SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended MARCH 31, 2003. ----------------- OR [ ] 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, PENNSYLVANIA 19438-2297 ------------------------------------------------------------------ (Address of principal executive offices, including zip code) (215) 256-5000 -------------------------------------------------------- (Registrant's telephone number, including area code) 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 X . No . ----- ----- At May 6, 2003, 30,150,885 shares of common stock of Harleysville Group Inc. were outstanding. Page 1 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES INDEX PAGE NUMBER ----------- Part I - Financial Information Consolidated Balance Sheets - March 31, 2003 and December 31, 2002 3 Consolidated Statements of Income - For the three months ended March 31, 2003 and 2002 4 Consolidated Statement of Shareholders' Equity - For the three months ended March 31, 2003 5 Consolidated Statements of Cash Flows - For the three months ended March 31, 2003 and 2002 6 Notes to Consolidated Financial Statements 7 Management's Discussion and Analysis of Results of Operations and Financial Condition 13 Quantitative and Qualitative Disclosure About Market Risk 23 Evaluation of Disclosure Controls and Procedures 24 Part II - Other Information 25 Page 2 ITEM 1. FINANCIAL STATEMENTS HARLEYSVILLE GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data) MARCH 31, DECEMBER 31, 2003 2002 ---------- ----------- (Unaudited) ASSETS ------ Investments: Fixed maturities: Held to maturity, at amortized cost (fair value $377,648 and $411,235) $ 347,189 $ 379,940 Available for sale, at fair value (amortized cost $1,005,085 and $932,889) 1,064,653 95,032 Equity securities, at fair value (cost $93,633 and $96,849) 102,119 107,177 Short-term investments, at cost, which approximates fair value 101,441 89,692 Fixed maturity securities on loan: Held to maturity, at amortized cost (fair value $6,179 and $5,707) 5,543 5,222 Available for sale, at fair value (amortized cost $117,679 and $118,991) 127,280 129,837 ---------- ---------- Total investments 1,748,225 1,706,900 Cash 2,491 2,944 Receivables: Premiums 140,306 138,905 Reinsurance (affiliate $3,666 and $55) 88,237 75,488 Accrued investment income 20,505 21,552 ---------- ---------- Total receivables 249,048 235,945 Deferred policy acquisition costs 99,255 94,896 Prepaid reinsurance premiums 20,037 19,421 Property and equipment, net 26,363 27,556 Deferred income taxes 31,821 25,784 Security lending collateral 137,702 139,215 Due from affiliate 10,709 Other assets 52,296 48,154 ---------- ---------- Total assets $2,367,238 $2,311,524 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ Liabilities: Unpaid losses and loss settlement expenses (affiliate $177,849 and $166,188) $ 977,761 $ 928,335 Unearned premiums (affiliate $64,401 and $54,035) 423,347 406,277 Accounts payable and accrued expenses 106,867 109,965 Security lending obligation 137,702 139,215 Debt (affiliate $18,500) 95,620 95,620 Due to affiliate 2,417 ---------- ---------- Total liabilities 1,743,714 1,679,412 ---------- ---------- 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 31,157,811 and 30,917,575 shares; outstanding 30,139,312 and 29,917,575 shares 31,158 30,918 Additional paid-in capital 154,938 149,091 Accumulated other comprehensive income 45,406 49,086 Retained earnings 410,370 418,582 Deferred compensation (2,356) Treasury stock, at cost, 1,018,499 and 1,000,000 shares (15,992) (15,565) ---------- ---------- Total shareholders' equity 623,524 632,112 ---------- ---------- Total liabilities and shareholders' equity $2,367,238 $2,311,524 ========== ========== See accompanying notes to consolidated financial statements. Page 3 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002 (dollars in thousands, except per share data) 2003 2002 -------- -------- Revenues: Premiums earned (ceded to affiliate, $198,829 $182,505 $172,305 and $160,271) Investment income, net of investment expense 21,447 21,482 Realized investment gains (losses) (433) 478 Other income (affiliate $2,010 and $1,754) 4,520 3,745 -------- -------- Total revenues 224,363 208,210 -------- -------- Losses and expenses: Losses and loss settlement expenses (ceded to affiliate, $142,882 and $113,667) 163,759 127,272 Amortization of deferred policy acquisition costs 48,317 44,622 Other underwriting expenses 18,557 16,922 Interest expense (affiliate $94 and $120) 1,394 1,421 Other expenses 1,211 1,050 -------- -------- Total expenses 233,238 191,287 -------- -------- Income (loss) before income taxes (8,875) 16,923 Income taxes (benefit) (5,635) 3,583 -------- -------- Net income (loss) $ (3,240) $ 13,340 ======== ======== Per common share: Basic earnings (loss) $ (.11) $ .45 ======== ======== Diluted earnings (loss) $ (.11) $ .44 ======== ======== Cash dividend $ .165 $ .15 ======== ======== See accompanying notes to consolidated financial statements. Page 4 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2003 (dollars in thousands) ACCUMULATED COMMON STOCK ADDITIONAL OTHER ------------------- PAID-IN COMPREHENSIVE RETAINED DEFERRED TREASURY SHARES AMOUNT CAPITAL INCOME EARNINGS COMPENSATION STOCK TOTAL ---------- ------- ---------- ------------- -------- ------------ -------- -------- Balance, December 31, 2002 30,917,575 $30,918 $149,091 $49,086 $418,582 $ $(15,565) $632,112 -------- Net loss (3,240) (3,240) Other compre- hensive loss, net of tax: Unrealized investment losses, net of reclassification adjustment (3,680) (3,680) -------- Comprehensive loss (6,920) Issuance of common stock 240,236 240 5,840 6,080 Tax benefit from stock options exercised 7 7 Deferred compensation (2,356) (2,356) Cash dividend paid (4,972) (4,972) Purchase of treasury stock, 18,499 shares (427) (427) ---------- ------- -------- ------- -------- ------- -------- -------- Balance at March 31, 2003 31,157,811 $31,158 $154,938 $45,406 $410,370 $(2,356) $(15,992) $623,524 ========== ======= ======== ======= ======== ======= ======== ======== See accompanying notes to consolidated financial statements. Page 5 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002 (in thousands) 2003 2002 --------- -------- Cash flows from operating activities: Net income (loss) $ (3,240) $ 13,340 Adjustments to reconcile net income to net cash provided by operating activities: Change in receivables, unearned premiums, prepaid reinsurance balances 3,351 6,161 Change in affiliate balance 13,126 (11,477) Increase in unpaid losses and loss settlement expenses 49,426 10,639 Deferred income taxes (4,056) (308) Increase in deferred policy acquisition costs (4,359) (2,635) Amortization and depreciation 844 595 Loss (gain) on sale of investments 433 (478) Other, net (18,066) 9,110 -------- -------- Net cash provided by operating activities 37,459 24,947 -------- -------- Cash flows from investing activities: Fixed maturity investments: Purchases (97,495) (61,721) Sales or maturities 68,431 50,395 Equity securities: Purchases (7,505) Sales 1,923 5,757 Net purchases of short-term investments (11,749) (8,945) Sale (purchase) of property and equipment 297 (1,431) -------- -------- Net cash used by investing activities (38,593) (23,450) -------- -------- Cash flows from financing activities: Issuance of common stock 6,080 2,370 Dividend paid (to affiliates, $2,743 and $2,491) (4,972) (4,435) Purchase of treasury stock (427) -------- -------- Net cash provided (used) by financing activities 681 (2,065) -------- -------- Decrease in cash (453) (568) Cash at beginning of period 2,944 1,839 -------- -------- Cash at end of period $ 2,491 $ 1,271 ======== ======== See accompanying notes to consolidated financial statements. Page 6 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, 2002 included in the Company's 2002 Annual Report filed with the Securities and Exchange Commission on Form 10-K. 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 and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim paying period, 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 indicate 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. Stock-Based Compensation Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation expense is Page 7 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES (UNAUDITED) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS recognized for fixed stock option grants and an employee stock purchase plan. Compensation expense would be recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. The following table illustrates the effect on net income and earnings per share as if the provisions of statement of Financial Accounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), "Accounting for Stock-Based Compensation," had been applied for the three months ended March 31, 2003 and 2002: 2003 2002 -------- ------- (in thousands, except per share data) Net income (loss), as reported $(3,240) $13,340 Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects 201 756 Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (1,088) (1,273) ------- ------- Pro forma net income (loss) $(4,127) $12,823 ======= ======= Basic earnings (loss) per share: As reported $ (0.11) $ 0.45 Pro forma $ (0.14) $ 0.43 Diluted earnings (loss) per share: As reported $ (0.11) $ 0.44 Pro forma $ (0.14) $ 0.43 Page 8 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES (UNAUDITED) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2 - Earnings Per Share The computation of basic and diluted earnings (loss) per share is as follows for the three months ended March 31: 2003 2002 ---------- -------- (dollars in thousands, except per share data) Numerator for basic and diluted earnings (loss) per share: Net income (loss) $ (3,240) $ 13,340 ========= ======== Denominator for basic earnings (loss) per share -- weighted average shares outstanding 29,987,316 29,510,116 Effect of stock incentive plans 552,462 ---------- ---------- Denominator for diluted earnings (loss) per share 29,987,316 30,062,578 ========== ========== Basic earnings (loss) per share $ (.11) $ .45 ======= ======= Diluted earnings (loss) per share $ (.11) $ .44 ======= ======= Page 9 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES (UNAUDITED) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following options to purchase shares of common stock were not included in the computation of diluted earnings (loss) per share because the exercise price of the options was greater than the average market price: FOR THE THREE MONTHS ENDED MARCH 31, 2003 2002 -------- -------- (in thousands) Number of options 904 433 === === For the three months ended March 31, 2003, an additional 1,212,316 options to purchase shares of common stock were not included in the computation of diluted earnings (loss) per share because their inclusion would have had an antidilutive effect. 3 - Reinsurance Premiums earned are net of amounts ceded of $16,400,000 and $16,448,000 for the three months ended March 31, 2003 and 2002, respectively. Losses and loss settlement expenses are net of amounts ceded of $17,865,000 and $5,781,000 for the three months ended March 31, 2003 and 2002, respectively. Such amounts do not include the reinsurance transactions with Harleysville Mutual Insurance Company (Mutual) under the pooling arrangement. Harleysville Group has a reinsurance agreement with Mutual whereby Mutual reinsures accumulated catastrophe losses in a quarter up to $14,400,000 in excess of $3,600,000 in return for a reinsurance premium. The agreement excludes catastrophe losses resulting from earthquakes, terrorism or hurricanes, and supplements the existing external catastrophe reinsurance program. Under the agreement, Harleysville Group ceded premiums earned of $2,024,000 and $1,791,000 and losses incurred of $3,756,000 and $28,000 to Mutual for the three months ended March 31, 2003 and 2002, respectively. Harleysville Group cedes business to and assumes business from Mutual under a reinsurance pooling agreement. Because this agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to Mutual. However, the reinsurance pooling agreement provides for the right of offset. Mutual has an A. M. Best rating of "A" (Excellent). Page 10 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES (UNAUDITED) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 4 - Cash Flows There were no cash tax payments in the first quarter of 2003 and 2002. Cash interest payments of $94,000 and $122,000 were made in the first quarter of 2003 and 2002, respectively. 5 - 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 March 31, 2003 and 2002: 2003 2002 -------- -------- (in thousands) Revenues: Premiums earned: Commercial lines $148,749 $128,305 Personal lines 50,080 54,200 -------- -------- Total premiums earned 198,829 182,505 Net investment income 21,447 21,482 Realized investment gains (losses) (433) 478 Other 4,520 3,745 -------- -------- Total revenues $224,363 $208,210 ======== ======== Income (loss) before income taxes: Underwriting gain (loss): Commercial lines $(28,006) $(10,164) Personal lines (7,894) 1,424 -------- -------- SAP underwriting loss (35,900) (8,740) GAAP adjustments 4,096 2,429 -------- -------- GAAP underwriting loss (31,804) (6,311) Net investment income 21,447 21,482 Realized investment gains (losses) (433) 478 Other 1,915 1,274 -------- -------- Income (loss) before income taxes $ (8,875) $ 16,923 ======== ======== Page 11 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES (UNAUDITED) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 6 - Comprehensive Income Comprehensive income (loss) for the three months ended March 31, 2003 and 2002 consisted of the following (all amounts are net of taxes): 2003 2002 -------- -------- (in thousands) Net income (loss) $(3,240) $ 13,340 Other comprehensive loss: Unrealized investment holding losses arising during period (4,120) (10,682) Less: Reclassification adjustment for (gains) losses included in net income 440 (158) ------- -------- Net unrealized investment losses (3,680) (10,840) ------- -------- Comprehensive income (loss) $(6,920) $ 2,500 ======= ======== 7 - 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. Page 12 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES ITEM 2. 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 economic, competitive and legislative developments. These forward looking statements are subject to change and uncertainty which are, in many instances, beyond the Company's control and have been made based upon management's expectations and beliefs concerning future developments and their potential effect on Harleysville Group. There can be no assurance that future developments will be in accordance with management's expectations so that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results including premium growth and underwriting results could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; catastrophe losses; competition in insurance product pricing; government regulation and changes therein which may impede the ability to charge adequate rates; performance of the financial markets; fluctuations in interest rates; availability and price of reinsurance; and the status of labor markets in which the Company operates. 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 for the year ended December 31, 2002 included in the Company's 2002 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. 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 Page 13 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (CONTINUED) 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. 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 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 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. Harleysville Group evaluates its investment portfolio quarterly to determine if a decline in fair value below cost is other than temporary. Harleysville Group has written down to fair value, without exception, any equity security that has declined below cost by more than 20% and maintained such decline for six months, or by 50% or more, in the quarter in which either such decline occurred. In some cases, securities that have declined by a lesser amount or for a shorter period of time are written down if the evaluation indicates the decline is other-than-temporary. For example, one equity security had declined for a short period of time but was written down in the fourth quarter of 2002 when the sale of the company at a value less than our cost was announced. Fair value of equity securities is based on the closing market value as reported by a national stock exchange or Nasdaq. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities but Harleysville Group does not own a material amount of non-traded securities. Page 14 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) 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 and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim paying period, 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 indicate 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 March 31, 2003 and 2002 is discussed in greater detail below. Results of Operations Premiums earned increased $16.3 million during the three months ended March 31, 2003 as compared to the three months ended March 31, 2002. The increase is primarily due to an increase of $20.4 million in premiums earned for commercial lines partially offset by a decline of $4.1 million in personal lines premiums earned. The increase in premiums earned for commercial lines was 15.9%, primarily due to higher rates partially offset by fewer policy counts. The decline in policy counts was primarily in the workers compensation line of business. The decline in premiums earned for personal lines was 7.6%, primarily due to fewer policy counts 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 Page 15 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) 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 was essentially unchanged for the three months ended March 31, 2003 as a higher level of invested assets was offset by a lower yield. Realized investment gains (losses) decreased $0.9 million for the three months ended March 31, 2003 compared to the same prior year quarter primarily resulting from greater losses on equity securities partially offset by greater gains on the sale of fixed maturity securities. There were no impairment charges in the first quarter of 2003 and $2.4 million of impairment charges in the first quarter of 2002. Harleysville Group had a gross realized loss of $1.3 million in the first quarter of 2003 which was from the sale of an equity security which had not declined by more than 20% below its cost for more than six months at the time of its sale. Harleysville Group holds securities with unrealized losses at March 31, 2003 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 $53,578 $11,752 $928 $8,186 $2,638 ======= ======= ==== ====== ====== Fixed maturities: Obligations of state and political subdivisions $27,303 $ 275 $159 $ 116 Corporate bonds 34,300 8,100 89 $8,011 ------- ------- ---- ------ ------ Total bonds $61,603 $ 8,375 $248 $ 116 $8,011 ======= ======= ==== ====== ====== Substantially all of the fixed maturity securities are classified as available for sale and are carried at fair value on the balance sheet. There are 26 positions that comprise the unrealized loss in equity investments at March 31, 2003. While 19 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. Page 16 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) There are $33.4 million in fixed maturity securities, at amortized cost, that at March 31, 2003, 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 $14,454 $ 9,405 2011 United Airlines 7,002 4,708 2010-2012 Other airlines 2,838 2,487 2011-2015 Other 9,135 8,818 2004-2008 ------- ------- $33,429 $25,418 ======= ======= After the events of September 11, 2001, air travel and the value of these airlines' EETC securities declined. The EETCs are all "A tranche" holdings, which means they are in a senior credit position to the underlying airplane collateral value as compared to B and C tranche holders. At the time of issuance, the collateral was appraised at approximately twice the value of the A tranche EETCs. Recent estimates indicate that in a distressed sale scenario, the value of the collateral would be approximately the same as the EETCs' cost. During the fourth quarter of 2002, United Airlines declared bankruptcy. At March 31, 2003, the United Airlines EETCs continued to carry an investment grade rating. In the first quarter of 2003, the debt ratings of American Airlines were downgraded 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 world events which impact the level of air travel. In the first quarter of 2003, Harleysville Group had a loss before income taxes of $8.9 million, compared to income before income taxes of $16.9 million in the first quarter of 2002. The decline in income before income taxes of $25.8 million for the three months ended March 31, 2003, as compared to the same period in 2002, was primarily due to a greater underwriting loss. The greater underwriting loss primarily was due to higher property catastrophe losses resulting from winter storms and an increase in the provision for insured events in prior years. Property catastrophe losses were $3.6 million and $0.8 million for the three months ended March 31, 2003 and 2002, respectively. The Page 17 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) provision for insured events in prior years consists of $20.5 million of adverse development ($19.9 million in the workers compensation line) and $3.7 million of favorable development for the three months ended March 31, 2003 and 2002, respectively. 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 115.4% for the three months ended March 31, 2003 from 103.3% for the three months ended March 31, 2002. Such increase was due to a higher underwriting loss in both commercial lines (including the adverse development in the workers compensation line) and personal lines. The statutory combined ratios by line of business for the three months ended March 31, 2003, as compared to the three months ended March 31, 2002, were as follows: FOR THE THREE MONTHS ENDED MARCH 31, 2003 2002 ------ ------ Commercial: Automobile 96.0% 97.5% Workers compensation 192.2% 122.0% Commercial multi-peril 98.8% 100.1% Other commercial 83.8% 89.8% Total commercial 114.1% 103.2% Personal: Automobile 117.5% 113.5% Homeowners 124.0% 89.3% Other personal 114.8% 59.7% Total personal 119.3% 103.1% Total personal and commercial 115.4% 103.3% Page 18 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) The following table presents the liability for unpaid losses and loss settlement expenses by major line of business: MARCH 31, DECEMBER 31, 2003 2002 -------- ------------ (in thousands) Commercial: Automobile $183,590 $181,537 Workers compensation 253,037 230,705 Commercial multi-peril 252,788 243,312 Other commercial 48,799 47,109 -------- -------- Total commercial 738,214 702,663 -------- -------- Personal: Automobile 111,070 115,025 Homeowners 40,612 37,768 Other personal 2,410 1,726 -------- -------- Total personal 154,092 154,519 -------- -------- Total personal and commercial 892,306 857,182 Plus reinsurance recoverables 85,455 71,153 -------- -------- Total liability $977,761 $928,335 ======== ======== Of the $19.9 million of adverse development in the provision for insured events in prior years in workers compensation, $16.7 million was attributable to the 1998 to 2001 accident years and the balance was attributable to other accident years. Such adverse development represented 8.6% of the December 31, 2002 workers compensation net liability for unpaid losses and loss settlement expenses. Harleysville Group has publicly noted adverse loss trends in its workers compensation line for several quarters. These trends are consistent with the experience of other companies writing this coverage, many of which have, during the past twelve months, made substantial additions to their reserves for insured events in prior years in this line of insurance. Actuarial analysis of the first quarter 2003 loss activity identified unusually large workers compensation case reserve development occurring in the month of March. Accordingly, Harleysville Group performed additional analysis and investigation of the claim activity and concluded that additional reserves were needed. The change in loss development patterns in the first quarter of 2003 was influenced by a number of factors. The reorganization of Harleysville Group's claims operations resulted in more proactive claims management which, in turn, provided more contemporaneous loss estimates. In addition, weak economic conditions have hampered the ability to return injured workers to employment thus extending the estimated length of disabilities and medical loss cost trends have increased. Page 19 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) 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 reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends. The loss reserve development in other lines of business was not significant and the total $20.5 million of adverse development in all lines represented 2.4% of the December 31, 2002 net liability for unpaid losses and loss settlement expenses. 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. As a result, more recent statistical data reflects different patterns than in the past and give rise to uncertainty as to the pattern of future loss settlements. The frequency of litigation on bodily injury liability cases has increased during the past two years while the rate of settlement has slowed. These changed patterns give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury liability claims. 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 March 31, 2003. For every 1% change in the estimate, the effect on pre-tax income would be $8.9 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. The personal lines combined ratio increased to 119.3% for the three months ended March 31, 2003 from 103.1% for the three months ended March 31, 2002. The increase primarily was due to higher catastrophe losses from winter weather which affected the homeowners line and higher loss severity which affected each of the personal lines. Net catastrophe losses increased $2.8 million and losses ceded under the aggregate catastrophe reinsurance agreement with Mutual increased $3.7 million for the three months ended March 31, 2003, due to a greater number and more severe catastrophes in the 2003 period. Page 20 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) The income tax expense for each of the three month periods ended March 31, 2003 and 2002 includes the tax benefit of tax-exempt investment income of $2.5 million and $2.3 million, respectively. Liquidity and Capital Resources Operating activities provided $37.5 million and $24.9 million of net cash for the three months ended March 31, 2003 and 2002, respectively. The change primarily is from improved underwriting cash flow, a change in the amount of realized gains (losses) and a change in the amount of accounts payable and accrued expenses. Investing activities used $38.6 million and $23.5 million for the three months ended March 31, 2003 and 2002, respectively. The increase is primarily due to an increase in net purchases of fixed maturity investments and an increase in the purchase of short-term investments. Financing activities provided $0.7 million of net cash and used $2.1 million of net cash for the three months ended March 31, 2003 and 2002, respectively. The change is primarily due to an increase in the issuance of common stock, partially offset by an increase in dividends paid and by the purchase of treasury stock in the 2003 period. 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 March 31, 2003, Harleysville Group held cash collateral of $137.7 million related to securities on loan with a market value of $133.5 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 GIC's and Funding Agreements from issuers rated A or better. 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 collateral held under the securities lending program and the obligation to return this collateral upon the return of the loaned securities. Page 21 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Continued) Harleysville Group Inc. had $10.5 million of cash and marketable securities and $42.0 million of dividends receivable from its subsidiaries at March 31, 2003 which is 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 November 2003; the Company expects to refinance this indebtedness at or prior to maturity. The Company has adopted a stock repurchase plan under which the Company and Mutual may each purchase up to 500,000 shares of Harleysville Group Inc. common stock up to a total of 1.0 million shares. As of March 31, 2003, the Company had repurchased 18,499 shares leaving 481,501 shares authorized to be repurchased. The Company has no other material commitments for capital expenditures as of March 31, 2003. 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 Exhibit 13(B) to the Company's annual report on Form 10-K for fiscal year 2002, filed with the Securities and Exchange Commission on March 26, 2003. Page 22 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. Harleysville Group has maintained approximately the same duration of its investment portfolio to its liabilities from December 31, 2002 to March 31, 2003. In addition, the Company has maintained approximately the same investment mix during this period. Page 23 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES ITEM 4. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our "disclosure controls and procedures" (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) as of a date (the "Evaluation Date") within 90 days before the filing date of this quarterly report, have concluded that as of the Evaluation Date, our disclosure controls and procedures were adequate and designed to ensure that material information relating to us and our consolidated subsidiaries would be made known to them by others within those entities. (b) Changes in internal controls. Except as stated in the next sentence, there were no significant changes in our internal controls or to our knowledge, in other factors that could significantly affect our internal controls and procedures subsequent to the Evaluation Date. A review of the process of estimating the case reserves for loss and loss settlement expenses is currently being conducted and is likely to result in refinements in the procedures for making such estimates and the internal audit process for compliance with such procedures. Page 24 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES PART II. OTHER INFORMATION ITEM 1. Legal Proceedings - None ITEM 2. Changes in Securities - None ITEM 3. Defaults Upon Senior Securities - None 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, 2003 (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 28,345,846 of the 30,064,517 shares of common stock outstanding and entitled to vote at the Meeting. On the resolution to elect Michael L. Browne, Frank E. Reed and Jerry S. Rosenbloom as class "B" 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 ---------- -------- Michael L. Browne 28,303,410 42,436 Frank E. Reed 28,303,961 41,885 Jerry S. Rosenbloom 28,303,365 42,481 There were no abstentions or broker non-votes recorded. On the basis of the above vote, Michael L. Browne, Frank E. Reed and Jerry S. Rosenbloom were elected as class "B" Directors to serve until the expiration of their respective terms and until their successors are duly elected. The resolution to approve the Amended and Restated Employee Stock Purchase Plan was adopted, 28,138,811 votes for the resolution, 182,000 votes against the resolution and 25,026 abstentions. Page 25 HARLEYSVILLE GROUP INC. AND SUBSIDIARIES PART II. OTHER INFORMATION (Continued) ITEM 5. Other Information - None ITEM 6. a. Exhibits - None b. Reports on Form 8-K - None 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: May 14, 2003 /s/BRUCE J. MAGEE ----------------- ----------------------------------- Bruce J. Magee Senior Vice President and Chief Financial Officer (principal financial officer and principal accounting officer) Page 26 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Harleysville Group Inc. (the "Company") on Form 10-Q for the period ended March 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Walter R. Bateman, Chairman of the Board, and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: May 14, 2003 /s/WALTER R. BATEMAN --------------- -------------------------- Walter R. Bateman Chairman of the Board, and Chief Executive Officer A signed original of this written statement required by Section 906 has been provided to Harleysville Group Inc. and will be retained by Harleysville Group Inc. and furnished to the Securities and Exchange Commission or its Staff upon request. Page 27 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Harleysville Group Inc. (the "Company") on Form 10-Q for the period ended March 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Bruce J. Magee, Senior Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: May 14, 2003 /s/BRUCE J. MAGEE ---------------- ------------------------- Bruce J. Magee Senior Vice President and Chief Financial Officer A signed original of this written statement required by Section 906 has been provided to Harleysville Group Inc. and will be retained by Harleysville Group Inc. and furnished to the Securities and Exchange Commission or its Staff upon request. Page 28 CERTIFICATION PURSUANT TO THE SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Walter R. Bateman certify that: 1. I have reviewed this quarterly report on Form 10Q of Harleysville Group Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial conditions, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/WALTER R. BATEMAN ----------------- ---------------------------- Walter R. Bateman Chairman of the Board and Chief Executive Officer Page 29 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Bruce J. Magee certify that: 1. I have reviewed this quarterly report on Form 10Q of Harleysville Group Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial conditions, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/BRUCE J. MAGEE ------------------- ---------------------------- Bruce J. Magee Senior Vice President and Chief Financial Officer Page 30