HARLEYSVILLE GROUP INC - FORM 10-Q

HARLEYSVILLE GROUP INC - FORM 10-Q - August 9, 2011

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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 June 30, 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 x 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. (Check one):

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 August 2, 2011 27,165,247 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 - June 30, 2011 and December 31, 2010	3

	Consolidated Statements of Income (Loss) - For the three months ended June 30, 2011 and 2010	4

	Consolidated Statements of Income - For the six months ended June 30, 2011 and 2010	5

	Consolidated Statement of Shareholders’ Equity - For the six months ended June 30, 2011	6

	Consolidated Statements of Cash Flows - For the six months ended June 30, 2011 and 2010	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36

Item 4.	Controls and Procedures	37

Part II	Other Information	38

Item 1A.	Risk Factors	38

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38

Item 6.	Exhibits	39

Item 1.

Financial Statements

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	June 30, 2011			December 31, 2010
	(Unaudited)
Assets
Investments:
Fixed maturities:
Held to maturity, at amortized cost (fair value $136,517 and $156,967)	$	128,482		$	148,362
Available for sale, at fair value (amortized cost $1,943,621 and $2,069,097)		2,064,269			2,165,101
Equity securities, at fair value (cost $270,760 and $191,095)		352,101			268,104
Short-term investments, at cost, which approximates fair value		78,278			79,909

Total investments		2,623,130			2,661,476
Cash		78			39
Premiums receivable		140,525			133,758
Reinsurance recoverables		219,190			219,149
Accrued investment income		25,818			26,910
Deferred policy acquisition costs		107,356			113,997
Prepaid reinsurance premiums		50,150			51,625
Property and equipment, net		12,946			13,312
Deferred income taxes					9,413
Other assets		60,272			48,553

Total assets	$	3,239,465		$	3,278,232

Liabilities and Shareholders’ Equity
Liabilities:
Unpaid losses and loss settlement expenses (affiliate $185,612 and $214,518)	$	1,758,060		$	1,771,661
Unearned premiums (affiliate $(11,282) and $32,935)		468,681			503,532
Accounts payable and accrued expenses		81,234			96,461
Due to affiliate		26,648			19,445
Deferred income taxes		4,678
Debt (affiliate $18,500 and $18,500)		118,500			118,500

Total liabilities		2,457,801			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 35,179,315 and 34,987,829 shares; outstanding 27,128,314 and 27,044,836 shares		35,179			34,988
Additional paid-in capital		273,201			263,857
Accumulated other comprehensive income		100,705			80,506
Retained earnings		617,725			630,603
Treasury stock, at cost, 8,051,001 and 7,942,993 shares		(245,146	)		(241,321	)

Total shareholders’ equity		781,664			768,633

Total liabilities and shareholders’ equity	$	3,239,465		$	3,278,232

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

For the three months ended June 30, 2011 and 2010

(dollars in thousands, except per share data)


	2011			2010
Revenues:
Premiums earned from affiliate (ceded to affiliate, $203,829 and $192,429)	$	200,976		$	213,488
Investment income, net of investment expense		24,839			25,814
Realized investment gains, net
Total other-than-temporary impairment losses		—			—
Portion of loss recognized in other comprehensive income		—			—
Other realized investment gains, net		98			192

Total realized investment gains, net		98			192

Other income (affiliate $2,339 and $1,864)		4,754			4,012

Total revenues		230,667			243,506

Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $172,518 and $135,217)		183,086			143,252
Amortization of deferred policy acquisition costs		50,398			54,568
Other underwriting expenses		19,826			21,897
Interest expense (affiliate $31 and $35)		1,513			1,516
Other expenses		1,242			1,268

Total expenses		256,065			222,501

Income (loss) before income taxes		(25,398	)		21,005
Income tax expense (benefit)		(14,070	)		3,951

Net income (loss)	$	(11,328	)	$	17,054

Per common share:
Basic net income (loss)	$	(.43	)	$	.61

Diluted net income (loss)	$	(.43	)	$	.61

Cash dividend	$	.36		$	.325

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

For the six months ended June 30, 2011 and 2010

(dollars in thousands, except per share data)


	2011			2010
Revenues:
Premiums earned from affiliate (ceded to affiliate, $405,732 and $378,883)	$	400,729		$	422,571
Investment income, net of investment expense		50,424			51,697
Realized investment gains, net
Total other-than-temporary impairment losses		—			—
Portion of loss recognized in other comprehensive income		—			—
Other realized investment gains, net		15,872			526

Total realized investment gains, net		15,872			526

Other income (affiliate $4,553 and $3,575)		9,164			7,669

Total revenues		476,189			482,463

Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $324,572 and $263,521)		327,281			295,288
Amortization of deferred policy acquisition costs		103,077			107,602
Other underwriting expenses		40,497			43,381
Interest expense (affiliate $63 and $67)		3,027			3,030
Other expenses		2,211			2,222

Total expenses		476,093			451,523

Income before income taxes		96			30,940
Income tax expense (benefit)		(6,803	)		5,836

Net income	$	6,899		$	25,104

Per common share:
Basic net income	$	.24		$	.90

Diluted net income	$	.24		$	.90

Cash dividend	$	.72		$	.65

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

For the six months ended June 30, 2011

(dollars in thousands)


	Common Stock
	Shares		Amount		Additional Paid-in Capital		Accumulated Other 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										6,899						6,899
Other comprehensive income, net of tax:
Unrealized investment gains, net of reclassification adjustment								18,834								18,834
Defined benefit pension plans:
Recognized net actuarial loss								1,365								1,365

Other comprehensive income																20,199

Comprehensive income																27,098
Issuance of common stock:
Incentive plans		170,796		171		4,576										4,747
Dividend Reinvestment Plan		20,690		20		627										647
Tax benefit from stock compensation						530										530
Stock compensation						3,611										3,611
Purchase of treasury stock, 108,008 shares													(3,825	)		(3,825	)
Dividends declared										(19,777	)					(19,777	)

Balance at June 30, 2011		35,179,315	$	35,179	$	273,201	$	100,705	$	617,725		$	(245,146	)	$	781,664

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

For the six months ended June 30, 2011 and 2010

(in thousands)


	2011			2010
Cash flows from operating activities:
Net income	$	6,899		$	25,104
Adjustments to reconcile net income to net cash provided by operating activities:
Change in receivables, unearned premiums and prepaid reinsurance balances		(131	)		18,800
Change in affiliate balance		7,203			(7,161	)
Increase (decrease) in unpaid losses and loss settlement expenses		(13,601	)		9,660
Deferred income taxes		3,215			(1,345	)
Increase in deferred policy acquisition costs		(357	)		(5,321	)
Amortization and depreciation		5,141			4,864
Realized investment gains, net		(15,872	)		(526	)
Other, net		(20,374	)		(3,765	)

		(27,877	)		40,310
Cash used by the change in the intercompany pooling agreement		(33,014	)

Net cash (used) provided by operating activities		(60,891	)		40,310

Cash flows from investing activities:
Fixed maturity investments:
Purchases		(11,937	)		(238,958	)
Sales or maturities		152,901			171,544
Equity securities:
Purchases		(121,469	)		(1,347	)
Sales		57,508
Other invested assets:
Maturities					436
Net sales of short-term investments		1,631			53,138
Purchase of property and equipment, net		(26	)		(73	)

Net cash provided (used) by investing activities		78,608			(15,260	)

Cash flows from financing activities:
Issuance of common stock		922			6,756
Purchase of treasury stock					(14,441	)
Dividends paid (to affiliate, $10,459 and $9,442)		(19,130	)		(18,021	)
Excess tax benefits from share-based payment arrangements		530			569

Net cash used by financing activities		(17,678	)		(25,137	)

Increase (decrease) in cash		39			(87	)
Cash at beginning of period		39			126

Cash at end of period	$	78		$	39

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 Inc. 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 INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Harleysville Group Inc. 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.

•

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 the 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 $2,238,000 and $2,497,000 for the three months ended June 30, 2011 and 2010, respectively, with a corresponding income tax benefit of $761,000 and $850,000, respectively. Compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $3,611,000 and $3,920,000 for the six months ended June 30, 2011 and 2010, respectively, with a corresponding income tax benefit of $1,214,000 and $1,320,000, respectively.

During the six months ended June 30, 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 127,040 units were also made during the six months ended June 30, 2011 and 30,855 of these units include performance conditions. The weighted average fair value of the grants of the restricted stock units was $37.66 per unit. These awards vest over three years.

During the six months ended June 30, 2010, 511,790 stock options were granted at a Black Scholes weighted average value of $6.84 per option. The options vest 33 1/3% per year over a three year period. Restricted stock unit grants of 109,510 units were also made during the six months ended June 30, 2010 and 39,485 of these units include performance conditions. The weighted average fair value of the grant of the restricted stock units was $36.67 per unit. These awards vest over three years.

In accordance with the terms of the EIP, the Company acquired 108,008 shares of its common stock from employees in connection with stock option exercises and the vesting of restricted stock and restricted stock units during 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 June 30, 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	$	6,060		1.95
Employee stock purchase plan	$	11		0.04

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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.

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 June 30, 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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.

The following is a summary of the fair value measurements of applicable Company assets by level within the fair value hierarchy as of June 30, 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 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
	June 30, 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	$	117,892	$	117,892
Obligations of U.S. government corporations and agencies		15,941			$	15,941
Obligations of states and political subdivisions		1,168,083				1,168,083
Corporate securities		426,970				426,970
Mortgage-backed securities		335,383				335,383

Total available for sale		2,064,269		117,892		1,946,377

Equity securities:
Dividend income portfolio of common stocks		176,525		176,525
International fund		46,737		46,737
Total stock market index fund		128,832		128,832
Other		7					$	7

Total equity securities		352,101		352,094				7

Total	$	2,416,370	$	469,986	$	1,946,377	$	7

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


			Fair Value Measurements at Reporting Date Using
	December 31, 2010		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


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the Three Months Ended June 30, 2011
	Fixed Maturities Available for Sale	Equity Securities		Total
	(in thousands)
Balance at April 1, 2011	$	$	7	$	7

Balance at June 30, 2011	$	$	7	$	7


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the Six Months Ended June 30, 2011
	Fixed Maturities Available for Sale	Equity Securities		Total
	(in thousands)
Balance at January 1, 2011	$	$	7	$	7

Balance at June 30, 2011	$	$	7	$	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 June 30, 2010
	Fixed Maturities Available for Sale		Equity Securities		Total
	(in thousands)
Balance at April 1, 2010	$	100	$	6	$	106

Balance at June 30, 2010	$	100	$	6	$	106


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the Six Months Ended June 30, 2010
	Fixed Maturities Available for Sale		Equity Securities		Total
	(in thousands)
Balance at January 1, 2010	$	100	$	6	$	106

Balance at June 30, 2010	$	100	$	6	$	106

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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


	June 30, 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	$	316	$	10				$	326
Obligations of states and political subdivisions		69,040		3,337					72,377
Corporate securities		59,126		4,688					63,814

Total held to maturity		128,482		8,035					136,517

Available for sale:
U.S. Treasury securities		112,962		4,930					117,892
Obligations of U.S. government corporations and agencies		15,278		663					15,941
Obligations of states and political subdivisions		1,111,501		56,945	$	(363	)		1,168,083
Corporate securities		390,265		36,761		(56	)		426,970
Mortgage-backed securities		313,615		21,782		(14	)		335,383

Total available for sale		1,943,621		121,081		(433	)		2,064,269

Total fixed maturities	$	2,072,103	$	129,116	$	(433	)	$	2,200,786

Total equity securities	$	270,760	$	82,089	$	(748	)	$	352,101


	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	$	191,095	$	77,322	$	(313	)	$	268,104

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

The amortized cost and estimated fair value of fixed maturity securities at June 30, 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	$	22,368	$	22,920
Due 2013 through 2016		94,140		100,998
Due 2017 through 2021		1,826		1,938
Due after 2021		10,148		10,661

		128,482		136,517

Available for sale:
Due through December 31, 2012		89,273		90,947
Due 2013 through 2016		588,510		629,187
Due 2017 through 2021		571,237		609,498
Due after 2021		380,986		399,254

		1,630,006		1,728,886

Mortgage-backed securities		313,615		335,383

		1,943,621		2,064,269

Total fixed maturities	$	2,072,103	$	2,200,786

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


	For the Three Months Ended June 30,
	2011		2010
	(in thousands)
Fixed maturity securities:
Available for sale:
Gross gains	$	98	$	827
Other invested assets:
Gross losses				(635	)

Net realized investment gains	$	98	$	192

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	For the Six Months Ended June 30,
	2011			2010
	(in thousands)
Fixed maturity securities:
Available for sale:
Gross gains	$	168		$	1,161

Equity securities:
Gross gains		16,499
Gross losses		(795	)

Other invested assets:
Gross losses					(635	)

Net realized investment gains	$	15,872		$	526

Harleysville Group held securities with unrealized losses at June 30, 2011 and December 31, 2010 as follows:


	June 30, 2011
					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:
Obligations of states and political subdivisions	$	32,624	$	363	$	363
Corporate securities		14,588		56		56
Mortgage-backed securities		3,874		14		14

Total fixed maturities		51,086		433		433

Equity securities		14,184		748		748

Total temporarily impaired securities	$	65,270	$	1,181	$	1,181

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 June 30, 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.

Four positions comprise the unrealized loss in equity investments at June 30, 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 credit-related impairment charges in the three and six months ended June 30, 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 (loss) per share is as follows:


	For the Three Months Ended June 30,					For the Six Months Ended June 30,
	2011			2010		2011		2010
	(dollars in thousands, except per share data)
Numerator for basic and diluted earnings (loss) per share:
Net income (loss)	$	(11,328	)	$	17,054	$	6,899	$	25,104

Denominator for basic earnings (loss) per share—weighted average common shares outstanding		27,090,626			27,737,746		27,028,138		27,723,696
Effect of stock incentive plans					167,620		149,700		191,234

Denominator for diluted earnings (loss) per share		27,090,626			27,905,366		27,177,838		27,914,930

Basic earnings (loss) per share	$	(.43	)	$	.61	$	.24	$	.90

Diluted earnings (loss) per share	$	(.43	)	$	.61	$	.24	$	.90

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 June 30,

For the Six Months
Ended June 30,

2011

2010

2011

2010

(in thousands)

Number of options

1,156

1,046

1,108

908

An additional 803,124 options to purchase common stock were not included in the computation of diluted earnings per share for the three months ended June 30, 2011 because their inclusion would have had an antidilutive effect. Net income (loss) per basic and diluted common share for the three and six months ended June 30, 2011 excluded the allocation of $299,000 and $190,000, respectively, of undistributed losses to participating share-based awards, since such allocation would result in anti-dilution of basic and diluted earnings per share.

6 – Reinsurance

Premiums earned are net of amounts ceded of $31,615,000 and $62,288,000 for the three and six months ended June 30, 2011, respectively, and $30,465,000 and $60,474,000 for the three and six months ended June 30, 2010, respectively. Losses and loss settlement expenses are net of amounts ceded of $12,562,000 and $17,984,000 for the three and six months ended June 30, 2011, respectively, and $14,492,000 and $25,962,000 for the three and six months ended June 30, 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 a 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

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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).

7 – Cash Flows

There were cash tax payments of $2,076,000 and $1,500,000 and cash interest payments of $2,939,000 and $2,942,000 in the first six months 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 June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)
Revenues:
Premiums earned
Commercial lines	$	148,522		$	167,310		$	297,542		$	331,943
Personal lines		52,454			46,178			103,187			90,628

Total premiums earned		200,976			213,488			400,729			422,571
Net investment income		24,839			25,814			50,424			51,697
Realized investment gains		98			192			15,872			526
Other		4,754			4,012			9,164			7,669

Total revenues	$	230,667		$	243,506		$	476,189		$	482,463

Income (loss) before income taxes:
Underwriting loss:
Commercial lines	$	(32,111	)	$	(6,319	)	$	(33,975	)	$	(16,970	)
Personal lines		(21,186	)		(2,292	)		(27,327	)		(10,657	)

SAP underwriting loss		(53,297	)		(8,611	)		(61,302	)		(27,627	)
GAAP adjustments		963			2,382			(8,824	)		3,927

GAAP underwriting loss		(52,334	)		(6,229	)		(70,126	)		(23,700	)
Net investment income		24,839			25,814			50,424			51,697
Realized investment gains		98			192			15,872			526
Other		1,999			1,228			3,926			2,417

Income (loss) before income taxes	$	(25,398	)	$	21,005		$	96		$	30,940

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

The GAAP adjustment of $8,824,000 for the six months ended June 30, 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.

9 – Comprehensive Income

Comprehensive income for the three and six months ended June 30, 2011 and 2010 consisted of the following (all amounts are net of taxes):


	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)
Net income (loss)	$	(11,328	)	$	17,054		$	6,899		$	25,104
Other comprehensive income :
Unrealized gains on securities:
Unrealized investment holding gains arising during period		23,967			3,863			29,151			13,006
Less:
Reclassification adjustment for gains included in net income		(64	)		(125	)		(10,317	)		(342	)

Net unrealized investment gains		23,903			3,738			18,834			12,664

Defined benefit pension plans:
Recognized net actuarial loss		709			485			1,365			970

Other comprehensive income		24,612			4,223			20,199			13,634

Comprehensive income	$	13,284		$	21,277		$	27,098		$	38,738

Accumulated other comprehensive income at June 30, 2011 and December 31, 2010 consisted of the following amounts (which are net of tax):


	June 30, 2011			December 31, 2010
	(in thousands)
Unrealized investment gains	$	131,293		$	112,459
Defined benefit pension plan - net actuarial loss		(30,588	)		(31,953	)

Accumulated other comprehensive income	$	100,705		$	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:

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)
Components of net periodic pension cost:
Interest cost	$	2,964		$	2,965		$	5,928		$	5,931
Expected return on plan assets		(3,102	)		(3,012	)		(6,204	)		(6,024	)
Recognized net actuarial loss		1,641			1,057			3,282			2,114

Net periodic pension cost:
Entire plan	$	1,503		$	1,010		$	3,006		$	2,021

Harleysville Group portion	$	1,006		$	713		$	1,924		$	1,426

Harleysville Group’s expected portion of the 2011 contribution to the pension plan is $7,124,000. Contributions of $3,569,000 were made in the first six months of 2011.

11 – Borrowings

Debt is as follows:


	June 30, 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 $103,973,000 and $99,413,000 at June 30, 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%.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

13 – Income Taxes

The actual income tax rate differed from the statutory federal income tax rate applicable to income (loss) before income tax expense (benefit) as follows:


	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010
Statutory federal income tax rate		(35.0	)%		35.0	%		35.0	%		35.0	%
Tax-exempt income		(13.8	)		(16.1	)					(21.4	)
Other, net		(6.6	)		(0.1	)					5.3

		(55.4	)%		18.8	%		N/M	*		18.9	%

*	N/M – Not Meaningful

Included in Other, net for the three months ended June 30, 2011 is a benefit of $1,700,000 resulting from the use of the actual year to date effective tax rate as of June 30, 2011, versus the estimated annual effective tax rate used as of March 31, 2011. Due to the pre-tax net loss in the second quarter of 2011, the Company is unable to make a reliable estimate of its annual effective tax rate, and as such, the actual effective tax rate for the year to date is deemed to be the best estimate of the annual effective tax rate.

As of June 30, 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 June 30, 2011.

14 – Contingencies

The Harleysville Group insurance subsidiaries are subject to disputes, including litigation and arbitration, arising in the ordinary course of their insurance business. The Company’s estimates of the costs of settling such matters are reflected in its liability for unpaid losses and loss settlement expenses, and the Company does not believe that the ultimate outcome of such matters will have a material adverse effect on its financial condition or results of operations. However, adverse outcomes of insurance claims are possible and could negatively impact the Company’s financial condition and results of operations in the future.

Harleysville Group is also subject to other non-insurance claims proceedings, lawsuits and claims arising in the normal course of business. The Company does not believe that the ultimate liability associated with these claims will have a material adverse effect on its financial condition or results of operations. However, adverse outcomes are possible and could negatively impact the Company’s financial condition and results of operations in the future.

15 – 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, sales,

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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.

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU result in common fair value measurement and disclosure in U.S. GAAP and IFRSs. The amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include: (1) those that clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements; and (2) those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurement. For public entities, the amendments in this ASU are effective during interim and annual periods beginning after December 15, 2011, and are to be applied prospectively. Early application by public entities is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s results of operations or financial position.

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income.” Under the amendments in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The entity is also required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income where the components of net income and the components of other comprehensive income are presented. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively. Early adoption is permitted. The adoption of this ASU is not expected to have a material impact on the Company’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 requires 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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.

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 not differ from those assessments.

The application of certain of these critical accounting policies to the periods ended June 30, 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 $12.5 million, or 5.9%, during the three months ended June 30, 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% by the Mutual Company. Excluding 2010 premiums earned on workers compensation business, premiums earned increased 3.3% during the three months ended June 30, 2011 compared to the same period in the prior year.

Premiums earned for commercial lines decreased $18.8 million during the three months ended June 30, 2011 compared to the same period in the prior year, primarily due to the change in pooling agreement described in the preceding paragraph. Excluding 2010 premiums earned on workers compensation business, premiums earned for the three months ended June 30, 2011 and 2010 were essentially equal.

Premiums earned for personal lines increased $6.3 million, or 13.6%, during the three months ended June 30, 2011 compared to the same period in the prior year, primarily due to higher average premiums and greater policy counts.

Premiums earned decreased $21.8 million, or 5.2% during the six months ended June 30, 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% by the Mutual Company. Excluding 2010 premiums earned on workers compensation business, premiums earned increased 4.2% during the six months ended June 30, 2011 compared to the same period in the prior year.

Premiums earned for commercial lines decreased $34.4 million during the six months ended June 30, 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, premiums earned increased 1.2% during the six months ended June 30, 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 $12.6 million, or 13.9%, during the six months ended June 30, 2011 compared to the same period in the prior year, primarily due to higher average premiums and greater policy counts.

Investment income decreased $1.0 million and $1.3 million for the three and six months ended June 30, 2011 as compared to the same periods 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Net realized investment gains increased $15.3 million for the six months ended June 30, 2011 as compared to the same period in the prior year, primarily due to realized gains on the sale of equity mutual funds in the first quarter of 2011, which sales were made in order to invest in dividend paying equities. There were no credit-related impairment charges in 2011 or 2010.

Harleysville Group holds securities with unrealized losses at June 30, 2011 as follows:


					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:
Obligations of states and political subdivisions	$	32,624	$	363	$	363
Corporate securities		14,588		56		56
Mortgage-backed securities		3,874		14		14

Total fixed maturities		51,086		433		433

Equity securities		14,184		748		748

Total temporarily impaired securities	$	65,270	$	1,181	$	1,181

All of the fixed maturity securities with an unrealized loss at June 30, 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 the Company’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 the Company intends to sell or more likely than not will be required to sell the security before recovery of its value. The Company believes, based on its analysis, that these securities are not other than temporarily impaired. However, depending on developments involving both the issuers and overall economic conditions, these investments may be written down in the income statement in the future.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The fair value and amortized cost of general obligation and special revenue bonds held by the Company as of June 30, 2011 is as follows:


	Fair Value		Amortized Cost
	(in thousands)
General obligation bonds	$	861,240	$	816,304
Special revenue bonds		379,220		364,237

Total	$	1,240,460	$	1,180,541

For each category above, no state, municipality or political subdivision comprised more than 10% of the total.

The break-down of the special revenue bonds category, by nature of activity for activities comprising more than 10% of the category, is as follows:


	Fair Value		Amortized Cost		Moody’s Average Credit Rating
	(dollars in thousands)
Education	$	115,302	$	109,364		Aa
Water & sewer		103,938		100,971		Aaa
Transportation		49,133		46,987		Aa
Escrowed To Maturity/Pre-refunded		48,778		47,437		Aa

Total	$	317,151	$	304,759

An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium; (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium; and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio increased to 125.2% for the three months ended June 30, 2011 from 101.3% for the three months ended June 30, 2010 and increased to 118.4% for the six months ended June 30, 2011 from 104.5% for the six months ended June 30, 2010. The combined ratio for the six months ended June 30, 2011 includes 1.9% 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 116.5% for the six months ended June 30, 2011. The greater statutory combined ratios in 2011 were primarily due to greater catastrophe losses and other weather-related losses affecting property coverages in both the three and six months ended June 30, 2011. Catastrophe losses increased to $34.4 million for the three months ended June 30, 2011 from $8.0 for the three months ended June 30, 2010. Catastrophe losses for the six months ended June 30, 2011 increased to $43.4 million from $29.0 million for the six months ended June 30, 2010.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The statutory combined ratios by line of business for the three and six months ended June 30, 2011, as compared to the three and six months ended June 30, 2010, are shown below.


	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010

Commercial:
Automobile		105.1	%		98.1	%		102.7	%		98.2	%
Workers compensation					111.0	%					109.2	%
Commercial multi-peril		136.7	%		105.4	%		127.1	%		108.0	%
Other commercial		99.3	%		85.5	%		93.2	%		89.3	%
Total commercial		120.9	%		101.5	%		116.3	%		103.1	%
Total commercial excluding the impact of the pool transfer								113.4	%

Personal:
Automobile		119.0	%		109.3	%		115.0	%		105.3	%
Homeowners		170.2	%		98.3	%		145.8	%		123.0	%
Other personal		69.8	%		56.4	%		71.7	%		58.3	%
Total personal		137.7	%		100.9	%		125.4	%		109.9	%

Total personal and commercial		125.2	%		101.3	%		118.4	%		104.5	%
Total personal and commercial excluding the impact of the pool transfer								116.5	%

The commercial lines statutory combined ratio increased to 120.9% and 113.4% for the three and six months ended June 30, 2011 (excluding the impact of the pool transfer) from 101.5% and 103.1% for the three and six months ended June 30, 2010. These increases are primarily due to unusually high tornado, hail and windstorm activity and other weather-related losses affecting property coverages in the three month period ended June 30, 2011. Unusually severe winter weather resulting in losses not meeting the catastrophe definition also contributed to the increase in the six months ended June 30, 2011. For the three months ended June 30, 2011, all regions were significantly impacted by catastrophe losses with the Southeast and Midwest regions being most adversely affected.

The personal lines statutory combined ratio increased to 137.7% and 125.4% for the three and six months ended June 30, 2011 from 100.9% and 109.9% for the three and six months ended June 30, 2010. The increase in the statutory combined ratio for the three months ended June 30, 2011 is primarily due to higher catastrophe experience affecting property coverages. Catastrophe losses in the personal lines represented 27.1 points of the combined ratio in the three months ended June 30, 2011 compared to 5.9 points in the three months ended June 30, 2010. The unusually severe winter weather described for commercial lines also impacted personal lines during the six month period ended June 30, 2011, resulting in a higher than average amount of catastrophe losses, as well as weather-related losses not meeting the catastrophe definition. These losses also contributed to the increase in the statutory combined ratio for the six months ended June 30, 2011. For the three months ended June 30, 2011, all regions were significantly impacted by catastrophe losses with the Southeast and Midwest regions being most adversely affected.

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 by major line of business:


	June 30, 2011		December 31, 2010
	(in thousands)

Commercial:
Automobile	$	279,357	$	288,289
Workers compensation		335,401		370,838
Commercial multi-peril		654,240		634,145
Other commercial		140,709		143,070

Total commercial		1,409,707		1,436,342

Personal:
Automobile		81,854		78,505
Homeowners		46,732		36,427
Other personal		2,765		2,791

Total personal		131,351		117,723

Total personal and commercial		1,541,058		1,554,065
Plus reinsurance recoverables		217,002		217,596

Total liability	$	1,758,060	$	1,771,661

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 six months ended June 30, 2011 by line of business:


	Total			Accident Years
	Total			2010			2009			2008 and Prior Years
	(in thousands)
Commercial:
Automobile	$	(4,897	)	$	836		$	(63	)	$	(5,670	)
Workers compensation		(6,016	)		1,897			521			(8,434	)
Commercial multi-peril		(5,271	)		(35	)		197			(5,433	)
Other commercial		(2,924	)		975			(1,306	)		(2,593	)

Total commercial		(19,108	)		3,673			(651	)		(22,130	)

Personal:
Automobile		(723	)		4,871			313			(5,907	)
Homeowners		(284	)		446			689			(1,419	)
Other personal		(26	)		93			(78	)		(41	)

Total personal		(1,033	)		5,410			924			(7,367	)

Total net development	$	(20,141	)	$	9,083		$	273		$	(29,497	)

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

There was $20.1 million of net favorable development in the provision for insured events of prior years for the six months ended June 30, 2011 ($7.0 million in the second quarter of 2011), of which $19.1 million was in commercial lines and $1.0 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, partially offset by adverse development in accident year 2010.

There was $22.1 million of net favorable development in the provision for insured events of prior years for the six months ended June 30, 2010 ($10.1 million in the second quarter of 2010), of which $19.3 million was in commercial lines and $2.8 million was in personal lines. The favorable development primarily related to the 2004 through 2007 accident years as a result of lower than expected claim severity experienced broadly across all lines of business.

Harleysville Group records the actuarial central estimate, which is management’s 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 June 30, 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.

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 June 30, 2011:


	Case		IBNR		LAE Liability		IBNR (Incl. LAE)		Total Liability
	(in thousands)
Commercial:
Automobile	$	96,722	$	132,076	$	50,559	$	182,635	$	279,357
Workers compensation		144,740		142,469		48,192		190,661		335,401
Commercial multi-peril		175,928		307,878		170,434		478,312		654,240
Other commercial		29,131		77,669		33,909		111,578		140,709

Total commercial		446,521		660,092		303,094		963,186		1,409,707

Personal:
Automobile		40,925		26,243		14,686		40,929		81,854
Homeowners		16,165		22,518		8,049		30,567		46,732
Other personal		738		1,637		390		2,027		2,765

Total personal		57,828		50,398		23,125		73,523		131,351

Total net liability		504,349		710,490		326,219		1,036,709		1,541,058

Reinsurance recoverables		137,222		79,517		263		79,780		217,002

Total gross liability	$	641,571	$	790,007	$	326,482	$	1,116,489	$	1,758,060

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Reinsurance recoverables were $219.2 million and $219.1 million at June 30, 2011 and December 31, 2010, respectively. Of these amounts, $101.1 million and $102.3 million, respectively, or 46% and 47%, respectively, of the recoverables 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 recoverables are principally due from reinsurers rated A- or higher by 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.

Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Harleysville Group’s previous reorganization of its claims operation has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. There are uncertainties regarding future loss cost trends particularly related to medical treatments and automobile repair. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at June 30, 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.

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.

Effective for one year from July 1, 2011, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiary renewed their catastrophe reinsurance treaty under which they are increasing their retention and changing their co-participations. Annual retentions and limits on the expiring and new treaties are set forth below:


NEW TREATY FOR 2011-2012		EXPIRING TREATY FOR 2010-2011
Retention: $60 million		Retention: $50 million
Coverage for Losses		Coverage for Losses

71.45% of losses between $60 and $90 million		82% of losses between $50 and $90 million

75.7% of losses between $90 and $200 million		78% of losses between $90 and $200 million

80.34% of losses between $200 and $475 million		75.4% of losses between $200 and $425 million

		75% of losses between $425 and $475 million

TREATY EFFECTIVE JANUARY 1, 2011 TO DECEMBER 31, 2011

Coverage for Losses

75% of losses between $475 and $525 million

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

The maximum recovery under the new program effective July 1, 2011 is $363.1 million; under the prior program it was $363.2 million. Harleysville Group’s current pooling share of this maximum recovery would be $290.5 million, compared to a maximum recovery of $290.5 million under the prior program. The treaties include reinstatement provisions providing for coverage for a second catastrophe and requiring payment of additional premium in the event a first catastrophe occurs.

Other income increased $1.5 million for the six months ended June 30, 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.

Income (loss) before income taxes decreased $46.4 million and $30.8 million for the three and six months ended June 30, 2011 compared to the same prior year periods. The decreases were primarily due to greater underwriting losses in the 2011 periods, compared to the prior year periods, and decreases in investment income. The greater underwriting losses in 2011 were primarily due to greater catastrophe losses and other weather-related losses affecting property coverages in both the three and six month periods of 2011 compared to the prior year periods. The six month period ended June 30, 2011 also includes greater realized gains of $15.3 million compared to the same prior year period.

The Company’s income tax benefit of $14.1 million and $6.8 million in the three and six months ended June 30, 2011, respectively, result primarily from the pre-tax net loss in the second quarter of 2011 and the impact of tax-exempt investment income on the calculation of the Company’s tax provision in both periods. The benefit for the three month period ended June 30, 2011 also includes a benefit of $1.7 million resulting from the use of the actual year to date effective tax rate as of June 30, 2011, versus the estimated annual effective tax rate used as of March 31, 2011.

The income tax expense (benefit) for the three and six months ended June 30, 2011 includes a tax benefit of $3.5 million and $6.9 million associated with tax-exempt income compared to $3.4 million and $6.6 million in the same prior year periods.

Liquidity and Capital Resources

Operating activities used net cash of $60.9 million and provided net cash of $40.3 million for the six months ended June 30, 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 $68.2 million is due to a decrease in underwriting cash flow, primarily from an increase in paid losses.

Investing activities provided net cash of $78.6 million and used net cash of $15.3 million for the six months ended June 30, 2011 and 2010, respectively. The change is primarily due to net sales of investments in the 2011 period due to the use of cash by operating activities and financing activities.

Net cash used by financing activities was $17.7 million and $25.1 million for the six months ended June 30, 2011 and 2010, respectively. The decrease is primarily due to a decrease in the purchase of treasury stock, partially offset by a decrease in common stock issued, in the 2011 period compared to the 2010 period.

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

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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. had $29.4 million of cash and marketable securities at June 30, 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 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. As of June 30, 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 June 30, 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. Through June 30, 2011, the Company’s insurance subsidiaries 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 Disclosures

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 quarterly report on Form 10-Q.

Harleysville Group has maintained approximately the same duration of its investment portfolio to its liabilities from December 31, 2010 to June 30, 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 June 30, 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 second 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 second 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 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 Program
April 1 - April 30, 2011		17,788	$	31.77		-0-		554,916
May 1 - May 31, 2011		3,666	$	31.62		-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. As of June 30, 2011, the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased.

(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. 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

101.INS**		XBRL Instance Document.

101.SCH**		XBRL Taxonomy Extension Schema Document.

101.CAL**		XBRL Taxonomy Extension Calculation Linkbase Document.

101.LAB**		XBRL Taxonomy Extension Label Linkbase Document.

101.PRE**		XBRL Taxonomy Extension Presentation Linkbase Document.

101.DEF**		XBRL Taxonomy Extension Definition Linkbase Document.

*	Filed herewith.

**	Furnished and not 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. 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.

101.INS**		XBRL Instance Document.

101.SCH**		XBRL Taxonomy Extension Schema Document.

101.CAL**		XBRL Taxonomy Extension Calculation Linkbase Document.

101.LAB**		XBRL Taxonomy Extension Label Linkbase Document.

101.PRE**		XBRL Taxonomy Extension Presentation Linkbase Document.

101.DEF**		XBRL Taxonomy Extension Definition Linkbase Document.

*	Filed herewith.

**	Furnished and not filed herewith.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company