Property and Casualty Underwriting

Harleysville Group and the Mutual Company together underwrite a broad line of personal and commercial property and casualty coverages, including automobile, homeowners, commercial multi-peril and workers compensation. The Mutual Company and the Company’s insurance subsidiaries participate in an intercompany pooling arrangement under which such subsidiaries and the Mutual Company combine their property and casualty business.

Harleysville Group and the Mutual Company have a pooled rating of “A-” (excellent) which was affirmed by A.M. Best Company, Inc. (Best’s) in December 2006. Best’s ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors. Management believes that the Best’s rating is an important factor in marketing Harleysville Group’s products to its agents and customers, and that the current rating is satisfactory in that regard.

The following table sets forth ratios for the Company’s property and casualty subsidiaries, prepared in accordance with U.S. generally accepted accounting principles (GAAP) and with statutory accounting practices (SAP) prescribed or permitted by state insurance authorities. The statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (i) the ratio of incurred losses and loss settlement expenses to net earned premium (loss ratio); (ii) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium (expense ratio); and (iii) the ratio of dividends to policyholders to net earned premium (dividend ratio). The GAAP combined ratio is calculated in the same manner except that it is based on GAAP amounts and the denominator for each component is net earned premium. When the combined ratio is under 100%, underwriting results are generally considered profitable. Conversely, when the combined ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. Harleysville Group’s operating income is a function of both underwriting results and investment income.

HARLEYSVILLE GROUP BUSINESS ONLY

Year Ended December 31,

2006

2005

2004

GAAP combined ratio

99.1

%

101.9

%

105.6

%

Statutory operating ratios:

Loss ratio

64.3

%

67.4

%

72.3

%

Expense and dividend ratios

34.3

%

34.8

%

33.6

%

Statutory combined ratio

98.6

%

102.2

%

105.9

%


The following table sets forth the net written premiums and combined ratios by line of insurance, prepared in accordance with statutory accounting practices prescribed or permitted by state insurance authorities, for Harleysville Group for the periods indicated:

HARLEYSVILLE GROUP BUSINESS ONLY

Year Ended December 31,

2006

2005

2004

(dollars in thousands)

Net Premiums Written

Commercial:

Automobile

$

206,316

$

221,680

$

227,105

Workers compensation

97,113

95,877

96,543

Commercial multi-peril

321,270

306,267

287,824

Other commercial

71,189

68,532

66,946

Total commercial

695,888

692,356

678,418

Personal:

Automobile

71,270

78,787

90,947

Homeowners

63,124

59,175

61,108

Other personal

8,535

8,726

9,230

Total personal

142,929

146,688

161,285

Total Harleysville Group Business

$

838,817

$

839,044

$

839,703

Combined Ratios

Commercial:

Automobile

99.3

%

101.1

%

104.4

%

Workers compensation

117.2

%

124.0

%

122.6

%

Commercial multi-peril

98.9

%

101.5

%

105.5

%

Other commercial

86.6

%

98.7

%

95.5

%

Total commercial

100.3

%

104.3

%

106.7

%

Personal:

Automobile

99.3

%

99.2

%

113.9

%

Homeowners

82.6

%

87.6

%

87.5

%

Other personal

69.8

%

72.3

%

87.7

%

Total personal

90.6

%

93.1

%

102.8

%

Total Harleysville Group Business

98.6

%

102.2

%

105.9

%


Pooling Arrangement

The Company’s property and casualty subsidiaries participate in an intercompany pooling arrangement with the Mutual Company. The underwriting pool is intended to produce a more uniform and stable underwriting result from year to year for all companies in the pool than they would experience individually and to reduce the risk of loss of any of the pool participants by spreading the risk among all the participants. Each company participating in the pool has at its disposal the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own capital and surplus. The additional capacity exists because such policy exposures are spread among all the pool participants which each have their own capital and surplus. Regulation is applied to the individual companies rather than to the pool.

Pursuant to the terms of the pooling agreement with the Mutual Company, each of the Company’s subsidiary participants cedes premiums, losses and expenses on all of its business to the Mutual Company which, in turn, retrocedes to such subsidiaries a specified portion of premiums, losses and expenses of the Mutual Company and such subsidiaries. Under the terms of the intercompany pooling agreement which became effective January 1, 1986, Preferred and HNJ ceded to the Mutual Company all of their insurance business written on or after January 1, 1986. All of the Mutual Company’s property and casualty insurance business written or in force on or after January 1, 1986, was also included in the pooled business. The pooling agreement provides, however, that Harleysville Group is not liable

for any losses incurred by the Mutual Company, Preferred and HNJ prior to January 1, 1986. The pooling agreement does not legally discharge Harleysville Group from its primary liability for the full amount of the policies ceded. However, it makes the Mutual Company liable to Harleysville Group to the extent of the business ceded.

The following table sets forth a chronology of the changes that have occurred in the pooling agreement since it became effective on January 1, 1986.

Chronology of Changes in Pooling Agreement

Date

Harleysville

Group

Percentage

Mutual

Company

Percentage

Event

January 1, 1986

30%

70%

Current pooling agreement began with Preferred and HNJ as participants with the Mutual Company.

July 1, 1987

35%

65%

Atlantic acquired and included in the pool.

January 1, 1989

50%

50%

Worcester included in the pool.

January 1, 1991

60%

40%

HIC New York and Mid-America acquired and included in the pool and the Mutual Company formed Pennland (not a pool participant) to write Pennsylvania personal automobile business.

January 1, 1996

65%

35%

Pennland included in the pool.

January 1, 1997

70%

30%

Lake States included in the pool.

January 1, 1998

72%

28%

HIC included in the pool.


When pool participation percentages increased as described above, cash and investments equal to the net increase in liabilities assumed less a ceding commission related to the net increase in the liability for unearned premiums, was transferred from the Mutual Company to Harleysville Group.

All premiums, losses, loss settlement expenses and other underwriting expenses are prorated among the parties to the pooling arrangement on the basis of their participation in the pool. The method of establishing reserves is set forth under “Business - Reserves.” The pooling agreement may be amended or terminated by agreement of the parties. Termination may occur only at the end of a calendar year. The Boards of Directors of the Company and the Mutual Company maintain a coordinating committee which reviews and evaluates, and when changes are warranted, approves the pooling arrangements between the Company and the Mutual Company. See “Business-Relationship with the Mutual Company.” In evaluating pool participation changes, the coordinating committee considers current and proposed acquisitions, the relative capital positions and revenue contributions of the pool participants, and growth prospects and ability to access capital markets to support that growth. Harleysville Group does not intend to terminate its participation in the pooling agreement.

The following table sets forth the net premiums written and combined ratios by line of insurance for the total pooled business after elimination of management fees, prepared in accordance with statutory accounting practices prescribed or permitted by state insurance authorities, for the periods indicated.

TOTAL POOLED BUSINESS

Year Ended December 31,

2006

2005

2004

(dollars in thousands)

Net Premiums Written

Commercial:

Automobile

$

286,550

$

308,576

$

316,180

Workers compensation

134,878

133,161

134,088

Commercial multi-peril

446,209

432,788

406,720

Other commercial

98,874

96,782

94,535

Total commercial

966,511

971,307

951,523

Personal:

Automobile

98,986

109,840

126,801

Homeowners

87,672

84,310

87,051

Other personal

11,854

12,119

12,819

Total personal

198,512

206,269

226,671

Total pooled business

$

1,165,023

$

1,177,576

$

1,178,194

Combined Ratios(1)

Commercial:

Automobile

99.5

%

101.0

%

104.2

%

Workers compensation

119.0

%

124.4

%

123.5

%

Commercial multi-peril

99.8

%

99.9

%

104.0

%

Other commercial

78.8

%

97.5

%

94.2

%

Total commercial

100.2

%

103.5

%

106.0

%

Personal:

Automobile

106.9

%

100.9

%

116.8

%

Homeowners

82.8

%

85.3

%

85.9

%

Other personal

69.8

%

72.3

%

87.7

%

Total personal

94.5

%

93.1

%

103.7

%

Total pooled business

99.3

%

101.6

%

105.5

%


———————

(1)

See the definition of combined ratio in “Business-Property and Casualty Underwriting.”

The combined ratio for the total pooled business differs from Harleysville Group’s combined ratio primarily because of the effect of the inclusion of incurred losses occurring prior to 1986 retained by the Mutual Company and, for 2005 and 2004, the effect of the aggregate catastrophe reinsurance agreement with the Mutual Company. See Note 2(a) of the Notes to Consolidated Financial Statements and Business–Reinsurance.

Reserves. Loss reserves are estimates at a given point in time of what the insurer expects to pay to claimants for claims occurring on or before such point in time, including claims which have been incurred but not yet been reported to the insurer. These are estimates, and it can be expected that the ultimate liability will exceed or be less than such estimates. During the loss settlement period, additional facts regarding individual claims may become known, and consequently it often becomes necessary to refine and adjust the estimates of liability.

Harleysville Group maintains reserves for estimates of the ultimate unpaid cost of all losses incurred, including losses for claims which have been incurred but have not yet been reported to Harleysville Group. Loss settlement expense reserves are intended to cover the ultimate costs of settling all claims, including investigation and litigation costs relating to such claims. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved and knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for incurred but 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. With the exception of reserves relating to some workers compensation long-term disability cases, loss reserves are not discounted.

The following table sets forth a reconciliation of beginning and ending net reserves for unpaid losses and loss settlement expenses for the years indicated for the total pooled business on a statutory basis.

TOTAL POOLED BUSINESS

Year Ended December 31,

2006

2005

2004

(in thousands)

Reserves for losses and
loss settlement expenses,
beginning of the year

$

1,761,198

$

1,613,374

$

1,514,548

Incurred losses and loss
settlement expenses:

Provision for insured events
of the current year

773,770

811,778

825,215

Increase (decrease) in provisions
for insured events of prior years

(17,424

)

(19,545

)

24,381

Total incurred losses and
loss settlement expenses

756,346

792,233

849,596

Payments:

Losses and loss settlement expenses
attributable to insured events
of the current year

228,632

254,441

260,417

Losses and loss settlement expenses
attributable to insured events
of prior years

395,159

389,968

490,353

Total payments

623,791

644,409

750,770

Reserves for losses and loss
settlement expenses, end of year

$

1,893,753

$

1,761,198

$

1,613,374



The following table sets forth the development of net reserves for unpaid losses and loss settlement expenses from 1996 through 2006 for the pooled business of the Mutual Company and Harleysville Group on a statutory basis. “Reserve for losses and loss settlement expenses” sets forth the estimated liability for unpaid losses and loss settlement expenses recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and loss settlement expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported.

The “Reserves reestimated” portion of the table shows the reestimated amount of the previously recorded liability based on experience of each succeeding year. The estimate is increased or decreased as payments are made and more information becomes known about the severity of remaining unpaid claims. For example, the 1996 liability has developed a redundancy after ten years, in that reestimated losses and loss settlement expenses are expected to be lower than the initial estimated liability established in 1996 of $1,033.4 million by $36.7 million, or 3.6%.

The “Cumulative amount of reserves paid” portion of the table shows the cumulative losses and loss settlement expense payments made in succeeding years for losses incurred prior to the balance sheet date. For example, the 1996 column indicates that as of December 31, 2006, payments of $909.3 million of the currently reestimated ultimate liability for losses and loss settlement expenses had been made.

The “Redundancy (deficiency)” portion of the table shows the cumulative redundancy or deficiency at December 31, 2006 of the reserve estimate shown on the top line of the corresponding column. A redundancy in reserves means that reserves established in prior years exceeded actual losses and loss settlement expenses or were reevaluated at less than the original reserved amount. A deficiency in reserves means that the reserves established in prior years were less than actual losses and loss settlement expenses or were reevaluated at more than the originally reserved amounts.

The following table includes all 2006 pool participants as if they had participated in the pooling arrangement in all years indicated except for acquired pool participant companies, which are included from their date of acquisition. Under the terms of the pooling arrangement, Harleysville Group is not responsible for losses on the pooled business occurring prior to January 1, 1986.

TOTAL POOLED BUSINESS

Year ended December 31,

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

(dollars in thousands)

Reserve for losses
and loss settlement
expenses

$

1,033,3766

$

1,124,910

$

1,172,664

$

1,181,066

$

1,136,848

$

1,147,517

$

1,224,380

$

1,514,548

$

1,613,374

$

1,761,198

$

1,893,753

Reserves reestimated:

One year later

995,656

1,068,687

1,090,640

1,115,747

1,114,404

1,143,701

1,397,821

1,538,929

1,593,829

1,743,774

Two years later

961,228

1,005,208

1,042,183

1,097,544

1,124,881

1,308,498

1,459,056

1,566,305

1,602,547
Three years later

918,006

972,318

1,027,968

1,106,107

1,245,333

1,369,239

1,501,724

1,605,840

Four years later

894,015

961,721

1,028,927

1,182,626

1,290,895

1,413,644

1,557,058

Five years later

887,697

962,861

1,073,694

1,214,740

1,325,808

1,478,729

Six years later

890,713

995,904

1,099,420

1,244,763

1,387,325

Seven years later

912,615

1,018,216

1,126,334

1,302,257

Eight years later

934,640

1,039,515

1,179,344

Nine years later

952,437

1,088,898

Ten years later

996,689

Cumulative amount
of reserves paid:

One year later

328,691

338,377

358,526

391,524

395,561

372,642

437,855

490,353

389,968

395,159

Two years later

523,307

540,522

562,908

609,016

609,777

654,045

759,313

742,476

642,066
Three years later

656,234

674,740

695,315

753,893

801,234

884,746

935,691

921,520

Four years later

741,013

756,502

777,204

864,840

945,886

1,005,199

1,051,788

Five years later

790,902

801,602

838,597

951,286

1,019,943

1,076,672

Six years later

821,164

837,855

892,222

1,001,074

1,066,271

Seven years later

845,843

877,219

926,315

1,035,686

Eight years later

873,007

902,405

952,929

Nine years later

893,244

924,160

Ten years later

909,318

Cumulative redundancy/
(deficiency)

36,687

36,012

(6,680

)

(121,191

)

(250,477

)

(331,212

)

(332,678

)

(91,292

)

10,827

17,424

Cumulative redundancy/
(deficiency) expressed
as a percent of
year-end reserves

3.6%

3.2%

(0.6%

)

(10.3%

)

(22.0%

)

(28.9%

)

(27.2%

)

(6.0%

)

0.7%

1.0%

Cumulative redundancy/
(deficiency) excluding pre-1986 reserve development (1)

78,294

72,708

27,529

(88,514

)

(220,187

)

(301,749

)

(305,396

)

(71,680

)

23,319

24,863



———————

(1)

Excludes years not included in pooling arrangement with Harleysville Group.

Harleysville Group’s reserves primarily are derived from those established for the total pooled business. The terms of the pooling agreement provide that Harleysville Group is not liable for any losses incurred by the Mutual Company, Preferred and HNJ prior to January 1, 1986. The GAAP loss reserve experience of Harleysville Group, as reflected in its financial statements, is shown in the following table which sets forth a reconciliation of beginning and ending net reserves for unpaid losses and loss settlement expenses for the years indicated for the business of Harleysville Group only.

HARLEYSVILLE GROUP BUSINESS ONLY

Year Ended December 31,

2006

2005

2004

(in thousands)

Reserves for losses and
loss settlement expenses,
beginning of the year

$

1,237,090

$

1,131,609

$

1,062,660

Incurred losses and loss
settlement expenses:

Provision for insured
events of the current year

557,908

584,929

593,198

Increase (decrease) in
provision for insured
events of prior years

(18,085

)

(17,533

)

12,462

Total incurred losses and
loss settlement expenses

539,823

567,396

605,660

Payments:

Losses and loss settlement
expenses attributable to
insured events of the
current year

165,409

183,645

186,629

Losses and loss settlement
expenses attributable to
insured events of prior years

281,655

278,270

350,082

Total payments

447,064

461,915

536,711

Reserves for losses and loss
settlement expenses, end of the year

$

1,329,849

$

1,237,090

$

1,131,609



See page 9 for reconciliation of net reserves to gross reserves.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $18,085,000 in 2006, primarily due to lower-than-expected claims severity in accident years 2002 through 2005 for most commercial and personal lines of business, partially offset by greater-than-expected claims severity in the 2001 and prior accident years. The favorable development consisted of $8,096,000 in commercial lines and $9,989,000 in personal lines.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $17,533,000 in 2005, primarily due to lower-than-expected claims severity in accident years 2004 and 2003, partially offset by greater-than-expected claims severity in commercial lines in 2002 and prior accident years. The favorable development consisted of $3,940,000 in commercial lines and $13,593,000 in personal lines.

Harleysville Group recognized net adverse development in the provision for insured events of prior years of $12,462,000 in 2004, primarily due to greater-than-expected claims severity in commercial lines.

The following table sets forth the development of net reserves for unpaid losses and loss settlement expenses for Harleysville Group. The effect of changes to the pooling agreement participation is reflected in this table. For example, the January 1, 1997 increase in Harleysville Group’s pooling participation from 65% to 70% is reflected in the first line of the 1997 column. Amounts of assets equal to increases in net liabilities were transferred to Harleysville Group from the Mutual Company in conjunction with each respective pooling change. The amount of the assets transferred has been netted against and has reduced the cumulative amounts paid for years prior to the pooling changes. For example, the 1996 column of the “Cumulative amount of reserves paid” portion of the table reflects the assets transferred in conjunction with the 1997 increase in the pooling percentage from 65% to 70% as a decrease netted in the “one year later” line. The cumulative amounts paid are reflected in this manner to maintain comparability. This is because when Harleysville Group pays claims subsequent to the date of a pool participation increase, the amounts paid

are greater, however, the prior year’s reserve amounts are reflective of a lower pool participation percentage. By reflecting pooling participation increases in this manner, loss development is not obscured. Loss development reflects Harleysville Group’s share of the total pooled business loss development since January 1, 1986 when Harleysville Group began participation, plus loss development of any subsidiary not participating in the pooling agreement.

Loss development information for the total pooled business is presented on pages 6 to 8 to provide greater analysis of underlying claims development.

HARLEYSVILLE GROUP BUSINESS

Year Ended December 31,

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

(dollars in thousands)

Reserve for losses and loss settlement expenses

$

718,700

$

793,563

$

813,519

$

823,914

$

792,584

$

800,861

$

857,182

$

1,062,660

$

1,131,609

$

1,237,090

$

1,329,849

Reserves reestimated:

One year later

688,972

750,956

753,987

774,977

775,234

796,213

976,241

1,075,122

1,114,076

1,219,005

Two years later

662,393

704,157

717,324

761,234

781,117

909,048

1,015,209

1,091,322

1,114,813
Three years later

630,170

678,757

706,491

765,816

862,320

947,660

1,042,276

1,114,275

Four years later

611,179

670,534

705,615

815,380

889,996

975,978

1,076,597

Five years later

606,037

669,789

732,315

833,373

911,482

1,017,319

Six years later

606,642

688,055

745,714

851,335

950,295

Seven years later

616,886

698,996

761,438

887,252

Eight years later

627,620

710,694

794,126

Nine years later

636,796

740,893

Ten years later

663,301

Cumulative amount of reserves paid:

One year later

200,907

228,622

252,972

279,153

282,110

265,422

312,224

350,082

278,270

281,655

Two years later

330,158

371,624

397,685

433,901

434,579

465,001

541,063

529,126

456,921
Three years later

423,337

465,897

491,274

536,547

569,696

628,494

665,513

655,219

Four years later

482,016

523,050

548,696

613,701

671,230

712,677

746,455

Five years later

516,221

553,984

590,172

673,327

722,038

761,490

Six years later

536,473

577,360

626,171

706,659

752,787

Seven years later

551,515

603,092

648,203

728,973

Eight years later

568,463

618,715

664,758

Nine years later

580,524

631,916

Ten years later

589,638

Net cumulative

redundancy/

(deficiency)

55,399

52,670

19,393

(63,338

)

(157,711

)

(216,458

)

(219,415

)

(51,615

)

16,796

18,085

Net cumulative

redundancy/

(deficiency)

expressed as a

percent of year

end reserves

7.7%

6.6%

2.4%

(7.7%

)

(19.9%

)

(27.0%

)

(25.6%

)

(4.9%

)

1.5%

1.5%

Gross reserve

$

796,820

$

868,393

$

893,420

$

901,352

$

864,843

$

879,056

$

928,335

$

1,219,977

$

1,317,735

$

1,480,802

$

1,493,645

Ceded reserve

78,120

74,830

79,901

77,438

72,259

78,195

71,153

157,317

186,126

243,712

163,796

Net reserve

$

718,700

$

793,563

$

813,519

$

823,914

$

792,584

$

800,861

$

857,182

$

1,062,660

$

1,131,609

$

1,237,090

$

1,329,849

Gross cumulative

redundancy/

(deficiency)

$

(16,176

)

$

(29,651

)

$

(60,118

)

$

(163,721

)

$

(282,071

)

$

(336,522

)

$

(340,284

)

$

(100,677

)

$

2,335

$

2,143

Gross re-estimated

$

812,996

$

898,044

$

953,538

$

1,065,073

$

1,146,914

$

1,215,578

$

1,268,619

$

1,320,654

$

1,315,400

$

1,478,659

Ceded re-estimated

149,695

157,151

159,412

177,821

196,619

198,259

192,022

206,379

200,587

259,654

Net re-estimated

$

663,301

$

740,893

$

794,126

$

887,252

$

950,295

$

1,017,319

$

1,076,597

$

1,114,275

$

1,114,813

$

1,219,005



———————

Note:

The amount of cash and investments received equal to the increase in liabilities for unpaid losses and loss settlement expenses was $93,966,000, $28,318,000 and $12,392,000 for the changes in pool participation in 1996, 1997 and 1998, respectively.

Reinsurance. Harleysville Group follows the customary industry practice of reinsuring a portion of its exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce the net liability on individual risks and to protect against catastrophic losses. Reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, although it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, a ceding company is subject to credit risk with respect to its reinsurers. Harleysville Group has not entered into any finite reinsurance agreements.

The reinsurance described below is maintained for the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiaries. Reinsurance premiums and recoveries are allocated to participants in the pooling agreement according to pooling percentages.

Reinsurance for property and auto physical damage losses is currently maintained under a per risk excess of loss treaty affording recovery to $8.0 million above a retention of $2.0 million. Harleysville Group’s 2006 pooling share of such recovery would be $5.8 million above a retention of $1.4 million. In addition, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiaries are reinsured under a catastrophe reinsurance treaty effective for one year from July 1, 2006 which provides coverage ranging from 20% to 85% of up to $245.0 million in excess of a retention of $40.0 million for any given catastrophe. Harleysville Group’s 2006 pooling share of this coverage would range from 20% to 85% of up to $176.4 million in excess of a retention of $28.8 million for any given catastrophe. Accordingly, pursuant to the terms of the treaty, the maximum recovery would be $153.5 million for any catastrophe involving an insured loss equal to or greater than $285.0 million. Harleysville Group’s pooling share of this maximum recovery would be $110.5 million for any catastrophe involving an insured loss of $205.2 million or greater. The treaty includes reinstatement provisions providing for coverage for a second catastrophe and requiring payment of an additional premium in the event of a first catastrophe occurring. Most terrorism losses would not be covered by the treaty. Harleysville Group has not purchased funded catastrophe covers. Harleysville Group and Mutual have purchased property per risk excess of loss reinsurance which covers certain terrorism losses and provides for recovery of up to $8.0 million in excess of $2.0 million of terrorism losses for any one risk under certain circumstances. The maximum recovery by Harleysville Group on a terrorism loss occurrence is $7.9 million.

Casualty reinsurance (including liability and workers compensation) is currently maintained under an excess of loss treaty affording recovery to $38.0 million above a retention of $2.0 million for each loss occurrence. Harleysville Group’s 2006 pooling share of a recovery would be up to $27.4 million above a retention of $1.4 million. In addition, there is reinsurance to protect Harleysville Group from large workers compensation losses. For umbrella liability coverages, reinsurance protection up to $9.0 million is provided over a retention of $1.0 million. Harleysville Group’s 2006 pooling share would provide for recovery of $6.5 million over a retention of $0.7 million. The casualty reinsurance programs provide coverage for a terrorist event with no reinstatement provision.

Effective January 1, 2007, the retention on the casualty excess of loss treaty was increased from $2.0 million to $3.0 million. Effective January 1, 2007, the treaty affords recovery to $37.0 million above the $3.0 million retention. Harleysville Group's pooling share of such recovery would be $26.6 million above a retention of $2.2 million. Additionally, effective January 1, 2007, the Company's subsidiaries and Mutual and its wholly owned subsidiaries retained a 25% co-participation of the first $4.0 million in excess of $1.0 million on their umbrella treaty. The maximum recovery for an umbrella loss under the new treaty is $8.0 million. Harleysville Group's pooling share of this recovery would be $5.8 million.

Harleysville Group had a reinsurance agreement with the Mutual Company whereby the Mutual Company reinsured accumulated catastrophe losses in a quarter up to $14.4 million in excess of $3.6 million in return for a reinsurance premium. The agreement excluded catastrophe losses resulting from earthquakes, hurricanes or terrorism. The agreement was terminated December 31, 2005 and the coverage will not be replaced as it is no longer deemed necessary based on the current catastrophe risk profile.

The terms and charges for reinsurance coverage are typically negotiated annually. The reinsurance market is subject to conditions which are similar to those in the direct property and casualty insurance market, and there can be no assurance that reinsurance will remain available to Harleysville Group to the same extent and at the same cost currently maintained.

Harleysville Group considers numerous factors in choosing reinsurers, the most important of which are the financial stability and credit worthiness of the reinsurer. Harleysville Group has not experienced any material uncollectible reinsurance recoverables.

The Company’s subsidiaries and the Mutual Company are servicing carriers in the “Write-Your-Own” (WYO) program of the United States government’s National Flood Insurance Program (NFIP). The WYO program is a cooperative undertaking of the insurance industry and the Federal Emergency Management Agency. As servicing carriers, Harleysville Group and Mutual bear no risk of loss on flood insurance policies. All of the premiums collected on flood insurance policies are ceded to the federal government and, in exchange a servicing fee is received from which agency commission, claim handling fees and other related expenses are paid.

As a writer of personal and commercial automobile policies in the state of Michigan, in compliance with applicable state regulations, Harleysville Group cedes premiums and claims for medical benefits and work loss, above a specified retention amount, to the Michigan Catastrophic Claims Association. For policies effective July 1, 2006 to June 30, 2007, the required retention is $400,000.

Competition. The property and casualty insurance industry is highly competitive on the basis of both price and service. There are numerous companies competing for the categories of business underwritten by Harleysville Group in the geographic areas where Harleysville Group operates, many of which are substantially larger and have considerably greater financial resources than Harleysville Group. In addition, because the insurance products of Harleysville Group and the Mutual Company are marketed exclusively through independent insurance agencies, most of which represent more than one company, Harleysville Group faces competition within each agency.

Marketing. Harleysville Group markets its insurance products through independent agencies and monitors the performance of these agencies relative to many factors including profitability, growth and retention. At December 31, 2006, there were approximately 1,500 agencies.

Investments

An important element of the financial results of Harleysville Group is the return on invested assets. An investment objective of Harleysville Group is to maintain a widely diversified fixed maturities portfolio structured to maximize after-tax investment income while minimizing credit risk through investments in high quality instruments. An objective also is to provide adequate funds to pay claims without forced sales of investments. At December 31, 2006, substantially all of Harleysville Group’s fixed maturity investment portfolio was rated investment grade and the investment portfolio did not contain any real estate or mortgage loans. Harleysville Group also invests in equity securities with the objective of capital appreciation.

Harleysville Group has adopted and follows an investment philosophy which precludes the purchase of non-investment grade fixed income securities. However, due to uncertainties in the economic environment, it is possible that the quality of investments held in Harleysville Group’s portfolio may change.

The following table shows the composition of Harleysville Group’s fixed maturity investment portfolio at amortized cost, excluding short-term investments, by rating as of December 31, 2006:

December 31, 2006

Amount

Percent

(dollars in thousands)

Rating(1)
U.S. Treasury and U.S. agency bonds (2) 

$

646,771

30.8

%

Aaa

677,484

32.3

Aa

462,664

22.0

A

287,129

13.7

Baa

6,604

0.3

Ba

15,475

0.7

B

3,981

0.2

Total

$

2,100,108

100.0

%


———————

(1)

Ratings assigned by Moody’s Investors Services, Inc.

(2)

Includes GNMA pass-through obligations and collateralized mortgage obligations.

Harleysville Group invests in both taxable and tax-exempt fixed income securities as part of its strategy to maximize after-tax income. Such strategy considers, among other factors, the impact of the alternative minimum tax. Tax-exempt bonds made up approximately 27%, 36% and 46% of the total investment portfolio at December 31, 2006, 2005 and 2004, respectively.

The following table shows the composition of Harleysville Group’s investment portfolio at carrying value, excluding short-term investments, by type of security as of December 31, 2006:

December 31, 2006

Amount

Percent

(dollars in thousands)

Fixed maturities:
U.S. Treasury obligations

$

85,601

3.9

%

U.S. agency obligations

185,837

8.5

Mortgage-backed securities

374,507

17.2

Obligations of states and political subdivisions

718,287

34.1

Corporate securities

741,099

33.0

Total fixed maturities

2,105,331

96.7

Equity securities

71,446

3.3

Total

$

2,176,777

100.0

%


Investment results of Harleysville Group’s fixed maturity investment portfolio are as shown in the following table:

Year Ended December 31,

2006

2005

2004

(dollars in thousands)

Invested assets(1)

$

1,954,158

$

1,733,086

$

1,640,367

Investment income(2)

$

95,101

$

86,463

$

84,367

Average yield

4.9

%

5.0

%

5.1

%


———————

(1)

Average of the aggregate invested amounts at amortized cost at the beginning and end of the period.

(2)

Investment income does not include investment expenses, realized investment gains or losses or provision for income taxes.

The following table indicates the composition of Harleysville Group’s fixed maturity investment portfolio at carrying value, excluding short-term investments, by time to maturity as of December 31, 2006:

December 31, 2006

Amount

Percent

(dollars in thousands)

Due in(1)
1 year or less

$

221,712

10.5

%

Over 1 year through 5 years

833,499

39.6

Over 5 years through 10 years

608,605

28.9

Over 10 years

67,008

3.2
1,730,824

82.2

Mortgage-backed securities

374,507

17.8

Total

$

2,105,331

100.0

%


———————

(1)

Based on stated maturity dates with no prepayment assumptions. Actual maturities may differ because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

The average expected life of Harleysville Group’s investment portfolio as of December 31, 2006 was approximately 5.0 years.

Regulation

Insurance companies are subject to supervision and regulation in the states in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company’s business and financial condition. The purpose of such supervision and regulation is the protection of policyholders. The extent of such supervision and regulation varies, but generally derives from state statutes which delegate regulatory, supervisory and administrative authority to state insurance departments. Accordingly, the authority of the state insurance departments typically includes the establishment of standards of solvency which must be met and maintained by insurers, the licensing to do business of insurers and agents, the nature of and limitations on investments, the approval process for premium rates for property and casualty insurance, the provisions which insurers must make for current losses and future liabilities, the deposit of securities for the benefit of policyholders and the approval of policy forms. Such insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies.

All of the states in which Harleysville Group and the Mutual Company do business have guaranty fund laws under which insurers doing business in such states can be assessed up to 2% of annual premiums written by the insurer in that state in order to fund policyholder liabilities of insolvent insurance companies. Under these laws in general, an insurer is subject to assessment, depending upon its market share of a given line of business, to assist in the payment of policyholder and third party claims against insolvent insurers.

State laws also require Harleysville Group to participate in involuntary insurance programs for automobile insurance, as well as other property and casualty lines, in states in which Harleysville Group writes such lines. These programs include joint underwriting associations, assigned risk plans, fair access to insurance requirements (FAIR) plans, reinsurance facilities and wind storm plans. These state laws generally require all companies that write lines covered by these programs to provide coverage (either directly or through reinsurance) for insureds who cannot obtain insurance in the voluntary market. The legislation creating these programs usually allocates a pro rata portion of risks attributable to such insureds to each company on the basis of direct written premiums or the number of automobiles insured. Generally, state law requires participation in such programs as a condition to doing business. The loss ratio on insurance written under involuntary programs generally has been greater than the loss ratio on insurance in the voluntary market.

State insurance holding company acts regulate insurance holding company systems. Each insurance company in the holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information concerning transactions between companies within the holding company system that may materially affect the operations, management or financial condition of the insurer within the system, including the payment of dividends from the insurance subsidiaries to the Company.

Insurance holding company acts require that all transactions involving any insurer within the holding company system, including those involving the Mutual Company and the Company’s insurance subsidiaries, must be fair and equitable to that insurer. Further, approval of the applicable insurance commissioner is required prior to the consummation of a transaction affecting the control of an insurer.

The Terrorism Risk Insurance Act of 2002 (the Act) established a program that provides a backstop for insurance-related losses resulting from any act of terrorism as defined. The Act, originally set to expire in 2005, was extended through December 31, 2007 in December 2005 (the Extended Act). Under the program, the federal government will pay 90% (85% in 2007) of covered losses after an insurer’s losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. The triggering threshold for certifying an act of terrorism was $50 million in 2006 and is $100 million in 2007 under the Extended Act.

The statutory formula for determining a company’s deductible for each year is based on the company’s direct commercial earned premiums for the prior calendar year multiplied by a specified percentage. These percentages were raised from 10% for 2004 and 15% for 2005 to 17.5% for 2006 and 20% for 2007. The Extended Act excludes the following lines of business from coverage under the Act and are not to be included in the deductible calculation: commercial auto, burglary and theft, surety, professional liability and farmowners’ multiperil insurance.

The Act requires all property and casualty insurers to make terrorism insurance coverage available in all of their covered commercial property and casualty insurance policies (as defined in the Act).

In the event the Act is not renewed beyond 2007, or is renewed in a materially different form, the Company may have to attempt to obtain appropriate reinsurance for the related terrorism risk, seek exclusion from coverage related to terrorism exposure from the appropriate regulatory authorities, limit certain of its writings, or pursue a solution encompassing aspects of one or more of the foregoing.

The insurance industry has received adverse publicity about alleged anti-competitive activities by certain insurance brokers and insurers. Harleysville Group primarily distributes its products through its agents and writes less than 1% of its premiums through brokers. There are no contingent commission arrangements with such brokers.

The property and casualty insurance industry has been subject to significant public scrutiny and comment primarily due to concerns regarding solvency issues, rising insurance costs, and the industry’s methods of operations. Accordingly, regulations and legislation may be adopted or enacted: to provide a greater role for the federal government in regulation of insurance companies; to strengthen state oversight, particularly in the field of solvency and investments; to further restrict an insurer’s flexibility in underwriting and pricing risks; and to impose new taxes and assessments. It is not possible to predict whether, in what form or in what jurisdictions, any of these measures might be adopted or the effect, if any, on Harleysville Group.

The Company’s insurance subsidiaries generally are restricted by the insurance laws of their respective states of domicile as to the amount of dividends they may pay to the Company without the prior approval of the respective state regulatory authorities. Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary, for the preceding year. Applying the current regulatory restrictions as of December 31, 2006, $117.5 million would be available for distribution to Harleysville Group Inc. during 2007 without prior approval. The Company’s insurance subsidiaries paid dividends to the Company of $15.0 million in 2005, and $26.6 million in 2004. No dividends were paid in 2006.

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.

Harleysville Group is required to file financial statements for its subsidiaries, prepared by using statutory accounting practices, with state regulatory authorities. The adjustments necessary to reconcile net income and shareholders’ equity determined by using SAP to net income and shareholders’ equity determined in accordance with GAAP are as follows:

Net Income

Year Ended December 31,

Shareholders’ Equity

December 31,

2006

2005

2004

2006

2005

(in thousands)

SAP amounts

$

131,263

$

62,330

$

45,776

$

686,149

$

566,802

Adjustments:

Deferred policy acquisition costs

(1,856

)

3,418

1,722

102,317

104,173

Deferred income taxes

(13,120

)

(513

)

10,361

33,709

Unrealized investment gains

5,262

13,215

Pension

(1,701

)

1,611

(18,251

)

(25,892

)

Other, net

(5,006

)

(1,276

)

(1,722

)

14,473

14,503

Holding company(1)

(330

)

(827

)

(834

)

(88,149

)

(92,127

)

GAAP amounts

$

111,069

$

61,431

$

46,878

$

712,162

$

614,383



———————

(1)

Represents the GAAP loss and equity amounts for Harleysville Group Inc., excluding the earnings of and investment in subsidiaries.

Relationship with the Mutual Company

Harleysville Group’s operations are interrelated with the operations of the Mutual Company due to the pooling arrangement and other factors. The Mutual Company owned approximately 54% of the issued and outstanding common stock of Harleysville Group Inc. at December 31, 2006. Harleysville Group employees provide a variety of services to the Mutual Company and its wholly owned subsidiaries. The cost of facilities and employees required to conduct the business of both companies is charged on a cost-allocated basis. Harleysville Group also manages the operations of the Mutual Company and its wholly owned subsidiaries pursuant to a management agreement which commenced January 1, 1993 under which Harleysville Group receives a management fee. Harleysville Group received $6.4 million, $6.7 million, and $6.8 million for the years ended December 31, 2006, 2005 and 2004, respectively, for all such management services.

All of the Company’s officers are officers of the Mutual Company, and six of the Company’s eight directors are directors of the Mutual Company. A coordinating committee exists to review and evaluate the pooling agreement and other material transactions between Harleysville Group and the Mutual Company and is responsible for matters involving actual or potential conflicts of interest between the two companies. The coordinating committee currently consists of six non-employee directors, two from Harleysville Group Inc. and three from the Mutual Company all of whom are not members of both Boards and one, a non-voting Chairman, who is a member of both Boards. The decisions of the coordinating committee are binding on the two companies. No intercompany transaction can be authorized by the coordinating committee unless both of the Company’s committee members conclude that such transaction is fair and equitable to Harleysville Group.

The Mutual Company leases the home office from a company subsidiary and it shares most of the facility with Harleysville Group. Rental income under the lease was $4.1 million for 2006, $4.0 million for 2005 and $3.7 million for 2004. Harleysville Group believes that the lease terms are no less favorable to it than if the property were leased to a non-affiliate.

In connection with the acquisition of Mid-America and HIC New York, the Company borrowed approximately $18.5 million from the Mutual Company. See Note 7 of the Notes to Consolidated Financial Statements. For additional information with respect to transactions with the Mutual Company, see Note 2 of the Notes to Consolidated Financial Statements.

Employees

All employees are paid by Harleysville Group Inc. and, accordingly, are considered to be employees of Harleysville Group Inc. As of December 31, 2006, there were 1,898 employees. They provide a variety of services to the Mutual Company and its wholly owned subsidiaries. See “Business-Relationship with the Mutual Company” and Note 2 of the Notes to Consolidated Financial Statements.

Available Information

The Company maintains a website at www.harleysvillegroup.com . Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge on our website as soon as practicable after electronic filing of such material with, or furnishing it to, the Securities and Exchange Commission.

Item 1A.

R isk Factors.

For a discussion of risk factors, see “Management’s Discussion and Analysis - Risk Factors.”

Item 1B.

Unresolve d Staff Comments.

None.