HARLEYSVILLE GROUP INC - FORM 10-Q

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EX-32.1 - CERTIFICATION OF CEO - HARLEYSVILLE GROUP INC	dex321.htm
EX-32.2 - CERTIFICATION OF CFO - HARLEYSVILLE GROUP INC	dex322.htm
EX-31.1 - CERTIFICATION OF CEO - HARLEYSVILLE GROUP INC	dex311.htm
EX-31.2 - CERTIFICATION OF CFO - HARLEYSVILLE GROUP INC	dex312.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2011

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

For the transition period from to

0-14697

(Commission file number)

HARLEYSVILLE GROUP INC.

(Exact name of registrant as specified in its charter)

Delaware

51-0241172

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

355 Maple Avenue, Harleysville, PA 19438-2297

(Address of principal executive offices) (Zip Code)

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

N/A

(Former name, former address and former fiscal year, if changed since last report)

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 ¨.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨.

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

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

At May 3, 2011, 27,092,471 shares of common stock of Harleysville Group Inc. were outstanding.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

INDEX


		Page Number
Part I	Financial Information

Item 1.	Financial Statements

	Consolidated Balance Sheets - March 31, 2011 and December 31, 2010		3

	Consolidated Statements of Income - For the three months ended March 31, 2011 and 2010		4

	Consolidated Statement of Shareholders’ Equity - For the three months ended March 31, 2011		5

	Consolidated Statements of Cash Flows - For the three months ended March 31, 2011 and 2010		6

	Notes to Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		20

Item 3.	Quantitative and Qualitative Disclosure About Market Risk		30

Item 4.	Controls and Procedures		31

Part II	Other Information

Item 1A.	Risk Factors		32

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		32

Item 6.	Exhibits		33

Item 1. Financial Statements

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	March 31, 2011			December 31, 2010
	(Unaudited)
Assets
Investments:
Fixed maturities:
Held to maturity, at amortized cost (fair value $146,344 and $156,967)	$	138,497		$	148,362
Available for sale, at fair value (amortized cost $2,015,390 and $2,069,097)		2,105,989			2,165,101
Equity securities, at fair value (cost $270,760 and $191,095)		345,378			268,104
Short-term investments, at cost, which approximates fair value		43,960			79,909

Total investments		2,633,824			2,661,476
Cash		36			39
Receivables:
Premiums		132,009			133,758
Reinsurance		218,674			219,149
Accrued investment income		25,364			26,910

Total receivables		376,047			379,817

Deferred policy acquisition costs		105,343			113,997
Prepaid reinsurance premiums		48,585			51,625
Property and equipment, net		13,141			13,312
Deferred income taxes		5,861			9,413
Other assets		46,076			48,553

Total assets	$	3,228,913		$	3,278,232

Liabilities and Shareholders’ Equity
Liabilities:
Unpaid losses and loss settlement expenses (affiliate $185,030 and $214,518)	$	1,751,242		$	1,771,661
Unearned premiums (affiliate $(7,601) and $32,935)		459,107			503,532
Accounts payable and accrued expenses		82,784			96,461
Due to affiliate		42,489			19,445
Debt (affiliate $18,500 and $18,500)		118,500			118,500

Total liabilities		2,454,122			2,509,599


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 35,135,659 and 34,987,829 shares; outstanding 27,106,112 and 27,044,836 shares		35,136			34,988
Additional paid-in capital		269,077			263,857
Accumulated other comprehensive income		76,093			80,506
Retained earnings		638,950			630,603
Treasury stock, at cost, 8,029,547 and 7,942,993 shares		(244,465	)		(241,321	)

Total shareholders’ equity		774,791			768,633


Total liabilities and shareholders’ equity	$	3,228,913		$	3,278,232

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

For the three months ended March 31, 2011 and 2010

(dollars in thousands, except per share data)


	2011		2010
Revenues:
Premiums earned from affiliate (ceded to affiliate, $201,903 and $186,454)	$	199,753	$	209,083
Investment income, net of investment expense		25,585		25,883
Realized investment gains, net:
Total other-than-temporary impairment losses		—		—
Portion of loss recognized in other comprehensive income		—		—
Other realized investment gains, net		15,774		334

Total realized investment gains, net		15,774		334

Other income (affiliate $2,213 and $1,711)		4,410		3,657


Total revenues		245,522		238,957


Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $152,054 and $128,304)		144,195		152,036
Amortization of deferred policy acquisition costs		52,679		53,034
Other underwriting expenses		20,671		21,484
Interest expense (affiliate $32 and $32)		1,514		1,514
Other expenses		969		954


Total expenses		220,028		229,022


Income before income taxes		25,494		9,935

Income taxes		7,267		1,885


Net income	$	18,227	$	8,050


Per common share:

Basic net income	$	.67	$	.29


Diluted net income	$	.66	$	.29


Cash dividend	$	.36	$	.325

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

For the three months ended March 31, 2011

(dollars in thousands)


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

Balance at December 31, 2010		34,987,829	$	34,988	$	263,857	$	80,506		$	630,603		$	(241,321	)	$	768,633

Net income											18,227						18,227

Other comprehensive income (loss), net of tax:

Unrealized investment losses, net of reclassification adjustment								(5,069	)								(5,069	)

Defined benefit pension plans:
Recognized net actuarial loss								656									656


Other comprehensive loss																	(4,413	)


Comprehensive income																	13,814

Issuance of common stock:
Incentive plans		137,388		137		3,151											3,288
Dividend Reinvestment Plan		10,442		11		325											336

Tax benefit from stock compensation						371											371

Stock compensation						1,373											1,373

Purchase of treasury stock, 86,554 shares														(3,144	)		(3,144	)

Dividends declared											(9,880	)					(9,880	)


Balance at March 31, 2011		35,135,659	$	35,136	$	269,077	$	76,093		$	638,950		$	(244,465	)	$	774,791

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

For the three months ended March 31, 2011 and 2010

(in thousands)


	2011			2010

Cash flows from operating activities:
Net income	$	18,227		$	8,050
Adjustments to reconcile net income to net cash provided by operating activities:
Change in receivables, unearned premiums and prepaid reinsurance balances		2,396			14,206
Change in affiliate balance		23,044			(10,322	)
Increase (decrease) in unpaid losses and loss settlement expenses		(20,419	)		17,615
Deferred income taxes		5,929			(1,522	)
(Increase) decrease in deferred policy acquisition costs		1,656			(2,024	)
Amortization and depreciation		2,551			2,268
Realized investment gains, net		(15,774	)		(334	)
Other, net		(12,701	)		(13,157	)


		4,909			14,780
Cash used by the change in the intercompany pooling agreement		(33,014	)


Net cash (used) provided by operating activities		(28,105	)		14,780


Cash flows from investing activities:
Fixed maturity investments:
Purchases		(2,026	)		(164,723	)
Sales or maturities		63,457			108,209
Equity securities:
Purchases		(117,733	)		(631	)
Sales		57,508
Other invested assets:
Maturities					180
Net sales of short-term investments		35,949			54,036
Purchase of property and equipment, net		(24	)		(67	)

Net cash provided (used) by investing activities		37,131			(2,996	)


Cash flows from financing activities:
Issuance of common stock		144			5,873
Purchase of treasury stock					(9,112	)
Dividends paid (to affiliate, $5,230 and $4,721)		(9,544	)		(9,030	)
Excess tax benefits from share-based payment arrangements		371			485

Net cash used by financing activities		(9,029	)		(11,784	)

Change in cash		(3	)		0
Cash at beginning of period		39			126

Cash at end of period	$	36		$	126

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1 – Basis of Presentation

The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments which are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations, and cash flows for the interim periods. The results of operations for the 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, 2010 included in the Company’s 2010 Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (SEC).

The affiliate transaction disclosures on the face of the financial statements relate to transactions with Harleysville Mutual Insurance Company (the Mutual Company). The Mutual Company owns approximately 54% of the outstanding common stock of Harleysville Group Inc. As used herein, “Harleysville Group” refers to Harleysville Group Inc. and its subsidiaries and the “Company” refers to Harleysville Group Inc.

2 – Change in Pooling Agreement

The Company’s property and casualty subsidiaries participate in a pooling agreement with the Mutual Company and its property and casualty insurance subsidiary, Harleysville Pennland Insurance Company (Pennland), whereby such subsidiaries and Pennland cede to the Mutual Company all of their insurance business and assume from the Mutual Company an amount equal to their participation in the pooling agreement. All losses and loss settlement expenses and other underwriting expenses are prorated among the parties on the basis of participation in the pooling agreement. The pooling agreement provides for the allocation of premiums, losses and loss settlement expenses and underwriting expenses between Harleysville Group and the Mutual Company. Harleysville Group is not liable for any losses incurred by its subsidiaries, Harleysville Preferred Insurance Company and Harleysville Insurance Company of New Jersey, and the Mutual Company prior to January 1, 1986, the date the pooling agreement became effective. Harleysville Group’s participation in the pool has been 80% since January 1, 2008. Effective January 1, 2010, the pooling agreement was amended to exclude reinsurance premiums, losses, loss settlement expenses and underwriting expenses voluntarily assumed by the Mutual Company.

Effective January 1, 2011, the Company’s property and casualty subsidiaries and the Mutual Company and Pennland amended their intercompany pooling agreement as it relates to their workers compensation business. The amendment establishes that the financial results associated with the workers compensation business for accident years 2011 and following will be retained 100 percent by the Mutual Company. The financial results of this business for prior accident years will continue to be shared between the Company’s property and casualty subsidiaries, the Mutual Company and Pennland under the existing pool participations. Harleysville Group paid cash of $33 million on January 3, 2011 associated with the transfer of the unearned premium liability on the workers compensation business as of January 1, 2011. Harleysville Group’s unearned premium liability decreased by $40 million and Harleysville Group received a ceding commission of $7 million for expenses that were incurred to generate the business ceded to the Mutual Company, which ceding commission reduced deferred policy acquisition costs.

3 – Share-Based Payments

Harleysville Group has several share-based compensation plans. Harleysville Group measures compensation expense associated with the plans based on the grant-date fair value of the awards.

Harleysville Group has the following share-based compensation plans:

•

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

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

•

The Employee Stock Purchase Plan provides that a participant may elect to have up to 15% of base pay withheld to purchase shares. The purchase price of the stock is 85% of the lower of the beginning-of-the-subscription period or end-of-the-subscription-period fair market value. There are two subscription periods during each year.

•

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

The compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $1,373,000 and $1,423,000 for the three months ended March 31, 2011 and 2010, respectively, with a corresponding income tax benefit of $453,000 and $470,000, respectively.

During the first quarter of 2011, 225,760 stock options were granted at a Black Scholes weighted average value of $6.63 per option. These options vest 33 1/3% per year over a three year period. Restricted stock unit grants of 125,475 units were also made during the first quarter of 2011 and 30,855 of these units include performance conditions. The weighted average fair value of the grants of the restricted stock units was $37.73 per unit. These awards vest over three years.

During the first quarter of 2010, 511,790 stock options were granted at a Black Scholes weighted average value of $6.84 per option. These options vest 33 1/3% per year over a three year period. Restricted stock unit grants of 99,060 units were also made during the first quarter of 2010 and 39,485 of these units include performance conditions. The weighted average fair value of the grants of the restricted stock units was $37.18 per unit. These awards vest over three years.

In accordance with the terms of the EIP, the Company acquired 86,554 shares of its common stock from employees in connection with stock option exercises and the vesting of restricted stock and restricted stock units during the first quarter of 2011. The stock was received in payment of the exercise price of the stock options and in satisfaction of withholding taxes due upon exercise or vesting.

As of March 31, 2011, the Company’s total unrecognized compensation cost related to nonvested share-based compensation arrangements and the weighted average period over which the compensation cost is expected to be recognized is as follows:


	Unrecognized Compensation Cost		Weighted Average Period of Recognition
	(in thousands)		(in years)
Equity incentive plan awards	$	7,846		2.10
Employee stock purchase plan	$	76		0.29

4 – Investments

Fair value accounting guidance defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.

Fair value measurements are determined under a three-level hierarchy which gives the highest priority to quoted prices in active markets and the lowest priority to unobservable inputs which are based on the Company’s own assumptions. The three levels of the hierarchy are as follows:

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

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

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Level 3 - Inputs that are unobservable, reflecting the Company’s own assumptions.

For investments that have quoted market prices in active markets, the Company uses the quoted market price as fair value and includes these investments in Level 1 of the fair value hierarchy. The Company classifies U.S. Treasury securities and publicly traded equity securities and equity mutual funds as Level 1. When quoted market prices in active markets are not available, the Company relies on a pricing service to estimate fair value. The Company classifies its fixed maturity securities other than U.S. Treasury securities and private placements as Level 2. Private placement fixed maturity securities and non-publicly traded equity securities are classified as Level 3.

The Company utilizes a nationally recognized independent pricing service to obtain fair value estimates for its fixed maturity holdings because of the detailed process it uses in arriving at a fair value estimate. For fixed maturity securities that have quoted prices in active markets, market quotations are provided. For fixed maturity securities that do not trade on a daily basis, the independent pricing service prepares estimates of fair value using a wide array of observable inputs including relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. The observable market inputs that our independent pricing service utilizes include, listed in approximate order of priority: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. Additionally, the independent pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.

When the independent pricing service provides a fair value estimate, the Company uses that estimate. At March 31, 2011, the independent pricing service provided a fair value estimate for all of the investments classified as Level 1 investments within the fair value hierarchy and approximately 99% of the investments classified as Level 2 estimates within the fair value hierarchy. The fair value of all Level 2 securities is based on observable market inputs.

In instances when the independent pricing service is unable to provide a fair value estimate, the Company attempts to obtain a non-binding fair value estimate from a number of broker/dealers and reviews any fair value estimate reported by an independent business news service. In instances where only one broker/dealer provides a fair value estimate for a fixed maturity security, the Company uses that estimate. In instances where the Company is able to obtain fair value estimates from more than one broker/dealer, the Company generally uses the lowest or next to lowest fair value estimate. In instances where neither the independent pricing service nor a broker/dealer is able to provide a fair value estimate, the fair value is based on cash flow analysis and other valuation techniques which utilize significant unobservable inputs and the Company classifies the fixed maturity investment as a Level 3 investment. Level 3 investments represent less than 1% of the Company’s total investment portfolio.

Quotes obtained from third parties are non-binding. The third parties from whom quotes are obtained are knowledgeable market participants that have a detailed understanding of the sector, the security type and the issuer. The non-binding quotes are fair value estimates based on observable market data utilized by these market participants. The Company does not adjust quotes or prices obtained from third parties.

Management reviews, on an ongoing basis, the reasonableness of the methodologies employed by the independent pricing service. As part of the monthly review process, management examines the prices obtained from the independent pricing service. This process routinely involves reviewing any available recent transaction activity reported via various investment research tools. Additionally, the Company tracks changes in credit ratings of all fixed maturity securities on a monthly basis and performs a more in-depth, quarterly evaluation of fixed income securities that are rated below single A by Moody’s and/or S&P. If as a result of its review, management does not believe that a price received with respect to any particular security is a reasonable estimate of the fair value of the security, it will discuss this with the independent pricing service to resolve the discrepancy. Management then determines the appropriate level of classification of each investment within the fair value hierarchy based on its evaluation of the inputs used in determining the fair value.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

The following is a summary of the fair value measurements of applicable Company assets by level within the fair value hierarchy as of March 31, 2011 and December 31, 2010. These assets are measured at fair value on a recurring basis. There were no transfers to or from Levels 1 and 2 of the fair value hierarchy in the first quarter of 2011. The Company’s policy is to recognize transfers between levels as of the end of the reporting period.


			Fair Value Measurements at Reporting Date Using
	March 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Fixed maturities available for sale:
U.S. Treasury securities	$	116,042	$	116,042
Obligations of U.S. government corporations and agencies		15,978			$	15,978
Obligations of states and political subdivisions		1,166,711				1,166,711
Corporate securities		459,076				459,076
Mortgage-backed securities		348,182				348,182

Total available for sale		2,105,989		116,042		1,989,947

Equity securities:
Dividend income portfolio of common stocks		169,710		169,710
International fund		46,316		46,316
Total stock market index fund		129,345		129,345
Other		7					$	7

Total equity securities		345,378		345,371				7


Total	$	2,451,367	$	461,413	$	1,989,947	$	7


			Fair Value Measurements at Reporting Date Using
	December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Fixed maturities available for sale:
U.S. Treasury securities	$	122,857	$	122,857
Obligations of U.S. government corporations and agencies		17,171			$	17,171
Obligations of states and political subdivisions		1,173,447				1,173,447
Corporate securities		481,805				481,805
Mortgage-backed securities		369,821				369,821

Total available for sale		2,165,101		122,857		2,042,244

Equity securities:
Dividend income portfolio of common stocks		51,684		51,684
International fund		44,877		44,877
Total stock market index fund		171,536		171,536
Other		7					$	7

Total equity securities		268,104		268,097				7


Total	$	2,433,205	$	390,954	$	2,042,244	$	7

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the Three Months Ended March 31, 2011
	Fixed Maturities Available for Sale		Equity Securities		Total
	(in thousands)
Balance at January 1, 2011	$		$	7	$	7

Balance at March 31, 2011	$		$	7	$	7


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the Three Months Ended March 31, 2010
	Fixed Maturities Available for Sale		Equity Securities		Total
	(in thousands)
Balance at January 1, 2010	$	100	$	6	$	106

Balance at March 31, 2010	$	100	$	6	$	106

The amortized cost and estimated fair value of investments in fixed maturity and equity securities are as follows:


	March 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
	(in thousands)
Held to maturity:
Obligations of U.S. government corporations and agencies	$	370	$	6				$	376
Obligations of states and political subdivisions		73,994		3,371					77,365
Corporate securities		64,133		4,470					68,603


Total held to maturity		138,497		7,847					146,344


Available for sale:
U.S. Treasury securities		112,976		3,120	$	(54	)		116,042
Obligations of U.S. government corporations and agencies		15,279		699					15,978
Obligations of states and political subdivisions		1,133,182		36,610		(3,081	)		1,166,711
Corporate securities		427,526		32,058		(508	)		459,076
Mortgage-backed securities		326,427		21,755					348,182


Total available for sale		2,015,390		94,242		(3,643	)		2,105,989


Total fixed maturities	$	2,153,887	$	102,089	$	(3,643	)	$	2,252,333


Total equity securities	$	270,760	$	75,903	$	(1,285	)	$	345,378

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
	(in thousands)
Held to maturity:
Obligations of U.S. government corporations and agencies	$	370	$	8				$	378
Obligations of states and political subdivisions		74,811		3,722					78,533
Corporate securities		73,181		4,875					78,056


Total held to maturity		148,362		8,605					156,967


Available for sale:
U.S. Treasury securities		119,009		3,886	$	(38	)		122,857
Obligations of U.S. government corporations and agencies		16,274		897					17,171
Obligations of states and political subdivisions		1,140,695		36,730		(3,978	)		1,173,447
Corporate securities		447,962		34,173		(330	)		481,805
Mortgage-backed securities		345,157		24,664					369,821


Total available for sale		2,069,097		100,350		(4,346	)		2,165,101


Total fixed maturities	$	2,217,459	$	108,955	$	(4,346	)	$	2,322,068


Total equity securities	$	191,094	$	77,322	$	(313	)	$	268,104

The amortized cost and estimated fair value of fixed maturity securities at March 31, 2011 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.


	Amortized Cost		Estimated Fair Value
	(in thousands)
Held to maturity:
Due through December 31, 2012	$	32,232	$	32,994
Due 2013 through 2016		94,214		100,735
Due 2017 through 2021		1,882		1,958
Due after 2021		10,169		10,657

		138,497		146,344

Available for sale:
Due through December 31, 2012		142,471		145,241
Due 2013 through 2016		587,402		621,792
Due 2017 through 2021		576,922		600,304
Due after 2021		382,168		390,470

		1,688,963		1,757,807

Mortgage-backed securities		326,427		348,182

		2,015,390		2,105,989

Total fixed maturities	$	2,153,887	$	2,252,333

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Realized gross gains (losses) from investments were as follows:


	For the Three Months Ended March 31,
	2011			2010
	(in thousands)

Fixed maturity securities:
Available for sale:
Gross gains	$	70		$	334
Equity securities:
Gross gains		16,499
Gross losses		(795	)


Net realized investment gains	$	15,774		$	334

Harleysville Group held securities with unrealized losses at March 31, 2011 and December 31, 2010 as follows:


	March 31, 2011
					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:
U.S. Treasury securities	$	6,914	$	54	$	54
Obligations of states and political subdivisions		193,409		3,081		3,081
Corporate securities		39,376		508		508

Total fixed maturities		239,699		3,643		3,643

Equity securities		38,846		1,285		1,285

Total temporarily impaired securities	$	278,545	$	4,928	$	4,928

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	December 31, 2010
					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:

U.S. Treasury securities	$	3,073	$	38	$	38

Obligations of states and political subdivisions		232,551		3,978		3,978

Corporate securities		33,594		330		330


Total fixed maturities		269,218		4,346		4,346


Equity securities		17,231		313		313


Total temporarily impaired securities	$	286,449	$	4,659	$	4,659

All of the fixed maturity securities with an unrealized loss at March 31, 2011 are classified as available for sale and are carried at fair value on the balance sheet.

The unrealized losses on fixed maturity investments were primarily due to an increase in interest rates rather than a decline in credit quality. Per Harleysville Group’s current policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and Harleysville Group intends to sell, or more likely than not will be required to sell, the security before recovery of its value. Harleysville Group believes, based on its analysis, that these securities are not other than temporarily impaired. However, depending on developments involving both the issuers and worsening economic conditions, these investments may be written down in the income statement in the future.

Twelve positions comprise the unrealized loss in equity investments at March 31, 2011. These securities have not been below cost for significant continuous amounts of time. Harleysville Group is monitoring these securities and some could possibly be written down in the income statement in the future.

There were no impairment charges in the three months ended March 31, 2011 or 2010.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

5 – Earnings Per Share

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


	For the Three Months Ended March 31,
	2011		2010
	(in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net income	$	18,227	$	8,050

Denominator for basic earnings per share—weighted average shares outstanding		27,388,586		27,709,496

Effect of stock incentive plans		224,179		206,983


Denominator for diluted earnings per share		27,612,765		27,916,479


Basic earnings per share	$	.67	$	.29


Diluted earnings per share	$	.66	$	.29

The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price:


	For the Three Months Ended March 31,
	2011		2010
	(in thousands)
Number of options		105		777

6 – Reinsurance

Premiums earned are net of amounts ceded of $30,673,000 and $30,009,000 for the three months ended March 31, 2011 and 2010, respectively. Losses and loss settlement expenses are net of amounts ceded of $5,422,000 and $11,470,000 for the three months ended March 31, 2011 and 2010, respectively. Such amounts ceded do not include the reinsurance transactions with the Mutual Company under the pooling arrangement (described below) which are reflected on the face of the income statements, but do include reinsurance with unaffiliated reinsurers.

Pursuant to the terms of the reinsurance pooling agreement with the Mutual Company, each of the insurance subsidiaries of Harleysville Group Inc. and Harleysville Pennland Insurance Company (Pennland), a subsidiary of the Mutual Company, cede premiums, losses and underwriting expenses on all of their respective business to the Mutual Company which, in turn, retrocedes to such subsidiaries and Pennland a specified portion of premiums, losses and underwriting expenses of the Mutual Company and such subsidiaries and Pennland, excluding the financial results associated with workers compensation business for accident years 2011 and following which is retained 100 percent by the Mutual Company. Because this agreement does not relieve Harleysville Group Inc.’s insurance subsidiaries of primary liability as originating insurers, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the reinsurance pooling agreement provides for the right of offset. The Mutual Company has an A. M. Best rating of “A” (Excellent).

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

7 – Cash Flows

There were cash tax refunds of $324,000 in the first quarter of 2011. There were no cash tax payments in the first quarter of 2010. Cash interest payments of $2,907,000 and $2,908,000 were made in the first quarter of 2011 and 2010, respectively.

8 – Segment Information

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

Financial data by segment is as follows:


	For the Three Months Ended March 31,
	2011			2010
	(in thousands)
Revenues:
Premiums earned:
Commercial lines	$	149,020		$	164,633
Personal lines		50,733			44,450

Total premiums earned		199,753			209,083
Net investment income		25,585			25,883
Realized investment gains		15,774			334
Other		4,410			3,657

Total revenues	$	245,522		$	238,957


Income before income taxes:
Underwriting income (loss):
Commercial lines	$	(1,864	)	$	(10,651	)
Personal lines		(6,141	)		(8,365	)

SAP underwriting loss		(8,005	)		(19,016	)
GAAP adjustments		(9,787	)		1,545

GAAP underwriting loss		(17,792	)		(17,471	)
Net investment income		25,585			25,883
Realized investment gains		15,774			334
Other		1,927			1,189

Income before income taxes	$	25,494		$	9,935

The GAAP adjustment of $9,787,000 for the three months ended March 31, 2011 includes the impact of deferring the ceding commission received in January 2011 of $6,998,000 related to the change in the intercompany pooling agreement as described in Note 2 of the Notes to Consolidated Financial Statements. The impact was all in commercial lines.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

9 – Comprehensive Income

Comprehensive income for the three months ended March 31, 2011 and 2010 consisted of the following:


	For the Three Months Ended March 31,
	2011			2010
	(in thousands)

Net income	$	18,227		$	8,050
Other comprehensive income:
Unrealized gains (losses) on securities:
Unrealized investment holding gains arising during period, net of taxes of $2,791 and $4,923		5,184			9,143
Less:
Reclassification adjustment for gains included in net income, net of taxes of $(5,521) and $(117)		(10,253	)		(217	)

Net unrealized investment gains (losses)		(5,069	)		8,926

Defined benefit pension plans:
Recognized net actuarial loss, net of taxes of $353 and $261		656			485

Other comprehensive income (loss)		(4,413	)		9,411

Comprehensive income	$	13,814		$	17,461

Accumulated other comprehensive income at March 31, 2011 and December 31, 2010 consisted of the following amounts (which are net of tax):


	March 31, 2011			December 31, 2010
	(in thousands)

Unrealized investment gains	$	107,390		$	112,459
Defined benefit pension plan - net actuarial loss		(31,297	)		(31,953	)

Accumulated other comprehensive income	$	76,093		$	80,506

10 – Pension

Harleysville Group Inc. has a frozen pension plan that covers employees hired before January 1, 2006. The net periodic pension cost for the plan, including the Mutual Company, consists of the following components:


	For the Three Months Ended March 31,
	2011			2010
	(in thousands)

Components of net periodic pension cost:
Interest cost	$	2,964		$	2,966
Expected return on plan assets		(3,102	)		(3,012	)
Recognized net actuarial loss		1,641			1,057

Net periodic pension cost:
Entire plan	$	1,503		$	1,011

Harleysville Group portion	$	918		$	713

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Harleysville Group’s expected portion of the 2011 contribution to the pension plan is $7,025,000. Contributions of $1,770,000 were made in the quarter ended March 31, 2011.

11 – Borrowings

Debt is as follows:


	March 31, 2011		December 31, 2010
	(in thousands)

Notes, 5.75%, due 2013	$	100,000	$	100,000
Demand term-loan payable to the Mutual Company, LIBOR plus 0.45%, due 2012		18,500		18,500

Total debt	$	118,500	$	118,500

The fair value of the notes was $103,756,000 and $99,413,000 at March 31, 2011 and December 31, 2010, respectively, based on quoted market prices for the same or similar debt. The carrying value of the remaining debt approximates fair value.

12 – Shareholders’ Equity

Various states have adopted the National Association of Insurance Commissioners (NAIC) risk-based capital (RBC) standards that require insurance companies to calculate and report statutory capital and surplus needs based on a formula measuring underwriting, investment and other business risks inherent in an individual company’s operations. These RBC standards have not affected the operations of Harleysville Group since each of the Company’s insurance subsidiaries has statutory capital and surplus in excess of RBC requirements.

These RBC standards require the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2010 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s eight insurance subsidiaries at December 31, 2010 ranged from 461% to 783%.

13 – Income Taxes

As of March 31, 2011, Harleysville Group had no material unrecognized tax benefits or accrued interest and penalties. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense. Federal tax years 2007 through 2010 were open for examination as of March 31, 2011.

14 – New Accounting Standards

In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, “Fair Value Measurements and Disclosures.” ASU 2010-06 applies to all entities that are required to make disclosures about recurring or non-recurring fair value measurements. ASU 2010-06 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases,

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories is for interim and annual periods beginning after December 15, 2009. The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category is for interim and annual periods beginning after December 15, 2010. The adoption of this ASU did not have a material impact on Harleysville Group’s results of operations or financial position.

In October 2010, the FASB issued ASU 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force).” This ASU amends FASB Accounting Standards Codification (ASC) Topic 944, Financial Services-Insurance, to address which costs related to the acquisition of new or renewal insurance contracts qualify for deferral. The ASU allows insurance entities to defer costs related to the acquisition of new or renewal insurance contracts that are (1) incremental direct costs of the contract transaction (i.e., would not have occurred without the contract transaction), (2) a portion of the employee’s compensation and fringe benefits related to certain activities for successful contract acquisitions, or (3) direct-response advertising costs as defined in ASC Subtopic 340-20, Other Assets and Deferred Costs – Capitalized Advertising Costs. An insurance entity would expense as incurred all other costs related to the acquisition of new or renewal insurance contracts. The amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2011, and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity’s annual reporting period. The impact of adopting this ASU is currently being evaluated.

In December 2010, the FASB issued ASU 2010-28, “Intangibles-Goodwill and Other.” The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For these units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. For public entities, this ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. The adoption of this ASU did not have a material impact on Harleysville Group’s results of operations or financial position.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Item 2.

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

Certain of the statements contained herein (other than statements of historical facts) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, legislative and regulatory developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on Harleysville Group. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on Harleysville Group will be those anticipated by management. Actual financial results, including premium levels and underwriting results, could differ materially from those anticipated by Harleysville Group depending on the outcome of certain factors, which may include changes in property and casualty loss trends and reserves; the insurance product pricing environment; changes in applicable law; government regulation and changes therein that may impede the ability to charge adequate rates; performance of and instability in the financial markets; investment losses; fluctuations in interest rates; significant catastrophe events in the geographic regions where we do business; decreased demand for property and casualty insurance; availability and price of reinsurance; the A.M. Best group rating of Harleysville Group; and the status of labor markets in which the Company operates.

Overview

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

•

net premium income;

•

investment income and realized investment gains (losses);

•

amounts paid or reserved to settle insured claims; and

•

other income and expense.

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

•

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

•

limitations on available business arising from a need to maintain the quality of underwritten risks;

•

the Company’s ability to maintain its A (“Excellent”) group rating by A.M. Best; and

•

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

Variations in investment income and realized investment gains (losses) are subject to a number of factors, including:

•

general interest rate levels and financial market conditions;

•

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

•

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

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

•

the quality of the risks underwritten by the Company;

•

the nature and severity of catastrophic losses;

•

the availability, cost and terms of reinsurance; and

•

underlying settlement costs, including medical and legal costs.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Variations in other income and expense are affected by a number of factors, including:

•

the level of premiums written by the Mutual Company and its subsidiaries which are subject to the management fee;

•

the amount of flood insurance written and ceded to the National Flood Insurance Program; and

•

the interest rate on debt issued by the Company.

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

Critical Accounting Policies and Estimates

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require Harleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements for the year ended December 31, 2010 included in the Company’s 2010 Annual Report on Form 10-K filed with the SEC). Harleysville Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and estimation. The judgments, or the methodology on which the judgments are made, are reviewed quarterly with the Audit Committee.

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

Investments. Generally, unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in shareholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. However, if the fair value of an investment in equity securities declines below its cost and that decline is deemed other than temporary, the amount of the decline below cost is charged to earnings. Per Harleysville Group’s current policy, a fixed maturity security is other than temporarily impaired if the present value of the cash flows expected to be collected is less than the amortized cost of the security or where the security’s fair value is below cost and Harleysville Group intends to sell, or more likely than not will be required to sell, the security before recovery of its value. If Harleysville Group does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.

The severe downturn in the public debt and equity markets in recent years, reflecting uncertainties associated with the mortgage crisis, worsening economic conditions, widening of credit spreads, bankruptcies and government intervention in large financial institutions, has resulted in significant realized and unrealized losses in our investment portfolio in the past. Depending on market conditions going forward, we could incur additional realized and unrealized losses in future periods.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The fair value of equity securities is based on the closing market value. The fair value of mutual fund holdings is based on the closing net asset value reported by the fund. The fair value of fixed maturities is based upon data supplied by an independent pricing service. It can be difficult to determine the fair value of non-traded securities, but Harleysville Group does not own a material amount of non-traded securities.

Policy Acquisition Costs. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and agency expenses that vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies and in proportion to the premiums earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. The estimation of net realizable value takes into account the premium to be earned, related investment income over the claim paying period, expected losses and loss settlement expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss settlement expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the deferred acquisition costs are not recoverable, they would be written off and further analyses would be performed to determine if an additional liability would need to be accrued.

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 periods ended March 31, 2011 and 2010 is discussed in greater detail below.

Results of Operations

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Effective January 1, 2010, the management agreement under which the Company provides certain management services to the Mutual Company was amended to include voluntary assumed reinsurance business written by the Mutual Company.

Premiums earned decreased $9.3 million, or 4.5%, during the three months ended March 31, 2011 compared to the same period in the prior year primarily due to the change to the pooling agreement effective January 1, 2011, whereby premiums earned on workers compensation business is retained 100 percent by the Mutual Company. Excluding 2010 premiums earned on workers compensation business of $19.1 million, premiums earned increased 5.1% during the three months ended March 31, 2011 compared to the same period in the prior year.

Premiums earned for commercial lines decreased $15.6 million during the three months ended March 31, 2011 compared to the same period in the prior year primarily due to the change in the pooling agreement described in the preceding paragraph. Excluding 2010 premiums earned on workers compensation business, commercial lines premiums earned increased 2.4% during the three months ended March 31, 2011 compared to the same period in the prior year. The growth was primarily in the commercial multi-peril line of business due to greater policy counts.

Premiums earned for personal lines increased $6.3 million, or 14.1%, during the three months ended March 31, 2011 compared to the same period in the prior year, primarily due to higher average premiums and greater policy counts.

Investment income decreased $0.3 million for the three months ended March 31, 2011 compared to the same period in the prior year primarily due to lower fixed income invested assets and a lower investment yield on fixed income securities and short-term investments, partially offset by greater dividends on equity securities.

Net realized investment gains increased $15.4 million for the three months ended March 31, 2011, compared to the three months ended March 31, 2010, primarily due to realized gains on the sale of equity mutual funds in 2011, which sales were made in order to invest in dividend paying equities. There were no impairment charges in the three months ended March 31, 2011 or 2010.

Harleysville Group held securities with unrealized losses at March 31, 2011 as follows:


					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:

U.S. Treasury securities	$	6,914	$	54	$	54

Obligations of states and political subdivisions		193,409		3,081		3,081

Corporate securities		39,376		508		508


Total fixed maturities		239,699		3,643		3,643


Equity securities		38,846		1,285		1,285


Total temporarily impaired securities	$	278,545	$	4,928	$	4,928

All of the fixed maturity securities with an unrealized loss at March 31, 2011 are classified as available for sale and are carried at fair value on the balance sheet.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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 for the three months ended March 31, 2011 was 112.3%, which includes 4.5% due to the impact of the statutory treatment of the ceding commission received on the unearned premiums ceded to the Mutual Company on January 1, 2011. Excluding the impact of the pool transfer, the statutory combined ratio was 107.8% for both the three months ended March 31, 2011 and March 31, 2010. The 2011 period includes unusually severe winter weather resulting in losses not meeting the catastrophe definition, as well as 4.5 points of catastrophe losses. The 2010 period includes 10.0 points of catastrophe losses.

The statutory combined ratios by line of business for the three months ended March 31, 2011 and March 31, 2010 are shown below.


	For the Three Months Ended March 31,
	2011			2010
Commercial:
Automobile		100.3	%		98.3	%
Workers compensation					107.7	%
Commercial multi-peril		117.6	%		110.7	%
Other commercial		87.2	%		93.1	%
Total commercial		113.1	%		104.7	%
Total commercial excluding the impact of the pool transfer		106.0	%

Personal:
Automobile		110.7	%		101.1	%
Homeowners		121.4	%		148.7	%
Other personal		74.0	%		60.4	%
Total personal		112.8	%		119.3	%

Total personal and commercial		112.3	%		107.8	%

Total personal and commercial excluding the impact of the pool transfer		107.8	%

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The commercial lines statutory combined ratio was 113.1% for the three months ended March 31, 2011. Excluding the impact of the pool transfer, the commercial lines statutory combined ratio increased to 106.0% for the three months ended March 31, 2011 from 104.7% for the three months ended March 31, 2010. The increase is primarily due to unusually severe winter weather resulting in losses not meeting the catastrophe definition, as well as 3.7 points of catastrophe losses in the three months ended March 31, 2011. Catastrophe losses in commercial lines represented 6.2 points of the combined ratio in the three months ended March 31, 2010. Geographically, the most significant increases in weather related losses in 2011 occurred throughout much of the Mid-Atlantic and Northeast regions, especially in New England and New York.

The personal lines statutory combined ratio decreased to 112.8% for the three months ended March 31, 2011 from 119.3% for the three months ended March 31, 2010. The decrease is primarily due to lower catastrophe experience affecting property coverages in the three months ended March 31, 2011. Catastrophe losses in the personal lines represented 6.8 points of the combined ratio in the three months ended March 31, 2011 compared to 24.2 points in the three months ended March 31, 2010. The unusually severe winter weather described for commercial lines also impacted personal lines during the first quarter of 2011, resulting in a higher than average amount of weather related losses not meeting the catastrophe definition. Geographically, weather related losses in personal lines were most significant in the Mid-Atlantic and Northeast regions.

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


	March 31, 2011		December 31, 2010
	(in thousands)
Commercial:
Automobile	$	282,715	$	288,289
Workers compensation		351,469		370,838
Commercial multi-peril		640,636		634,145
Other commercial		139,074		143,070

Total commercial		1,413,894		1,436,342


Personal:
Automobile		78,514		78,505
Homeowners		40,413		36,427
Other personal		2,775		2,791

Total personal		121,702		117,723


Total personal and commercial		1,535,596		1,554,065

Plus reinsurance recoverables		215,646		217,596


Total liability	$	1,751,242	$	1,771,661

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The following table presents the increase (decrease) in the estimated ultimate loss and loss settlement expenses attributable to insured events of prior years for the three months ended March 31, 2011 by line of business:


				Accident Years
	Total			2010		2009			2008 and Prior Years
	(in thousands)
Commercial:
Automobile	$	(2,948	)	$	1,047	$	4		$	(3,999	)
Workers compensation		(3,660	)		703		343			(4,706	)
Commercial multi-peril		(3,748	)		167		6			(3,921	)
Other commercial		(2,113	)		314		(816	)		(1,611	)

Total commercial		(12,469	)		2,231		(463	)		(14,237	)


Personal:
Automobile		(689	)		4,407		347			(5,443	)
Homeowners		(61	)		510		380			(951	)
Other personal		116			116		46			(46	)

Total personal		(634	)		5,033		773			(6,440	)

Total net development	$	(13,103	)	$	7,264	$	310		$	(20,677	)

There was $13.1 million of net favorable development in the provision for insured events of prior years for the three months ended March 31, 2011, of which $12.5 million was in commercial lines and $0.6 million was in personal lines. The favorable development primarily related to the 2003 through 2008 accident years as a result of lower than expected claim severity experienced broadly across all lines of business, particularly commercial multi-peril, commercial and personal automobile, and workers compensation, partially offset by adverse development in accident year 2010.

There was $12.0 million of net favorable development in the provision for insured events of prior years for the three months ended March 31, 2010, of which $9.9 million was in commercial lines and $2.1 million was in personal lines. The favorable development primarily related to the 2004 through 2006 accident years as a result of lower than expected claim severity experienced broadly across all lines of business, particularly commercial multi-peril, commercial and personal automobile, and workers compensation.

Harleysville Group records the actuarial best estimate of the ultimate unpaid losses and loss settlement expenses incurred. The estimate represents the actuarially determined expected amount of future payments on all loss and loss settlement expenses incurred on or before March 31, 2011. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The following table presents the liability for unpaid losses and loss settlement expenses (LAE) by case and incurred but not reported (IBNR) reserves by line of business as of March 31, 2011:


	Case		IBNR		LAE Liability		IBNR (Incl. LAE)		Total Liability
	(in thousands)
Commercial:
Automobile	$	100,701	$	131,053	$	50,961	$	182,014	$	282,715
Workers compensation		153,990		147,117		50,362		197,479		351,469
Commercial multi-peril		177,706		293,116		169,814		462,930		640,636
Other commercial		28,552		76,982		33,540		110,522		139,074

Total commercial		460,949		648,268		304,677		952,945		1,413,894


Personal:
Automobile		39,782		24,500		14,232		38,732		78,514
Homeowners		15,424		17,286		7,703		24,989		40,413
Other personal		590		1,790		395		2,185		2,775

Total personal		55,796		43,576		22,330		65,906		121,702


Total net liability		516,745		691,844		327,007		1,018,851		1,535,596


Reinsurance recoverables		135,912		79,588		146		79,734		215,646


Total gross liability	$	652,657	$	771,432	$	327,153	$	1,098,585	$	1,751,242

Reinsurance receivables were $218.7 million and $219.1 million at March 31, 2011 and December 31, 2010, respectively. Of these amounts, $100.1 million and $102.3 million, respectively, or 46% and 47%, respectively, of the receivables were due from governmental bodies, regulatory agencies or quasi-governmental pools and reinsurance facilities where Harleysville Group believes there is limited credit risk. The remainder of the reinsurance receivables are principally due from reinsurers rated A- or higher by the A.M. Best Company. Ceded reinsurance contracts do not relieve Harleysville Group’s primary obligation to its policyholders. Consequently, an exposure exists with respect to reinsurance recoverables to the extent that any reinsurer is unable to meet its obligation or disputes the liabilities assumed under the reinsurance contract. From time to time, Harleysville Group may encounter such disputes with its reinsurers. In addition, the creditworthiness of our reinsurers could deteriorate in the future due to adverse events affecting the reinsurance industry, such as a large number of major catastrophes.

Effective January 1, 2011, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiary purchased additional property catastrophe reinsurance for one year providing coverage of 75% of up to $50.0 million in excess of $475.0 million. Harleysville Group’s pooling share of this coverage is 75% of up to $40.0 million in excess of $380.0 million. Accordingly, effective January 1, 2011, pursuant to the terms of the property catastrophe treaties, the maximum recovery would be $363.2 million for any catastrophe involving an insured loss equal to or greater than $525.0 million. Harleysville Group’s pooling share of this maximum recovery would be $290.5 million for any catastrophe involving an insured loss of $420.0 million or greater.

Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Harleysville Group’s reorganization of its claims operation in recent years has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. There are uncertainties regarding future

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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, 2011.

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

Other income increased $0.8 million for the three months ended March 31, 2011 compared to the same period in the prior year primarily due to an increase in fee income received in connection with the National Flood Insurance Program and an increase in management fees received from the Mutual Company. The management fees received from the Mutual Company are expected to increase through the remainder of 2011, as the Mutual Company has entered into additional assumed reinsurance agreements in 2011 which are subject to the management fee.

In the first quarter of 2011, Harleysville Group had income before income taxes of $25.5 million, compared to $9.9 million in the first quarter of 2010. The increase in income before income taxes of $15.6 million for the three months ended March 31, 2011, as compared to the same period in 2010, was primarily due to greater realized gains in the 2011 period compared to the 2010 period.

The income tax expense for the three month periods ended March 31, 2011 and 2010 includes a tax benefit of $3.4 million and $3.2 million, respectively, related to tax-exempt investment income.

Liquidity and Capital Resources

Operating activities used net cash of $28.1 million and provided net cash of $14.8 million for the three months ended March 31, 2011 and 2010, respectively. The 2011 amount includes $33.0 million paid in connection with the change to the intercompany pooling agreement effective January 1, 2011. The remaining decrease of $9.9 million is due to a decrease in underwriting cash flow.

Investing activities provided $37.1 million and used $3.0 million of net cash for the three months ended March 31, 2011 and 2010, respectively. The change is primarily due to net sales of investments in the 2011 period due to the decrease in cash provided by operating activities, partially offset by the decrease in cash used by financing activities.

Financing activities used $9.0 million and $11.8 million of net cash for the three months ended March 31, 2011 and 2010, respectively. The change is primarily due to the purchase of treasury stock in 2010, partially offset by a greater issuance of common stock in 2010.

The due to affiliate balance increased $23.0 million in the three months ended March 31, 2011. Approximately $13 million of the 2011 increase was due to the change in the intercompany pooling agreement effective January 1, 2011, whereby the financial results associated with the workers compensation business for accident years 2011 and following are retained 100 percent by the Mutual Company.

Harleysville Group’s investment strategy is designed to complement and support the insurance operations. Harleysville Group considers projected cash flow (premiums, investment income, reinsurance programs, liability payout patterns, general expenses, large seasonal obligations, intercompany transfers, etc.) to assure that sufficient liquidity exists within Harleysville Group and the Mutual Company. Maintaining a regular maturity schedule in readily marketable securities is an essential part of addressing liquidity. This regular maturity schedule is maintained in all interest rate environments. After-tax yield will be maximized consistent with safety and liquidity considerations by investment in taxable or tax-exempt securities, depending on Harleysville Group’s tax position.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Harleysville Group Inc. had $12.6 million of cash and marketable securities at March 31, 2011 which is available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. On July 30, 2009, the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases, or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float and did not repurchase shares from the Mutual Company. This program was completed on August 3, 2010. On August 6, 2010, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009. The Company currently intends to repurchase shares in open market transactions from the public float, and not repurchase shares from the Mutual Company. As of March 31, 2011, the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased. Harleysville Group has no other material commitments for capital expenditures as of March 31, 2011.

As a holding company, the Company’s principal source of cash for the payment of dividends is dividends from its insurance subsidiaries. The Company’s insurance subsidiaries are subject to state laws that restrict their ability to pay dividends. As of March 31, 2011, the Company’s insurance subsidiaries had not yet paid dividends of $24.2 million to the Company which had been declared in 2010.

The timing of future cash payments associated with unpaid losses and loss settlement expenses and contractual obligations pursuant to debt agreements is not expected to be materially different from that disclosed in the Company’s Annual Report on Form 10-K for fiscal year 2010.

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. Changes to Harleysville Group’s market risk since December 31, 2010 are reflected within Management’s Discussion and Analysis of Financial Condition and Results of Operations and within the financial statements contained within this Form 10-Q.

Harleysville Group has maintained approximately the same duration of its investment portfolio to its liabilities from December 31, 2010 to March 31, 2011. During the first quarter of 2011, Harleysville Group increased its holdings of equity securities by approximately $80 million.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Item 4.

Controls and Procedures

(a)

Evaluation of disclosure controls and procedures. Our management, under the supervision and with the participation of the chief executive officer and the chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures as required by Rule 13a-15(b) or Rule 15d-15(b) of the Securities Exchange Act of 1934, as amended, as of March 31, 2011, which is the end of the period covered by this quarterly report on Form 10-Q. Based on that evaluation, the chief executive officer and chief financial officer have concluded that these disclosure controls and procedures are effective to provide that (a) material information relating to us, including our consolidated subsidiaries, is made known to these officers by other employees of us and our consolidated subsidiaries, particularly material information related to the first quarter of 2011, for which this periodic report is being prepared; and (b) this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the rules and forms of the SEC.

(b)

Change in internal control over financial reporting. There was no change in the Company’s internal control over financial reporting that occurred during the first quarter of 2011 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

ITEM 1A.

Risk Factors

The business, results of operations and financial condition, and therefore the value of Harleysville Group’s securities, are subject to a number of risks. Some of those risks are set forth in the Company’s annual report on Form 10-K for fiscal year 2010, filed with the SEC on March 4, 2011. There has been no material change from the risk factors as previously disclosed in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2010.

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities ⁽¹⁾


Period	Total Number of Shares Purchased ⁽²⁾		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
January 1 - January 31, 2011		20,294	$	37.37		-0-		554,916
February 1 - February 28, 2011		9,283	$	36.21		-0-		554,916
March 1 - March 31, 2011		56,977	$	35.97		-0-		554,916

(1)

On July 30, 2009, the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases, or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed on August 3, 2010. On August 6, 2010, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its outstanding common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009. The Company currently intends to repurchase shares in open market transactions from the public float, and not repurchase shares from the Mutual Company.

(2)

In accordance with the terms of its Equity Incentive Plan, the Company acquired all of the above shares from employees in connection with stock option exercises and the vesting of restricted stock and restricted stock units. The stock was received in payment of the exercise price of the stock options and in satisfaction of withholding taxes due upon exercise or vesting.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

(Continued)

ITEM 6.

a. Exhibits



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

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

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

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

*	Filed herewith.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

SIGNATURE

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


	Harleysville Group Inc.

Date: May 6, 2011	By:	/s/ ARTHUR E. CHANDLER
		Arthur E. Chandler Senior Vice President and Chief Financial Officer (principal financial officer)

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

EXHIBIT INDEX


Exhibit No.		Description of Exhibits

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

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

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

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

*	Filed herewith.

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Smaller reporting company