S&P Lowers Harleysville Group Ratings to ‘BBB-‘

January 2, 2004

Standard & Poor’s Ratings Services has lowered its counterparty credit and senior debt ratings on Harleysville Group Inc. to “BBB-” from ‘BBB’. It has also removed the ratings from CreditWatch, where they had been placed on Oct. 17, 2003, and assigned a negative outlook.

Summarizing its reasons for the New Year’s Eve announcement, S&P said: “The downgrade reflects the company’s weakened underlying financial risk profile and the business position of its insurance operations. Partially offsetting these factors is the company’s ability to service its debt obligation from funds held at the holding company while it continues to reposition its underlying insurance operations to more fully focus on its niche of serving small business accounts. The negative outlook reflects the uncertainty in resolving reserve deficiencies, restructuring while retaining ongoing business, and the sudden retirement of Chief Executive Officer Walter R. Bateman and the lack of an heir-apparent. “

Commenting on the negative outlook, S&P said: It “expects that cash on hand at the holding company will be maintained to service the company’s debt issuance for up to two years. This is particularly important as the company’s subsidiaries continue to reestablish themselves in their niche market. Although management continues to see rate increases in its commercial lines segment and the re-underwriting or shedding of different portions of its workers’ compensation and personal lines, Standard & Poor’s believes the company will continue to struggle and is expected to have a combined ratio of more than 100 percent at year-end 2004.

“In particular, further reserve adjustment to prior accident years may occur as the company continues to recast its claims divisions and identify weakness in its case reserves. It is expected the company will continue to be challenged in maintaining its top line and defend its market position as market rate increases begin to taper off and reserves possibly increase. In combination, this could weaken the organization’s retention level as it is forced to increase rates to more than the industry average. A search for a CEO is underway, and it is expected one could be in place the first quarter of 2004.”

S&P noted the following “Major Rating Factors:”
— Poor underwriting performance. Standard & Poor’s is concerned that the company may be deficient in its ability to underwrite risks in line with price as indicated by the loss ratio for the nine months ended Sept. 30, 2003, which measured 87 percent. A significant contributing factor to this weak loss ratio is the adverse loss-reserve development associated with the 1997-2001 accident years totaling $76.8 million (pretax) and earning a 119 percent nine-month combined ratio. This is particularly troubling because over the last three years the industry has experienced strong rate increases.

— Business position. Standard & Poor’s believes Harleysville will continued to be challenged as it competes with local, regional, and national insurance companies. As a middle tier insurer focusing on main street business with 50 or fewer employees, the company may struggle to maintain its market share. Currently the company is repositioning itself to more fully focus on its niche of serving small business accounts by re-underwriting or shedding various portions of its personal lines and workers’ compensation business. The success of the restructuring will be in part measured by the company’s ability to retain ongoing business in its selected market.

— Adequate liquidity. Harleysville is an intermediate holding company with two primary sources of income. The first is derived from management fees for the management of the Harleysville Group insurance operations. The second is derived from dividends from its underlying insurers. Over the past three years Harleysville has received management fees that provide a suitable source of income to service interest on its newly issued $100 million 5.75 percent senior unsecured notes due July 15, 2013. Nevertheless, Standard & Poor’s believes the historical basis for the ratings on the company has been the financial strength of its insurance operations. Taking into consideration that Harleysville’s insurance operations’ dividend capacity is driven by formula, ongoing losses at these companies could impair the holding company’s ability to maintain an ample cushion to service its debt. As of Nov. 30, 2003, the company maintained about $15.9 million of cash on hand, which could be used to service its debt over the next two or more years. In addition, about $11.6 million in dividends receivable are available to the holding company from its underlying insurers. The insurance operations as of the third quarter of 2003 maintained capitalization, as measured by Standard & Poor’s model, of more than 150%, a level considered strong.

— Unexpected departure of CEO: CEO Walter R. Bateman has suddenly retired, and there is no obvious replacement. Succession planning is currently underway by the board of directors; however, for an undefined period Harleysville’s senior management team will report to the board of directors.

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