S&P: Harleysville Group ‘BBB-‘ Ratings Affirmed; Outlook for Company Remains Negative

Standard & Poor’s Ratings Services affirmed its ‘BBB-‘ counterparty credit rating on Pennsylvania-based Harleysville Group Inc. The outlook remains negative.

The rating reflects management’s efforts to revitalize the insurance operations’ underwriting and competitive position. After a year of significant underperformance, the organization is showing some signs of recovery. Although earnings remain weak, they are improving. There are lingering concerns about reserve adequacy and strategic execution. Difficulties are certain to persist as the group reestablishes its focus following the appointment of Michael Browne, chief executive officer. Offsetting these weaknesses is insurance operations’ good capitalization. Harleysville’s financial coverage and leverage are in line with the rating.

Harleysville’s financial coverage and leverage are expected to remain in line with the rating, with GAAP financial leverage of less than 30% and cash on hand to service debt payments for about two years. Operating earnings and capitalization at the insurance operations are expected to continue to improve, though the combined ratio for year-end 2004 is expected to be about 105%.

In addition, although a modest amount of reserve strengthening could be expected, the rating does not take into account any material adverse developments in this area.

The negative outlook reflects the need for the stability in its management team, additional organizational and structural controls, improved underwriting, and a sustainable level of earnings. The actualization of these various conditions is critical for Harleysville to maintain the current rating.

Major rating factors

— Weakened, though stabilizing, competitive position. After a year of significant underperformance compared with the industry, Harleysville’s competitive position is showing some signs of stabilization. Over the past year, it was difficult to assess the impact that managerial, organizational, and structural changes would have on the organization’s market position. In particular, there was major uncertainty about which business lines and regional focus would remain viable and which are to be discontinued. Management is beginning to resolve these issues, though challenges are certain to continue as the group reestablishes its focus.

— Weak underwriting results. The company’s underwriting performance from continuing operations is improving though still considered especially weak. In the first half of 2004, Harleysville reported a combined ratio of 106.3% in a time when the industry is reporting combined ratios in commercial and personal lines of 100% or less. Although this result is a noticeable improvement from Harleysville’s year-end 2003 combined ratio of 123.4%, Standard & Poor’s remains watchful of the potential shortfall in loss reserves, a recurring problem for the organization in 2003.

— Evolving management team. The uncertainty surrounding corporate leadership remained a significant concern prior to the appointment of Michael Browne, CEO, formally a member of the organizations board of directors. To date, under his leadership, focus appears to have been restored to the organization, as various profit centers have tightened controls, improved automation and claims handling, and strengthened underwriting criteria. Browne and the management team have yet to demonstrate an ability to generate strong and consistent operating returns.

— Potential for further adverse reserve development. Reserve adequacy could hamper the company from achieving earnings progress. Given the frequency and severity of reserve strengthening that occurred ($123 million at year-end 2003), Standard & Poor’s believes future possible reserve actions could be necessary, but it is expected to be less drastic than before. This belief is based on an analysis of Schedule P data, benefits derived from continued but tapering rate increases, improved risk selection, and progress in the reorganization of key operating units.

— Good financial coverage and leverage. Harleysville has conservative GAAP financial leverage of less than 20% and cash on hand to service debt payments for about three years. The company has an additional $48 million of dividend capacity available without prior approval for 2004. Holding company cash flow has been derived chiefly from dividend payments and fees associated with the management of Harleysville Mutual Insurance Co., which add an additional layer of cash flow.

— Strong capitalization. The collective insurance organization’s capital adequacy ratio, as measured by Standard & Poor’s model, is adequate for the rating at about 150%, with more than $50 million in excess capital available before the organization will fall below Standard & Poor’s minimum capital level for the rating. Standard & Poor’s believes the decline in capital adequacy over the past year does reduce the pool’s ability to absorb the type of unscheduled losses experienced over the past year.Ratings ListHarleysville Group Inc. Counterparty credit rating BBB-/Negative/– Senior debt rating BBB-.