Harleysville Confirms Loss; Best Lowers Ratings

February 18, 2004

Harleysville Group Inc. reported a diluted net loss of $0.66 per share in the fourth quarter of 2003, reflecting the previously announced loss reserve increases in several business lines for prior accident years (See IJ Web site Feb. 12).

The company said its diluted net income for the fourth quarter was $0.57 per share, and that “there were essentially no realized investment gains or losses in the fourth quarter of 2003, compared to $0.04 per share of realized gains in the fourth quarter of 2002. For the 12 months, the company reported a diluted net loss per share of $1.59, compared to diluted net income per share of $1.53 in 2002. For the full year, 2003 results included realized investment losses of $0.02 per share, compared to $0.39 per share of realized losses in 2002.”

A.M. Best Co. reacted to the report with an announcement that it has downgraded Harleysville’s financial strength ratings to “A-” (Excellent) from “A” (Excellent) for the property/casualty pool members. Concurrently, Best also downgraded the debt ratings of Harleysville Group Inc.’s (HGIC) existing senior notes to “bbb-” from “bbb+” and the indicative ratings of senior debt to “bbb-” from “bbb+”, subordinated debt to “bb+” from “bbb”, trust preferred securities to “bb” from “bbb-” and preferred stock to “bb” from “bbb-“, which have been filed as part of its universal shelf registration, as well as its financial strength rating of Harleysville Life Insurance Company to “B++” (Very Good) from “A-” (Excellent). The rating outlook for all of the ratings is stable.

“Our 2003 results were totally unacceptable,” commented CEO Michael L. Browne. “We will return Harleysville not only to profitability, but also to superior levels of profitability. To do this, we have strengthened our management in key areas, including claims, and conducted thorough claims and actuarial reviews, using internal and external resources, in order to address the issues that led to our additions to loss reserves in 2003. With these changes in place, we can now focus on growing our business and our profits.”

The bulletin noted: “The company’s fourth quarter and 12-month results were reduced by the previously announced addition of $42 million pretax, or $0.92 per share after tax, to the company’s loss and loss adjustment reserves for prior accident years, primarily in its workers compensation ($11.8 million), commercial automobile ($9.5 million), commercial multi-peril ($19.3 million) and personal automobile ($3.8 million) lines of business. Harleysville Group’s end-of-the- quarter reserve analysis showed higher-than-expected development in the casualty lines of business in accident years prior to 2003, which caused the company to make the reserve adjustment. Of the reserve development, about two-thirds relates to the 1999 to 2001 accident years. Harleysville Group’s 12-month earnings were reduced by $119 million pretax, or $2.58 per share after tax, due to reserve development. In light of the higher-than-expected development in prior accident years, the company raised its loss estimates for the 2003 accident year, which also impacted the company’s fourth quarter and 12-month results.”

Best also indicated that in addition to the recent announcements of losses due to increased reserves it had also considered the “significant reserve charges already taken by HGIC in the first three quarters of 2003.” The downgrading of the ratings “reflects the recent volatility and continued uncertainty as it pertains to future loss reserve development, weaker than expected results reported in 2003, diminished albeit still adequate capitalization and A.M. Best’s cautious view of Harleysville’s earnings prospects over the near term.”

Best noted the company’s position “that the loss reserve development stems largely from increased loss severity and different loss patterns since the recent reorganization of the group’s claims operations.” It also indicated that “it is apparent that Harleysville has lagged its peers in terms of implementing more stringent underwriting standards, particularly in personal lines, which could result in continued unfavorable accident year underwriting performance relative to its competitors. The downgrade of Harleysville Life’s rating reflects the impact of the rating change of the property/casualty group, Harleysville Life’s modest size relative to Harleysville and inconsistent statutory operating results due to weak performance of several lines of business.”

Although Harleysville reported that “fourth quarter net written premiums rose 3 percent to $197.6 million in 2003, while net written premiums through 12 months increased by 6 percent to $843.5 million in 2003,” this wasn’t sufficient to compensate for the losses. The company reported that its “overall statutory combined ratio* was 134.6 percent in the fourth quarter of 2003, compared to 102.1 percent in the fourth quarter of 2002. For the 12 months, the statutory combined ratio was 123.2 percent in 2003, versus 101.9 percent in 2002. Reserve development added 20.0 points and 14.5 points to the 2003 fourth quarter and 12-month statutory combined ratios, respectively. In addition, property catastrophe losses added 2.4 points and 0.6 points to the 2003 and 2002 statutory combined ratios, respectively.”

“We are committed to improved profitability in commercial lines and personal lines,” Browne explained. “In commercial lines, we will continue with our strategy aimed at the core business controlled by our independent agency partners. In personal lines, the business plan we’ve put in place in the last two quarters is realistic and achievable, and it has been welcomed enthusiastically by our agents.

“Our financial condition is solid. We have a strong balance sheet, characterized by significantly strengthened reserves, a modest 17 percent debt-to-capital ratio, a high-quality investment portfolio and a premium-to-surplus ratio of 1.8 to 1. Additionally, operating cash flow is at a historical high,” he continued. “Our relationships with our agents are strong. As we move past the issues of 2003, we know we will improve our results in 2004 and beyond. We are going to focus intensely on four cornerstones — underwriting, claims handling, service to agents and policyholders, and productivity. Bottom line, our future success will be driven by consistent execution of the fundamentals.”

Best seemed to agree. It noted that “Notwithstanding, Harleysville’s current rating and stable outlook reflect the group’s continued strong capitalization and regional market franchise. Harleysville is afforded additional financial flexibility through its publicly traded holding company, HGIC, which has access to the public markets. HGIC maintains only moderate financial leverage, which is enhanced by good available cash coverage.”

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