate the potential impact of inflation. In the
past, inflation has contributed to increased losses and loss settlement
expenses.
RISK FACTORS
You should consider carefully the following risks, as well as the other
information contained in our 2002 Report on Form 10-K. If any of the following
risks actually occur, our business, financial condition and results of
operations could be adversely affected. You should refer to the other
information set forth in our 2002 Report on Form 10-K including our consolidated
financial statements and the related notes.
OUR RESERVES MAY NOT BE ADEQUATE TO COVER OUR ULTIMATE LIABILITY FOR LOSSES AND
LOSS SETTLEMENT EXPENSES.
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
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
financial condition. 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 aware,
predictions of future events, trends in claims severity and frequency and other
subjective factors. Although we use a number of methods to project our ultimate
liability, there is no method that can always exactly predict our ultimate
liability for losses and loss settlement expenses.
In addition to reviewing our reserving techniques, as part of our reserving
process we also consider:
- information regarding each claim for losses;
- our loss history and the industry's loss history;
- legislative enactments, judicial decisions and legal developments
regarding damages;
- changes in political attitudes; and
- trends in general economic conditions, including inflation.
We cannot be certain that the reserves we establish are adequate now or
will be adequate in the future.
CATASTROPHIC EVENTS CAN HAVE A SIGNIFICANT IMPACT ON OUR FINANCIAL AND
OPERATIONAL CONDITION.
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.
Our insurance subsidiaries have experienced, and are expected in the future
to experience, catastrophe losses. It is possible that a catastrophic event or
a series of multiple catastrophic events could have a material adverse effect on
the operating results and financial condition of our insurance subsidiaries,
thereby limiting the ability of our insurance subsidiaries to pay dividends to
us.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
Various events can cause catastrophes, including severe winter weather,
hurricanes, windstorms, earthquakes, hail, terrorism, explosions and fires. The
frequency and severity of these catastrophes are inherently unpredictable. The
extent of losses from a catastrophe is a function of both the total amount of
insured exposures in the area affected by the event and the severity of the
event.
Our insurance subsidiaries seek to reduce the impact on our business of a
catastrophe through geographic diversification and through the purchase of
reinsurance covering various categories of catastrophes, which generally
excludes terrorism. Nevertheless, reinsurance may prove inadequate if:
- a major catastrophic loss exceeds the reinsurance limit, or
- an insurance subsidiary pays a number of smaller catastrophic
loss claims that, individually, fall below the subsidiary's
retention level.
WE FACE SIGNIFICANT COMPETITION FROM OTHER REGIONAL AND NATIONAL INSURANCE
COMPANIES, AGENTS AND FROM SELF-INSURANCE.
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.
The property and casualty insurance industry is highly competitive on the
basis of product, price and service. If our competitors offer products with
more coverage, or price their products more aggressively, our ability to grow or
renew our business may be adversely impacted. There are many companies
competing for the same insurance customers in the geographic areas in which we
operate. The internet also could emerge as a significant source of new
competition, both from existing competitors using their brand name and resources
to write business through this new distribution channel and from new
competitors.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
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.
A number of new, proposed or potential legislative or industry developments
could further increase competition in the property and casualty insurance
industry. These developments include:
- the enactment of the Gramm-Leach-Bliley Act of 1999, which could
result in increased competition from new entrants to the insurance
market, including banks and other financial service companies;
- programs in which state-sponsored entities provide property insurance
in catastrophe-prone areas or other alternative market types of
coverage; and
- changing practices caused by the internet, which have led to
greater competition in the insurance business and, in some cases,
greater expectations for customer service.
New competition from these developments could cause the supply or demand
for insurance to change, which could adversely affect our results of operations
and financial condition.
WE ARE HEAVILY REGULATED IN THE STATES IN WHICH WE OPERATE.
We are subject to extensive supervision and regulation in the states in
which we transact business. The primary purpose of supervision and regulation
is to protect individual policyholders and not shareholders or other investors.
Our business can be adversely affected by private passenger automobile insurance
regulations and any other regulations affecting property and casualty insurance
companies. For example, laws and regulations can reduce or set rates at levels
that we do not believe are adequate for the risks we insure. Other laws and
regulations can limit our ability to cancel or refuse to renew policies and
require us to offer coverage to all consumers. Changes in laws and regulations,
or their interpretations, pertaining to insurance, including workers
compensation, may also have an adverse effect on our business. Although the
federal government does not directly regulate the insurance industry, federal
initiatives, such as federal terrorism backstop legislation, from time to time,
also can impact the insurance industry.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
In addition, proposals intended to control the cost and availability of
health care services have been debated in the U.S. Congress and state
legislatures. Although we do not write health insurance, rules affecting health
care services can affect other insurance that we write, including workers
compensation, and commercial and personal automobile and liability insurance. We
cannot determine whether or in what form health care reform legislation may be
adopted by the U.S. Congress or any state legislature. We also cannot determine
the nature and effect, if any, that the adoption of health care legislation or
regulations, or changing interpretations, at the federal or state level would
have on us.
THE PROPERTY AND CASUALTY INSURANCE INDUSTRY IS CYCLICAL.
Historically, the results of the property and casualty insurance industry
have been subject to significant fluctuations over time due to competition and
due to unpredictable developments, including:
- natural and man-made disasters;
- fluctuations in interest rates and other changes in the
investment environment that affect returns on our
investments;
- inflationary pressures that affect the size of losses;
and
- legislative and regulatory changes and judicial decisions
that affect insurers' liabilities.
The demand for property and casualty insurance, particularly commercial
lines, also can vary with the overall level of economic activity. In addition
to the cyclicality of the property and casualty industry, our surety business is
affected adversely by economic downturns that make it difficult for the insureds
whose obligations we guarantee to fulfill their obligations.
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
OUR ABILITY TO REDUCE OUR EXPOSURE TO RISKS DEPENDS ON THE AVAILABILITY AND COST
OF REINSURANCE.
We transfer a portion of our exposure to selected risks to other insurance
and reinsurance companies through reinsurance arrangements. Under our
reinsurance arrangements, another insurer assumes a specified portion of our
losses and loss adjustment expenses in exchange for a specified portion of
policy premiums. The availability, amount and cost of reinsurance depend on
market conditions and may vary significantly. Any decrease in the amount of our
reinsurance will increase our risk of loss. Furthermore, we face a credit risk
when we obtain reinsurance because we are still liable for the transferred risks
if the reinsurer cannot meet the transferred obligations. Therefore, the
inability of any of our reinsurers to meet its financial obligations could
materially and adversely affect our operations.
Many reinsurers experienced significant losses related to the terrorist
acts of September 11, 2001, and future terrorist acts may have similar effects.
As a result, we may incur significantly higher reinsurance costs and more
restrictive terms and conditions, or may be unable to attain reinsurance for
some types of commercial exposures.
OUR PERFORMANCE IS TIED TO THE ECONOMIC AND REGULATORY CONDITIONS AND
WEATHER-RELATED EVENTS IN THE EASTERN AND MIDWESTERN UNITED STATES.
We write property and casualty insurance business in the eastern and
midwestern United States. Consequently, unusually severe storms or other
natural or man-made disasters that destroy property in these states could
adversely affect our operations. Our revenues and profitability also are subject
to prevailing economic and regulatory conditions in the states in which we write
insurance. We may be exposed to risks of adverse developments that are greater
than if we conducted business nationwide.
WE DEPEND ON OUR INVESTMENTS TO SUPPORT OUR OPERATIONS AND TO PROVIDE A
SIGNIFICANT PORTION OF OUR REVENUES AND EARNINGS.
We, like many other property and casualty insurance companies, depend on
income from our investment portfolio for a significant portion of our revenues
and earnings. Any significant decline in our investment income as a result of
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
falling interest rates, decreased dividend payment rates or general market
conditions would have an adverse effect on our results. Any significant decline
in the market value of our investments would reduce our shareholders' equity and
our policyholders' surplus, which could impact our ability to write additional
business.
WE DEPEND ON INDEPENDENT INSURANCE AGENTS.
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
geographically, then we may need to expand our network of agencies to
successfully market our products. If these agencies fail to market our products
successfully, our business may be adversely impacted. Also, independent agents
may decide to sell their businesses to banks, other insurance agencies or other
businesses. Changes in ownership of agencies, or expansion of agencies through
acquisition, could adversely affect an agency's ability to control growth and
profitability, thereby adversely affecting our business.
WE MAY BE ADVERSELY IMPACTED BY A CHANGE IN OUR RATING.
Insurance companies are subject to financial strength ratings produced by
external rating agencies. Higher ratings generally indicate financial stability
and a strong ability to pay claims. Ratings are assigned by rating agencies to
insurers based upon factors that they believe are relevant to policyholders.
Ratings are not recommendations to buy, hold or sell our securities.
The principal agencies that cover the property and casualty industry are
A.M. Best Company, Standard & Poor's and Moody's. We believe our ability to
write business is most influenced by our rating from A.M. Best. According to
A.M. Best, its ratings are designed to assess an insurer's financial strength
and ability to meet ongoing obligations to policyholders. A rating below "A-"
from A.M. Best could materially adversely affect the business we write. We
believe that ratings from Standard & Poor's or Moody's, although important, have
less of an impact on our
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
business. An unfavorable change in either of these ratings, however, could make
it more expensive for us to access capital markets. We cannot be sure that we
will maintain our current A.M. Best, Standard & Poor's or Moody's ratings.
BECAUSE WE ARE AN INSURANCE HOLDING COMPANY, WE RELY ON RECEIVING ADEQUATE
DIVIDENDS FROM OUR INSURANCE SUBSIDIARIES.
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. 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.
APPLICABLE INSURANCE LAWS MAKE IT DIFFICULT TO EFFECT A CHANGE OF CONTROL, AND A
LARGE SHAREHOLDER MAY HAVE SIGNIFICANT INFLUENCE OVER POTENTIAL CHANGE OF
CONTROL TRANSACTIONS.
Under applicable insurance laws and regulations of the states in which our
subsidiaries are domiciled, no person may acquire control of us unless that
person has filed a statement containing specified information with the insurance
commissioner of each state and obtains advance approval for such acquisition.
Under applicable laws and regulations, any person acquiring, directly or
indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of
any other person is presumed to have acquired control of such person, and a
person who beneficially acquires 10% or more of our common stock without
obtaining advance approval of the insurance commissioner of each state would be
in violation of applicable insurance laws and would be subject to injunctive
action requiring disposition or seizure of the shares and prohibiting the voting
of such shares, as well as other action determined by the insurance commissioner
of each such state.
In addition, many state insurance laws require prior notification to the
state insurance department of a change of control of a non-domiciliary insurance
company licensed to transact insurance in that state. Although these pre-
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HARLEYSVILLE GROUP
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
(Continued)
RISK FACTORS (CONTINUED)
notification statutes do not authorize the state insurance departments to
disapprove the change of control, they authorize regulatory action - including a
possible revocation of our authority to do business - in the affected state if
particular conditions exist such as undue market concentration. Any future
transactions that would constitute a change of control of us may require prior
notification in the states that have pre-acquisition notification laws.
As of December 31, 2002, Mutual owned approximately 56% of our outstanding
common stock. Mutual's stock ownership and ability, by reason of such
ownership, to elect our board of directors, provides it with significant
influence over potential change of control transactions.
Finally, our certificate of incorporation permits the Board of Directors to
issue up to one million shares of preferred stock having such terms, including
voting rights, as the Board shall fix and determine.
WE DEPEND ON KEY PERSONNEL.
The success of our business is dependent, to a large extent, on our ability
to attract and retain key employees, in particular our senior officers, and key
management, sales, information systems, underwriting, claims and corporate
personnel. Competition to attract and retain key personnel is intense. Although
we have change of control agreements with a number of key managers, in general
we do not have employment contracts or non-compete arrangements with our
employees, including our key employees.
Page 28