Form 10-Q

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

10-Q 1 d235997d10q.htm FORM 10-Q Form 10-Q

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 September 30, 2011

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

For the transition period from to

Commission file number: 0-14697

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 (§ 232.405 of this chapter) 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.

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 November 2, 2011 27,188,176 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 - September 30, 2011 and December 31, 2010		3

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

	Consolidated Statements of Income (Loss) - For the nine months ended September 30, 2011 and 2010		5

	Consolidated Statement of Shareholders’ Equity - For the nine months ended September 30, 2011		6

	Consolidated Statements of Cash Flows - For the nine months ended September 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		25

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		37

Item 4.	Controls and Procedures		38

Part II	Other Information		39

Item 1.	Legal Proceedings		39

Item 1A.	Risk Factors		39

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		40

Item 6.	Exhibits		41

Item 1.

Financial Statements

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	September 30, 2011			December 31, 2010
	(Unaudited)
Assets
Investments:
Fixed maturities:
Held to maturity, at amortized cost (fair value $132,410 and $156,967)	$	125,128		$	148,362
Available for sale, at fair value (amortized cost $1,897,400 and $2,069,097)		2,052,474			2,165,101
Equity securities, at fair value (cost $268,338 and $191,095)		317,319			268,104
Short-term investments, at cost, which approximates fair value		113,588			79,909

Total investments		2,608,509			2,661,476
Cash		36			39
Premiums receivable		131,972			133,758
Reinsurance recoverables		272,816			219,149
Accrued investment income		23,149			26,910
Deferred policy acquisition costs		105,778			113,997
Prepaid reinsurance premiums		55,007			51,625
Property and equipment, net		12,913			13,312
Deferred income taxes		4,745			9,413
Other assets		67,507			48,553

Total assets	$	3,282,432		$	3,278,232

Liabilities and Shareholders’ Equity
Liabilities:
Unpaid losses and loss settlement expenses (affiliate $163,330 and $214,518)	$	1,841,366		$	1,771,661
Unearned premiums (affiliate $(9,692) and $32,935)		467,132			503,532
Accounts payable and accrued expenses		81,089			96,461
Due to affiliate		22,566			19,445
Debt (affiliate $18,500 and $18,500)		118,500			118,500

Total liabilities		2,530,653			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 35,231,859 and 34,987,829 shares; outstanding 27,180,797 and 27,044,836 shares		35,232			34,988
Additional paid-in capital		276,558			263,857
Accumulated other comprehensive income		102,675			80,506
Retained earnings		582,462			630,603
Treasury stock, at cost, 8,051,062 and 7,942,993 shares		(245,148	)		(241,321	)

Total shareholders’ equity		751,779			768,633

Total liabilities and shareholders’ equity	$	3,282,432		$	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 September 30, 2011 and 2010

(dollars in thousands, except per share data)


	2011			2010

Revenues:
Premiums earned from affiliate (ceded to affiliate, $205,976 and $200,174)	$	201,736		$	220,235
Investment income, net of investment expense		23,829			25,323
Realized investment losses, net
Total other-than-temporary impairment losses		(3,967	)		—
Portion of loss recognized in other comprehensive income		—			—
Other realized investment gains, net		1,308			—

Total realized investment losses, net		(2,659	)		—

Other income (affiliate $2,595 and $1,908)		5,273			4,241

Total revenues		228,179			249,799


Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $202,522 and $140,076)		190,956			144,567
Amortization of deferred policy acquisition costs		51,666			56,177
Other underwriting expenses		18,676			20,967
Interest expense (affiliate $30 and $35)		1,511			1,517
Other expenses		7,190			841


Total expenses		269,999			224,069


Income (loss) before income taxes		(41,820	)		25,730

Income tax expense (benefit)		(17,023	)		4,901

Net income (loss)	$	(24,797	)	$	20,829


Per common share:
Basic net income (loss)	$	(.92	)	$	.76


Diluted net income (loss)	$	(.92	)	$	.76


Cash dividend	$	.38		$	.36

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

For the nine months ended September 30, 2011 and 2010

(dollars in thousands, except per share data)


	2011			2010

Revenues:
Premiums earned from affiliate (ceded to affiliate, $611,708 and $579,057)	$	602,465		$	642,806
Investment income, net of investment expense		74,253			77,020
Realized investment gains, net
Total other-than-temporary impairment losses		(3,967	)		—
Portion of loss recognized in other comprehensive income		—			—
Other realized investment gains, net		17,180			526

Total realized investment gains, net		13,213			526

Other income (affiliate $7,148 and $5,483)		14,437			11,910


Total revenues		704,368			732,262


Losses and expenses:
Losses and loss settlement expenses (ceded to affiliate, $527,094 and $403,597)		518,237			439,855
Amortization of deferred policy acquisition costs		154,743			163,779
Other underwriting expenses		59,173			64,348
Interest expense (affiliate $93 and $102)		4,538			4,547
Other expenses		9,401			3,063


Total expenses		746,092			675,592


Income (loss) before income taxes		(41,724	)		56,670

Income tax expense (benefit)		(23,826	)		10,737


Net income (loss)	$	(17,898	)	$	45,933


Per common share:
Basic net income (loss)	$	(.68	)	$	1.66


Diluted net income (loss)	$	(.68	)	$	1.65


Cash dividend	$	1.10		$	1.01

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

For the nine months ended September 30, 2011

(dollars in thousands)


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

Balance at December 31, 2010		34,987,829	$	34,988	$	263,857	$	80,506	$	630,603		$	(241,321	)	$	768,633
Net loss										(17,898	)					(17,898	)
Other comprehensive income, net of tax:
Unrealized investment gains, net of reclassification adjustment								20,177								20,177
Defined benefit pension plans:
Recognized net actuarial loss								1,992								1,992


Other comprehensive income																22,169


Comprehensive income																4,271

Issuance of common stock:
Incentive plans		214,166		214		6,064										6,278
Dividend Reinvestment Plan		29,864		30		959										989

Tax benefit from stock compensation						589										589

Stock compensation						5,089										5,089

Purchase of treasury stock, 108,069 shares													(3,827	)		(3,827	)

Dividends declared										(30,243	)					(30,243	)


Balance at September 30, 2011		35,231,859	$	35,232	$	276,558	$	102,675	$	582,462		$	(245,148	)	$	751,779

See accompanying notes to consolidated financial statements.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

For the nine months ended September 30, 2011 and 2010

(in thousands)


	2011			2010

Cash flows from operating activities:
Net income (loss)	$	(17,898	)	$	45,933
Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities:
Change in receivables, recoverables, unearned premiums and prepaid reinsurance balances		(51,651	)		33,085
Change in affiliate balance		3,121			(15,324	)
Increase in unpaid losses and loss settlement expenses		69,705			4,977
Deferred income taxes		(7,268	)		(689	)
(Increase) decrease in deferred policy acquisition costs		1,221			(3,488	)
Amortization and depreciation		7,666			7,554
Realized investment gains, including other than temporary impairment losses, net		(13,213	)		(526	)
Other, net		(22,648	)		(2,386	)

		(30,965	)		69,136
Cash used by the change in the intercompany pooling agreement		(33,014	)


Net cash provided (used) by operating activities		(63,979	)		69,136


Cash flows from investing activities:
Fixed maturity investments:
Purchases		(37,067	)		(313,751	)
Sales or maturities		224,992			264,299
Equity securities:
Purchases		(131,250	)		(27,095	)
Sales		67,380
Other invested assets:
Sales or maturities					1,845
Net (purchases) sales of short-term investments		(33,679	)		54,731
Purchase of property and equipment, net		(188	)		(274	)

Net cash provided (used) by investing activities		90,188			(20,245	)


Cash flows from financing activities:
Issuance of common stock		2,453			9,057
Purchase of treasury stock					(30,787	)
Dividends paid (to affiliate, $15,979 and $14,672)		(29,254	)		(27,839	)
Excess tax benefits from share-based payment arrangements		589			588

Net cash used by financing activities		(26,212	)		(48,981	)

Decrease in cash		(3	)		(90	)
Cash at beginning of period		39			126

Cash at end of period	$	36		$	36

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 53% 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 – Merger Agreement

On September 28, 2011, the Company and the Mutual Company entered into a merger agreement with Nationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide will merge into the Company. Nationwide will acquire all of the publicly held shares of common stock of the Company for $60.00 per share in cash, and the Mutual Company will merge into Nationwide and the policyholders of the Mutual Company will become policyholders and members of Nationwide. The Mutual Company has also entered into a voting agreement with Nationwide under which it has agreed to vote its 53% voting interest in the Company in favor of the Company’s merger. The merger agreement restricts the Company from engaging in certain actions and taking certain actions without Nationwide’s approval, including among others, the payment of shareholder dividends.

The transactions are subject to customary closing conditions, including, among others, approvals from stockholders of the Company, policyholders of the Mutual Company and Nationwide, the Pennsylvania Insurance Department, the Ohio Insurance Department and various other regulatory bodies. The transactions are expected to close in early 2012. The merger agreement provides certain termination rights. In the event that the agreement is terminated under certain conditions by the Company’s Board of Directors, the Company will be required to pay Nationwide a termination fee of $29.6 million and reimburse Nationwide for its transaction expenses.

3 – 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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 established 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.

4 – Share-Based Payments

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

Harleysville Group has the following share-based compensation plans:

•

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

•

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

•

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

The compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $1,478,000 and $1,457,000 for the three months ended September 30, 2011 and 2010, respectively, with a corresponding income tax benefit of $494,000 and $489,000, respectively. Compensation expense for the various share-based compensation plans that has been charged against income before income taxes was $5,089,000 and $5,377,000 for the nine months ended September 30, 2011 and 2010, respectively, with a corresponding income tax benefit of $1,708,000 and $1,809,000, respectively.

During the nine months ended September 30, 2011, 232,325 stock options were granted at a Black Scholes weighted average value of $6.58 per option. The options vest 33 1/3% per year over a three year period, subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder. Restricted stock unit grants of 133,010 units were also made during the nine months ended September 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 $37.43 per unit. These awards vest over a period of three years, subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

During the nine months ended September 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, subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder. Restricted stock unit grants of 112,040 units were also made during the nine months ended September 30, 2010 and 39,485 of these units include performance conditions. The weighted average fair value of the grants of the restricted stock units was $36.54 per unit. These awards vest over a period of three years, subject to earlier or accelerated vesting in designated situations, including a change-in-control or qualifying retirement of the award holder.

In accordance with the terms of the EIP, the Company acquired 108,069 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 September 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	$	4,793		1.89
Employee stock purchase plan	$	82		0.29

5 – 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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 September 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.

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 September 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


			Fair Value Measurements at Reporting Date Using
	September 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	$	119,609	$	119,609
Obligations of U.S. government corporations and agencies		9,149			$	9,149
Obligations of states and political subdivisions		1,163,504				1,163,504
Corporate securities		430,213				430,213
Mortgage-backed securities		329,999				329,999

Total available for sale		2,052,474		119,609		1,932,865

Equity securities:
Dividend income portfolio of common stocks		171,842		171,842
International fund		36,827		36,827
Total stock market index fund		108,643		108,643
Other		7					$	7

Total equity securities		317,319		317,312				7


Total	$	2,369,793	$	436,921	$	1,932,865	$	7


			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

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 September 30, 2011
	Equity Securities		Total
	(in thousands)
Balance at July 1, 2011	$	7	$	7

Balance at September 30, 2011	$	7	$	7


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the nine months ended September 30, 2011
	Equity Securities		Total
	(in thousands)
Balance at January 1, 2011	$	7	$	7

Balance at September 30, 2011	$	7	$	7


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) For the three months ended September 30, 2010
	Fixed Maturities Available for Sale		Equity Securities		Total
	(in thousands)
Balance at July 1, 2010	$	100	$	6	$	106

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


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

Balance at September 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:


	September 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	$	315	$	19				$	334
Obligations of states and political subdivisions		66,822		2,974					69,796
Corporate securities		57,991		4,383	$	(94	)		62,280


Total held to maturity		125,128		7,376		(94	)		132,410


Available for sale:
U.S. Treasury securities		112,949		6,660					119,609
Obligations of U.S. government corporations and agencies		8,525		624					9,149
Obligations of states and political subdivisions		1,078,181		85,323					1,163,504
Corporate securities		388,225		42,000		(12	)		430,213
Mortgage-backed securities		309,520		20,479					329,999


Total available for sale		1,897,400		155,086		(12	)		2,052,474


Total fixed maturities	$	2,022,528	$	162,462	$	(106	)	$	2,184,884


Total equity securities	$	268,338	$	48,981	$			$	317,319


	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 September 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	$	20,805	$	21,133
Due 2013 through 2016		92,476		98,790
Due 2017 through 2021		1,823		1,939
Due after 2021		10,024		10,548

		125,128		132,410

Available for sale:
Due through December 31, 2012		62,438		63,499
Due 2013 through 2016		575,390		618,827
Due 2017 through 2021		569,634		623,884
Due after 2021		380,418		416,265

		1,587,880		1,722,475

Mortgage-backed securities		309,520		329,999

		1,897,400		2,052,474

Total fixed maturities	$	2,022,528	$	2,184,884

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


	For the three months ended September 30,
	2011			2010
	(in thousands)

Fixed maturity securities:
Available for sale:
Gross gains	$	53		$
Other than temporary impairment losses		(381	)

Equity securities:
Gross gains		1,255
Other than temporary impairment losses		(3,586	)


Net realized investment losses	$	(2,659	)	$	—

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)


	For the nine months ended September 30,
	2011			2010
	(in thousands)

Fixed maturity securities:
Available for sale:
Gross gains	$	221		$	1,161
Other than temporary impairment losses		(381	)

Equity securities:
Gross gains		17,754
Gross losses		(795	)
Other than temporary impairment losses		(3,586	)

Other invested assets:
Gross losses					(635	)


Net realized investment gains	$	13,213		$	526

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


	September 30, 2011
					Length of Unrealized Loss
	Fair Value		Unrealized Losses		Less Than 12 Months
	(in thousands)
Fixed maturities:
Corporate securities	$	3,371	$	106	$	106


Total temporarily impaired securities	$	3,371	$	106	$	106

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

Of the total fixed maturity securities with an unrealized loss at September 30, 2011, securities with a fair value of $1,470,000 and an unrealized loss of $12,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $1,901,000 and an unrealized loss of $94,000 are classified as held to maturity on the balance sheet and are carried at amortized cost.

The unrealized losses on fixed maturity investments were primarily due to a widening of credit spreads on securities in the financial sector. 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.

There were impairment charges in the three and nine months ended September 30, 2011 of $3,586,000 on equity securities and $381,000 on fixed maturity securities that the Company intends to sell. There were no impairment charges in the three and nine months ended September 30, 2010. At September 30, 2011, a bond with an amortized cost of $999,000 was transferred from the held to maturity category to the available for sale category due to a significant deterioration in the credit worthiness of the issuer. An impairment charge of $21,000 recognized on this security is included in the fixed maturity impairment total of $381,000 for the three and nine months ended September 30, 2011. In October 2011, the Company sold virtually all of its equity securities and realized a gain of $62.3 million in order to reduce potential volatility in statutory surplus.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

6 – Earnings Per Share

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


	For the three months ended September 30,					For the nine months ended September 30,
	2011			2010		2011			2010
	(dollars in thousands, except per share data)

Numerator for basic and diluted earnings per share:
Net income (loss)	$	(24,797	)	$	20,829	$	(17,898	)	$	45,933

Denominator for basic earnings per share — weighted average shares outstanding		27,160,607			27,397,201		27,072,779			27,613,629
Effect of stock incentive plans					157,029					188,873


Denominator for diluted earnings per share		27,160,607			27,554,230		27,072,779			27,802,502


Basic earnings (loss) per share	$	(.92	)	$	.76	$	(.68	)	$	1.66


Diluted earnings (loss) per share	$	(.92	)	$	.76	$	(.68	)	$	1.65

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 September 30,

For the nine months
ended September 30,

2011

2010

2011

2010

(in thousands)

Number of options

—

1,001

186

904

An additional 1,945,548 and 1,776,451 options to purchase common stock were not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2011, respectively, because their inclusion would have had an antidilutive effect. Net loss per basic and diluted common share for the three and nine months ended September 30, 2011 excluded the allocation of $482,000 and $692,000, respectively, of undistributed losses to participating share-based awards, since such allocation would result in anti-dilution of basic and diluted earnings per share.

7 – Reinsurance

Premiums earned are net of amounts ceded of $33,220,000 and $95,508,000 for the three and nine months ended September 30, 2011, respectively, and $31,578,000 and $92,052,000 for the three and nine months ended September 30, 2010, respectively. Losses and loss settlement expenses are net of amounts ceded of $65,227,000 and $83,211,000 for the three and nine months ended September 30, 2011, respectively, and $8,431,000 and $34,393,000 for the three and nine months ended September 30, 2010, respectively. Losses and loss settlement expenses ceded for the three and nine months ended September 30, 2011 include $64,365,000 and $71,345,000 of losses ceded to the federal government’s National Flood Insurance Program (NFIP), primarily related to flood losses from Hurricane Irene and Tropical Storm Lee. Reinsurance recoverables include $64,215,000 and $2,361,000 at September 30, 2011 and December 31, 2010, respectively, for flood losses recoverable from the NFIP. Since such flood losses are entirely ceded to the NFIP they did not impact results of operations. 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Pursuant to the terms of a reinsurance pooling agreement with the Mutual Company, each of the insurance subsidiaries of the Company and Harleysville Pennland Insurance Company (Pennland), a subsidiary of the Mutual Company, cede premiums, losses and underwriting expenses on all of their respective business to the Mutual Company which, in turn, retrocedes to such subsidiaries and Pennland a specified portion of premiums, losses and underwriting expenses of the Mutual Company and such subsidiaries and Pennland. Because this agreement does not relieve the Company’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).

8 – Cash Flows

Net cash tax payments of $2,076,000 and $5,100,000 were made in the first nine months of 2011 and 2010, respectively. Cash interest payments of $5,844,000 and $5,852,000 were made in the first nine months of 2011 and 2010, respectively.

9 – 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 September 30,						For the nine months ended September 30,
	2011			2010			2011			2010
	(in thousands)

Revenues:

Premiums earned
Commercial lines	$	147,909		$	171,725		$	445,451		$	503,668
Personal lines		53,827			48,510			157,014			139,138

Total premiums earned		201,736			220,235			602,465			642,806
Net investment income		23,829			25,323			74,253			77,020
Realized investment gains (losses)		(2,659	)		—			13,213			526
Other		5,273			4,241			14,437			11,910


Total revenues	$	228,179		$	249,799		$	704,368		$	732,262


Income (loss) before income taxes:

Underwriting gain (loss):
Commercial lines	$	(32,834	)	$	2,357		$	(66,809	)	$	(14,613	)
Personal lines		(24,400	)		(589	)		(51,727	)		(11,246	)

SAP underwriting gain (loss)		(57,234	)		1,768			(118,536	)		(25,859	)
GAAP adjustments		(2,328	)		(3,244	)		(11,152	)		683

GAAP underwriting loss		(59,562	)		(1,476	)		(129,688	)		(25,176	)
Net investment income		23,829			25,323			74,253			77,020
Realized investment gains (losses)		(2,659	)		—			13,213			526
Other		(3,428	)		1,883			498			4,300


Income (loss) before income taxes	$	(41,820	)	$	25,730		$	(41,724	)	$	56,670

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

The GAAP adjustment of $11,152,000 for the nine months ended September 30, 2011 includes the impact on deferred acquisition costs related to the ceding commission received in January 2011 of $6,998,000 related to the change in the intercompany pooling agreement as described in Note 3 of the Notes to Consolidated Financial Statements. The impact was all in commercial lines.

10 – Comprehensive Income (Loss)

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


	For the three months ended September 30,					For the nine months ended September 30,
	2011			2010		2011			2010
	(in thousands)

Net income (loss)	$	(24,797	)	$	20,829	$	(17,898	)	$	45,933

Other comprehensive income:
Unrealized gains on securities:
Unrealized investment holding gains (losses) arising during period		(385	)		38,238		28,766			51,244
Less:
Reclassification adjustment for (gains) losses included in net income		1,728			—		(8,589	)		(342	)

Net unrealized investment gains		1,343			38,238		20,177			50,902

Defined benefit pension plans:
Recognized net actuarial loss		627			606		1,992			1,576


Other comprehensive income		1,970			38,844		22,169			52,478


Comprehensive income (loss)	$	(22,827	)	$	59,673	$	4,271		$	98,411

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


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

Unrealized investment gains	$	132,636		$	112,459
Defined benefit pension plan - net actuarial loss		(29,961	)		(31,953	)

Accumulated other comprehensive income	$	102,675		$	80,506

11 – 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 those incurred by the Mutual Company, consists of the following components:


	For the three months ended September 30,						For the nine months ended September 30,
	2011			2010			2011			2010
	(in thousands)

Components of net periodic pension cost:
Interest cost	$	2,977		$	2,989		$	8,905		$	8,920
Expected return on plan assets		(3,148	)		(3,036	)		(9,352	)		(9,060	)
Recognized net actuarial loss		1,455			1,321			4,737			3,435


Net periodic pension cost:
Entire plan	$	1,284		$	1,274		$	4,290		$	3,295

Harleysville Group portion	$	852		$	899		$	2,776		$	2,325

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

Harleysville Group’s portion of the 2011 contributions to the pension plan is $7,124,000. Contributions of $5,370,000 were made in the nine months ended September 30, 2011.

12 – Borrowings

Debt is as follows:


	September 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 $103,920,000 and $99,413,000 at September 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.

13 – 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)

14 – 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 September 30,						For the nine months ended September 30,
	2011			2010			2011			2010

Statutory federal income tax rate		(35.0	)%		35.0	%		(35.0	)%		35.0	%
Tax-exempt income		(8.2	)		(12.7	)		(24.7	)		(17.5	)
Other, net		2.5			(3.3	)		2.6			1.4

		(40.7	)%		19.0	%		(57.1	)%		18.9	%

Due to the pre-tax net loss in 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 September 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 September 30, 2011.

15 – 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.

Harleysville Group is also subject to two class action lawsuits in connection with the merger agreement with Nationwide described in Note 2. The Company does not believe that the ultimate liability associated with these lawsuits 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.

16 – 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.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories is for interim and annual periods beginning after December 15, 2009. The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category is for interim and annual periods beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’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 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

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

(Unaudited)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Continued)

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.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment.” The amendments in this ASU permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in ASC Topic 350, Intangibles-Goodwill and Other. Previous guidance under this topic required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount. If the fair value of the reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. This ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. 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); and

•

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

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

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

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 September 30, 2011 and 2010 is discussed in greater detail below.

Results of Operations

On September 28, 2011, the Company and the Mutual Company entered into a merger agreement with Nationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide will merge into the Company. Nationwide will acquire all of the publicly held shares of common stock of the Company for $60.00 per share in cash, and the Mutual Company will merge into Nationwide and the policyholders of the Mutual Company will become policyholders and members of Nationwide. The Mutual Company has also entered into a voting agreement with Nationwide under which it has agreed to vote its 53% voting interest in the Company in favor of the merger. The merger agreement restricts the Company from engaging in certain actions and taking certain actions without Nationwide’s approval, including among others, the payment of shareholder dividends.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

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 which were members of the pool since its inception, 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, 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 $18.5 million, or 8.4%, during the three months ended September 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 0.7% during the three months ended September 30, 2011 compared to the same period in the prior year.

Premiums earned for commercial lines decreased $23.8 million during the three months ended September 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 for the three months ended September 30, 2011 decreased 2.6% compared to the same period in the prior year.

Premiums earned for personal lines increased $5.3 million, or 11.0%, during the three months ended September 30, 2011 compared to the same period in the prior year, primarily due to higher average premiums and greater policy counts.

Premiums earned decreased $40.3 million, or 6.3%, during the nine months ended September 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 3.0% during the nine months ended September 30, 2011 compared to the same period in the prior year.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Premiums earned for commercial lines decreased $58.2 million during the nine months ended September 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 were essentially flat during the nine months ended September 30, 2011 compared to the same period in the prior year.

Premiums earned for personal lines increased $17.9 million, or 12.8%, during the nine months ended September 30, 2011 compared to the same period in the prior year, primarily due to higher average premiums and greater policy counts.

Investment income decreased $1.5 million and $2.8 million for the three and nine months ended September 30, 2011, respectively, compared to the same prior year periods. The decreases were primarily due to a lower investment yield on fixed income securities and short-term investments and lower average invested assets, partially offset by greater dividends on equity securities.

Net realized investment losses were $2.7 million in the three months ended September 30, 2011 as compared to zero in the same period in the prior year primarily due to impairment charges. There were impairment charges of $3,586,000 on equity securities and $381,000 on fixed maturity securities that the Company intends to sell in the 2011 period. There were no impairment charges in the 2010 period. In October 2011, the Company sold virtually all of its equity securities and realized a gain of $62.3 million in order to reduce potential volatility in statutory surplus.

Net realized investment gains increased $12.7 million in the nine months ended September 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, partially offset by the impairment charges recorded in the third quarter of 2011. The sales of the equity mutual funds were made in order to invest in dividend paying equities.

Harleysville Group held securities with unrealized losses at September 30, 2011 as follows:


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

Corporate securities	$	3,371	$	106	$	106


Total temporarily impaired securities	$	3,371	$	106	$	106

The unrealized losses on fixed maturity investments were primarily due to a widening of credit spreads on securities in the financial sector. 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 September 30, 2011 is as follows:


	Fair Value		Amortized Cost
	(in thousands)

General obligation bonds	$	861,696	$	796,832
Special revenue bonds		371,604		348,171


Total	$	1,233,300	$	1,145,003

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	$	117,968	$	109,139	Aa
Water & sewer		102,160		96,563	Aaa
Transportation		49,098		45,448	Aa
Escrowed To Maturity/Pre-refunded		40,634		38,929	Aa


Total	$	309,860	$	290,079

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 statutory 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 129.5% for the three months ended September 30, 2011 from 99.9% for the three months ended September 30, 2010 and increased to 122.1% for the nine months ended September 30, 2011 from 102.9% for the nine months ended September 30, 2010. The combined ratio for the nine months ended September 30, 2011 includes 1.3% 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 120.8% for the nine months ended September 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 nine months ended September 30, 2011. Catastrophe losses increased to $39.2 million for the three months ended September 30, 2011 from $3.7 million for the three months ended September 30, 2010. Catastrophe losses for the nine months ended September 30, 2011 increased to $82.6 million from $32.7 million for the nine months ended September 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 nine months ended September 30, 2011, as compared to the three and nine months ended September 30, 2010, are shown below.


	For the three months ended September 30,						For the nine months ended September 30,
	2011			2010			2011			2010

Commercial:
Automobile		110.9	%		104.0	%		105.5	%		100.2	%
Workers compensation					105.1	%					107.8	%
Commercial multi-peril		141.0	%		102.4	%		131.7	%		106.1	%
Other commercial		100.7	%		84.8	%		95.6	%		87.8	%
Total commercial		125.0	%		100.9	%		119.2	%		102.3	%
Total commercial excluding the impact of the pool transfer								117.2	%

Personal:
Automobile		121.2	%		104.1	%		117.1	%		104.9	%
Homeowners		178.4	%		94.9	%		156.8	%		113.2	%
Other personal		77.2	%		60.0	%		73.6	%		58.8	%
Total personal		142.8	%		97.2	%		131.3	%		105.4	%

Total personal and commercial		129.5	%		99.9	%		122.1	%		102.9	%
Total personal and commercial excluding the impact of the pool transfer								120.8	%

The commercial lines statutory combined ratio increased to 125.0% and 117.2% for the three and nine months ended September 30, 2011 (excluding the impact of the pool transfer) from 100.9% and 102.3% for the three and nine months ended September 30, 2010. These increases are primarily due to unusually high catastrophe and non-catastrophe weather losses experienced in each of the three quarters of 2011. In the three months ended March 31, 2011, unusually severe winter weather resulting in catastrophe and non-catastrophe losses contributed to elevated loss activity during this period, particularly in the Northeast and Mid-Atlantic regions. For the three months ended June 30, 2011, all regions were significantly impacted by catastrophes with the Southeast and Midwest regions being most adversely affected due to tornado and hail losses. For the three months ended September 30, 2011, Hurricane Irene, Tropical Storm Lee, and other hail and windstorm events contributed to significant losses, particularly in the Northeast and Mid-Atlantic regions. Catastrophe losses in the commercial lines represented 15.7 points of the combined ratio in the three months ended September 30, 2011 compared to 0.4 points in the three months ended September 30, 2010. Catastrophe losses in the commercial lines represented 11.0 points of the combined ratio in the nine months ended September 30, 2011 compared to 3.2 points in the nine months ended September 30, 2010.

The personal lines statutory combined ratio increased to 142.8% and 131.3% for the three and nine months ended September 30, 2011 from 97.2% and 105.4% for the three and nine months ended September 30, 2010. The increase in the statutory combined ratio for the three and nine months ended September 30, 2011 is primarily due to higher catastrophe and non-catastrophe weather losses affecting property coverages during the respective periods. The unusually severe winter weather described for commercial lines also impacted personal lines during the three and nine months ended September 30, 2011. Catastrophe losses in the personal lines represented 29.8 points of the combined

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

ratio in the three months ended September 30, 2011 compared to 6.2 points in the three months ended September 30, 2010. Catastrophe losses in the personal lines represented 21.5 points of the combined ratio in the nine months ended September 30, 2011 compared to 11.9 points in the nine months ended September 30, 2010.

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


	September 30, 2011		December 31, 2010
	(in thousands)
Commercial:
Automobile	$	283,353	$	288,289
Workers compensation		320,966		370,838
Commercial multi-peril		680,734		634,145
Other commercial		143,256		143,070

Total commercial		1,428,309		1,436,342


Personal:
Automobile		84,176		78,505
Homeowners		55,308		36,427
Other personal		2,761		2,791

Total personal		142,245		117,723


Total personal and commercial		1,570,554		1,554,065

Plus reinsurance recoverable		270,812		217,596


Total liability	$	1,841,366	$	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 nine months ended September 30, 2011 by line of business:


				Accident Years
	Total			2010		2009			2008 and Prior Years
	(in thousands)
Commercial:
Automobile	$	(5,049	)	$	1,083	$	(110	)	$	(6,022	)
Workers compensation		(8,998	)		1,904		482			(11,384	)
Commercial multi-peril		(8,039	)		2,312		636			(10,987	)
Other commercial		(3,849	)		821		(1,557	)		(3,113	)

Total commercial		(25,935	)		6,120		(549	)		(31,506	)


Personal:
Automobile		(543	)		6,038		189			(6,770	)
Homeowners		(441	)		530		937			(1,908	)
Other personal		(50	)		157		(298	)		91

Total personal		(1,034	)		6,725		828			(8,587	)


Total net development	$	(26,969	)	$	12,845	$	279		$	(40,093	)

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

There was $27.0 million of net favorable development in the provision for insured events in prior years for the nine months ended September 30, 2011, ($6.8 million in the third quarter of 2011), of which $25.9 million was in commercial lines and $1.0 million was in personal lines. The favorable development primarily related to the 2001 through 2008 accident years as a result of lower than expected claim severity experienced broadly across all lines of business, particularly workers compensation, commercial multi-peril, commercial automobile and other commercial lines, partially offset by adverse development in accident year 2010.

There was $35.1 million of net favorable development in the provision for insured events in prior years for the nine months ended September 30, 2010, ($13.0 million in the third quarter of 2010), of which $30.9 million was in commercial lines and $4.2 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 most 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 September 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 September 30, 2011:


	Case		IBNR		LAE Liability		IBNR (Incl. LAE)		Total Liability
	(in thousands)
Commercial:
Automobile	$	99,047	$	133,467	$	50,839	$	184,306	$	283,353
Workers compensation		138,529		135,215		47,222		182,437		320,966
Commercial multi-peril		185,966		317,851		176,917		494,768		680,734
Other commercial		29,990		78,644		34,622		113,266		143,256

Total commercial		453,532		665,177		309,600		974,777		1,428,309


Personal:
Automobile		41,297		27,934		14,945		42,879		84,176
Homeowners		19,517		27,362		8,429		35,791		55,308
Other personal		777		1,561		423		1,984		2,761

Total personal		61,591		56,857		23,797		80,654		142,245


Total net liability		515,123		722,034		333,397		1,055,431		1,570,554


Reinsurance recoverable		136,874		133,422		516		133,938		270,812


Total gross liability	$	651,997	$	855,456	$	333,913	$	1,189,369	$	1,841,366

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Reinsurance recoverables were $272.8 million and $219.1 million at September 30, 2011 and December 31, 2010, respectively. Of these amounts, $159.7 million and $102.3 million, or 59% 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. 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 changes in its claims operation in recent years have 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 September 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 an additional premium in the event a first catastrophe occurs.

Other expenses increased $6.3 million for the three and nine months ended September 30, 2011 compared to the same prior year periods due to merger-related expenses of $6.3 million incurred in the 2011 periods.

Income (loss) before income taxes decreased $67.6 million and $98.4 million for the three and nine months ended September 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, decreases in investment income and merger-related expenses in 2011. 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 nine month periods of 2011 compared to the prior year periods. The nine month period ended September 30, 2011 also includes greater realized gains of $12.7 million compared to the same prior year period.

The Company’s income tax benefits of $17.0 million and $23.8 million in the three and nine months ended September 30, 2011, respectively, result primarily from the pre-tax net losses in the three and nine months ended September 30, 2011 and the impact of tax-exempt investment income on the calculation of the Company’s tax provision in both periods. The income tax benefit for the three and nine months ended September 30, 2011 includes a tax benefit of $3.4 million and $10.3 million associated with tax-exempt income compared to $3.3 million and $9.9 million in the same prior year periods.

Liquidity and Capital Resources

Operating activities used net cash of $64.0 million and provided net cash of $69.1 million for the nine months ended September 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 $100.1 million is due to a decrease in underwriting cash flow, primarily from an increase in paid losses from greater catastrophe losses and a decrease in premiums due to the change in the pooling agreement.

Investing activities provided net cash of $90.2 million and used net cash of $20.2 million for the nine months ended September 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.

Financing activities used $26.2 million and $49.0 million of net cash for the nine months ended September 30, 2011 and 2010, respectively. The decrease is primarily due to the 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 readily marketable securities is an essential part of addressing liquidity. This regular maturity schedule is maintained in all interest rate environments. After-tax yield will be maximized consistent with safety and liquidity considerations by investment in taxable or tax-exempt securities, depending on Harleysville Group’s tax position.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

(Continued)

Harleysville Group Inc. had $36.1 million of cash and marketable securities at September 30, 2011 which is available for general corporate purpose including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. On July 30, 2009, the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed on August 3, 2010. On August 6, 2010, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009. As of September 30, 2011, the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased. Provisions in the merger agreement with Nationwide restrict the Company from repurchasing further shares. Harleysville Group has no other material commitments for capital expenditures as of September 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. The Company’s insurance subsidiaries paid dividends of $43.4 million to the Company in 2011, $24.2 million of these dividends 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 September 30, 2011. During the first quarter of 2011, the Company increased its holdings of equity securities by approximately $80 million. During the third quarter of 2011, the Company recognized an impairment loss of $4.0 million on securities it intends to sell. The Company sold virtually all of its equity securities in October 2011.

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 September 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 third 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 third 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 1.

Legal Proceedings

On October 4, 2011, the Company received a class action complaint, captioned Louisiana Municipal Police Employees Retirement System on behalf of itself and all others similarly situated v. Harleysville Group Inc., et al., Case No. 6907VCP. This purported class action complaint was filed in the State of Delaware Chancery Court. The complaint contains two counts: (1) a count that alleges breach of fiduciary duties by the individually-named directors of the Company; and (2) a count that alleges that Nationwide Mutual Insurance Company aided and abetted such breach of fiduciary duties. Both counts relate to the announced merger transaction between Nationals Sub, Inc., a wholly owned subsidiary of Nationwide Mutual Insurance Company, and the Company. The complaint seeks relief in the form of an injunction, damages and attorney’s fees. The Company is still in the process of reviewing the complaint, but believes that the plaintiff’s allegations are without merit, and intends to vigorously defend against these claims.

On October 6, 2011, the Company received a class action complaint, captioned Eric H. Berger, on behalf of himself and all other similarly situated v. Harleysville Group Inc. et al., Case No. 6918-VCP. This purported class action complaint was filed in the State of Delaware Chancery Court. The complaint contains two counts: (1) a count that alleges breach of fiduciary duties by the individually-named directors of the Company; and (2) a count that alleges that Nationwide Mutual Insurance Company aided and abetted such breach of fiduciary duties. Both counts relate to the announced merger transaction between Nationals Sub, Inc., a wholly owned subsidiary of Nationwide Mutual Insurance Company, and the Company. The complaint seeks relief in the form of an injunction, damages and attorney’s fees. The Company is still in the process of reviewing the complaint, but believes that the plaintiff’s allegations are without merit, and intends to vigorously defend against these claims.

Item 1A.

Risk Factors

The announcement of the merger agreement among Harleysville Group Inc., Harleysville Mutual Insurance Company and Nationwide Mutual Insurance Company could have an adverse effect on our stock price, financial condition, results of operations or business prospects.

The announcement of the merger agreement with Nationwide could disrupt our business in the following ways, among others:

•

employees may experience uncertainty regarding their future roles with the merged company, which might adversely affect the Company’s ability to retain, recruit and motivate key personnel;

•

the attention of the Company’s management may be directed toward the completion of the merger and transaction-related considerations and may be diverted from the day-to-day business operations of the Company, and the matters related to the merger may require commitments of time and resources that could otherwise have been devoted to other opportunities that might have been beneficial to the Company; and

•

third parties with business relationships with the Company may seek to terminate or renegotiate their relationships with the Company as a result of the merger.

The merger agreement also restricts the Company from engaging in certain actions and taking certain actions without Nationwide’s approval, which could prevent us from pursing opportunities that may arise prior to the closing of the merger or termination of the agreement.

Any of these matters could adversely affect our financial condition, results of operations or business prospects.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

(Continued)

Failure to complete the merger could negatively affect our stock price and our future business and financial results.

If the merger is not completed, our ongoing business may be adversely affected and we will be subject to the following risks, among others:

•

we may have to pay significant costs relating to the merger without receiving the benefits of the merger; and

•

any resulting negative customer perception could adversely affect our ability to compete for, or to win, new and renewal business in the marketplace.

We will incur substantial transaction and merger-related costs in connection with the merger.

We expect to incur a number of substantial non-recurring transaction fees and other costs associated with the merger. During the third quarter of 2011, we incurred expenses of approximately $6.3 million related to the merger. Additional unanticipated costs may be incurred in the integration of the merged businesses. In the event the merger agreement is terminated, under certain circumstances we may be required to pay Nationwide a termination fee of $29.6 million and reimburse them for their expenses.

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

July 1 - July 31, 2011		61	$	32.04		-0-		554,916
August 1 - August 31, 2011		-0-				-0-		554,916
September 1 - September 30, 2011		-0-				-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. As of September 30, 2011, the Company had repurchased 245,084 shares under this authorization, leaving 554,916 shares authorized to be repurchased. Provisions in the merger agreement with Nationwide restrict the Company from repurchasing further shares.

HARLEYSVILLE GROUP INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

(Continued)

(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.

Item 6.

a. Exhibits



10.1*		Change in Control Employment Agreement with Arne Herenstein – July 11, 2011

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

10.1*		Change in Control Employment Agreement with Arne Herenstein – July 11, 2011

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.