UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 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

Securities registered pursuant to Section 12(b) of the Act:


Title of each class		Name of each exchange on which registered
None		None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1 par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x.

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x.

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨.

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.

On June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value (based on the closing sales price on that date) of the voting stock held by non-affiliates of the registrant was $392,800,274.

The number of shares outstanding of the registrant’s common stock, as of March 8, 2012 was 27,277,285.

HARLEYSVILLE GROUP INC.

ANNUAL REPORT ON FORM 10-K

DECEMBER 31, 2011


		Page

	PART I

ITEM 1.	BUSINESS		1

ITEM 1A.	RISK FACTORS		16

ITEM 1B.	UNRESOLVED STAFF COMMENTS		16

ITEM 2.	PROPERTIES		17

ITEM 3.	LEGAL PROCEEDINGS		17

ITEM 4.	MINE SAFETY DISCLOSURES		18

	PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES		19

ITEM 6.	SELECTED FINANCIAL DATA		22

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		22

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		51

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		52

ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		87

ITEM 9A.	CONTROLS AND PROCEDURES		87

ITEM 9B.	OTHER INFORMATION		87

	PART III

ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE		89

ITEM 11.	EXECUTIVE COMPENSATION		97

ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS		123

ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE		126

ITEM 14.	PRINCIPAL ACCOUNTANT FEES AND SERVICES		128

	PART IV

ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES		129

PART I

Item 1.

Business.

General

Harleysville Group Inc. (the Company) is an insurance holding company headquartered in Pennsylvania which, through its subsidiaries, engages in the property and casualty insurance business on a regional basis in the United States. As used herein, “Harleysville Group” refers to Harleysville Group Inc. and its subsidiaries.

The Company is a Delaware corporation formed by Harleysville Mutual Insurance Company (the Mutual Company) in 1979 as a wholly owned subsidiary. In May 1986, the Company completed an initial public offering of its common stock, reducing the percentage of outstanding shares owned by the Mutual Company to approximately 70%. In April 1992, the Mutual Company completed a secondary public offering of a portion of the Company’s common stock then owned by it, further reducing the percentage of outstanding shares owned by the Mutual Company. At December 31, 2011, the Mutual Company owned approximately 53% of the Company’s outstanding shares.

Harleysville Group and the Mutual Company operate together to pursue a strategy of underwriting a broad array of personal and commercial coverages. These insurance coverages are marketed primarily in the eastern and midwestern United States through approximately 1,300 insurance agencies. Regional offices are maintained in Georgia, Illinois, Indiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Pennsylvania, Tennessee, and Virginia. The Company’s property and casualty insurance subsidiaries are: Harleysville-Atlantic Insurance Company (Atlantic), Harleysville Insurance Company (HIC), Harleysville Insurance Company of New Jersey (HNJ), Harleysville Insurance Company of New York (HIC New York), Harleysville Insurance Company of Ohio (HIC Ohio), Harleysville Lake States Insurance Company (Lake States), Harleysville Preferred Insurance Company (Preferred), and Harleysville Worcester Insurance Company (Worcester). Atlantic and HIC Ohio were merged into Worcester in December 2011. Harleysville Group Inc. acquired Mainland Insurance Company (Mainland) from the Mutual Company in December 2010. HIC New York was then merged into Mainland and the surviving company was re-named Harleysville Insurance Company of New York (HIC New York). Mainland was a shell property and casualty insurance company with no premiums or outstanding insurance obligations. The acquisition and merger were completed to facilitate the redomestication of HIC New York from New York to Pennsylvania in order to improve the efficiency of the corporate structure.

The Company operates regionally. Management believes that the Company’s regional organization permits each regional operation to benefit from economies of scale provided by centralized support while encouraging local marketing autonomy and managerial entrepreneurship. Services which directly involve the insured or the agent (i.e., underwriting, claims and marketing) generally are performed regionally in accordance with Company-wide standards to promote high quality service, while actuarial, investment, legal, data processing and similar services are performed centrally. Since its formation, the Company’s network of insurance companies has expanded significantly. In 1983, the Company acquired Worcester, a property and casualty insurer which has conducted business in New England since 1823. In 1984, HNJ was formed by the Company and began underwriting property and casualty insurance in New Jersey. In 1987, the Company acquired Atlantic, a property and casualty insurer which has conducted business in the southeastern United States since 1905. In 1991, the Company acquired HIC New York, which conducts business in New York. In 1993, the Company acquired Lake States, which primarily conducts business in Michigan. In 1994, the Company formed HIC Ohio which began underwriting property and casualty insurance in Ohio. In 1997, the Company acquired HIC, which primarily conducted business in Minnesota and neighboring states.

The Company’s property and casualty subsidiaries participate in an intercompany pooling arrangement whereby these subsidiaries cede to the Mutual Company all of their net premiums written and assume from the Mutual Company a portion of the pooled business. See “Business - Pooling Arrangement.”

On September 28, 2011, the Company and the Mutual Company entered into an agreement and plan of merger (the Merger Agreement) with Nationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide would merge into the Company, (the Merger). Nationwide would acquire all of the publicly held shares of common stock of the Company for $60.00 per share in cash and the Mutual Company would merge into Nationwide and the policyholders and members of the Mutual Company would become policyholders and members of Nationwide. The Mutual Company has also entered into a voting agreement with Nationwide (the Voting Agreement) under which the Mutual Company 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 activities and taking certain actions without Nationwide’s prior approval, including among others, the payment of stockholder dividends.

The transactions contemplated by the Merger Agreement are subject to customary closing conditions, including among others, approvals from stockholders of the Company, members of the Mutual Company and members of Nationwide, the Pennsylvania Insurance Department, the Ohio Insurance Department and various other regulatory bodies. The transactions are expected to close in the first half of 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.

Business Segments

Harleysville Group has three segments which consist of the personal lines of insurance, the commercial lines of insurance and the investment function. Financial information about these segments is set forth in Note 13 of the Notes to Consolidated Financial Statements.

Narrative Description of Business

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 and its property and casualty insurance subsidiary, Harleysville Pennland Insurance Company (Pennland), combine their property and casualty business.

Harleysville Group and the Mutual Company have an A.M. Best Company, Inc. (Best’s) group rating of “A” (Excellent). 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,
	2011			2010			2009

GAAP combined ratio		119.9	%		103.1	%		99.5	%

Statutory operating ratios:
Loss ratio		84.7	%		67.9	%		64.3	%
Expense and dividend ratios		35.2	%		34.6	%		35.5	%

Statutory combined ratio		119.9	%⁽¹⁾		102.5	%		99.8	%

⁽¹⁾

The statutory combined ratio for 2011 includes 0.9% due to the impact of the transfer of liabilities in connection with the pool change. This impact results from the statutory treatment of the ceding commission received on the unearned premiums transferred on January 1, 2011. Excluding this impact, the statutory combined ratio was 119.0%. See Note 3(a) of the Notes to Consolidated Financial Statements.

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,
	2011			2010			2009
	(dollars in thousands)
Net Premiums Written
Commercial:
Automobile	$	169,490		$	178,353		$	182,169
Workers compensation		(40,012	)		77,734			80,484
Commercial multi-peril		337,691			338,992			326,242
Other commercial		73,521			84,078			85,380

Total commercial		540,690			679,157			674,275

Total commercial without workers compensation net premiums written⁽¹⁾		580,702


Personal:
Automobile		109,820			102,045			85,195
Homeowners		94,063			87,736			80,044
Other personal		14,044			13,123			12,103

Total personal		217,927			202,904			177,342


Total Harleysville Group Business	$	758,617		$	882,061		$	851,617


Total Harleysville Group Business without workers compensation net premiums written⁽¹⁾	$	798,629


Combined Ratios
Commercial:
Automobile		105.4	%		100.0	%		91.4	%
Workers compensation					106.1	%		106.2	%
Commercial multi-peril		127.6	%		106.1	%		105.1	%
Other commercial		98.7	%		88.8	%		97.6	%
Total commercial		116.7	%		102.3	%		100.7	%
Total commercial without intercompany pooling transfer⁽¹⁾		115.4	%

Personal:
Automobile		119.4	%		104.9	%		103.0	%
Homeowners		148.9	%		108.2	%		92.7	%
Other personal		75.9	%		62.6	%		81.1	%
Total personal		129.3	%		103.5	%		96.8	%

Total Harleysville Group Business		119.9	%		102.5	%		99.8	%

Total Harleysville Group Business without intercompany pooling transfer⁽¹⁾		119.0	%

⁽¹⁾	The effect of the January 1, 2011 pooling transfer of $40 million of net premiums written (representing the transfer of the January 1, 2011 unearned premium balance of workers compensation) and the effect of the pool transfer on the statutory combined ratios are excluded for comparative purposes.

Pooling Arrangement

The Company’s property and casualty subsidiaries participate in an intercompany pooling arrangement with the Mutual Company and Pennland. 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 and Pennland cede premiums, losses and underwriting expenses on all of its business to the Mutual Company which, in turn, retrocedes to such subsidiaries a specified portion of premiums, losses and underwriting expenses of the Mutual Company, Pennland 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/Pennland 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 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.

January 1, 2008		80	%		20	%	Amendment to the pooling participation percentages.

January 1, 2010		80	%		20	%	Amendment to exclude any premiums, losses and expenses assumed by the Mutual Company, other than business assumed from any mandatory regulatory pool or association.

January 1, 2011		80	%		20	%	Amendment to establish that the financial results of the workers compensation line of business for accident years 2011 and following is retained 100% by the Mutual Company.

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. In connection with the January 1, 2011

pool change, cash equal to the net decrease in the liability for unearned premiums, less a ceding commission, was transferred from Harleysville Group to the Mutual Company. See Note 3(a) of the Notes to Consolidated Financial Statements.

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.

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

TOTAL BUSINESS OF POOLED COMPANIES


	Year Ended December 31,
	2011			2010			2009
	(dollars in thousands)

Net Premiums Written
Commercial:
Automobile	$	211,862		$	222,941		$	227,711
Workers compensation		94,613			97,167			100,606
Commercial multi-peril		422,114			423,742			407,803
Other commercial		91,901			105,097			106,724

Total commercial		820,490			848,947			842,844


Personal:
Automobile		137,275			127,556			106,493
Homeowners		117,578			109,670			100,056
Other personal		17,555			16,403			15,128

Total personal		272,408			253,629			221,677


Total pooled business	$	1,092,898		$	1,102,576		$	1,064,521


Combined Ratios(1)
Commercial:
Automobile		105.7	%		100.0	%		91.6	%
Workers compensation		106.1	%		109.6	%		106.4	%
Commercial multi-peril		127.8	%		106.1	%		105.1	%
Other commercial		98.8	%		89.1	%		97.6	%
Total commercial		116.1	%		102.7	%		100.7	%

Personal:
Automobile		119.8	%		106.8	%		104.4	%
Homeowners		149.0	%		108.1	%		92.8	%
Other personal		75.9	%		62.6	%		81.1	%
Total personal		129.5	%		104.4	%		97.5	%

Total pooled business		119.3	%		103.0	%		100.0	%

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

The combined ratio for the total business of the pooled companies 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 2011, due to the impact of the pool change on the statutory combined ratio described in note (1) on page 2. See Note 3(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 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 business of the pooled companies, excluding the voluntary assumed reinsurance business of the Mutual Company, on a statutory basis.

TOTAL BUSINESS OF POOLED COMPANIES


	Year Ended December 31,
	2011			2010			2009
	(in thousands)

Reserves for losses and loss settlement expenses, beginning of the year	$	1,994,835		$	1,997,647		$	1,998,006


Incurred losses and loss settlement expenses:
Provision for insured events of the current year		980,258			798,294			734,820
Decrease in provision for insured events of prior years		(36,699	)		(56,437	)		(42,781	)


Total incurred losses and loss settlement expenses		943,559			741,857			692,039


Payments:
Losses and loss settlement expenses attributable to insured events of the current year		409,457			311,542			254,342
Losses and loss settlement expenses attributable to insured events of prior years		476,460			433,127			438,056


Total payments		885,917			744,669			692,398


Reserves for losses and loss settlement expenses, end of the year	$	2,052,477		$	1,994,835		$	1,997,647

The following table sets forth the development of net reserves for unpaid losses and loss settlement expenses from 2001 through 2011 for the total pooled business of the Mutual Company, Pennland and Harleysville Group on a statutory basis. “Net 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 “Net reserves re-estimated” portion of the table shows the re-estimated 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 2001 liability has developed a deficiency after ten years, in that re-estimated losses and loss settlement expenses are expected to be higher than the initial estimated liability established in 2001 of $1,147.5 million by $387.4 million, or 33.8%.

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 2001 column indicates that as of December 31, 2011, payments of $1,238.8 million of the currently re-estimated 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, 2011 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 2011 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 of the Mutual Company, Preferred and HNJ occurring prior to January 1, 1986.

TOTAL BUSINESS OF POOLED COMPANIES


	Year ended December 31,
	2001			2002			2003			2004			2005			2006			2007			2008			2009			2010			2011
	(dollars in thousands)

Net reserve for losses and loss settlement expenses	$	1,147,517		$	1,224,380		$	1,514,548		$	1,613,374		$	1,761,198		$	1,893,753		$	1,967,094		$	1,998,006		$	1,997,647		$	1,994,835			$	2,052,477
Net reserves re-estimated:
One year later		1,143,701			1,397,821			1,538,929			1,593,829			1,743,774			1,867,438			1,932,787			1,955,225			1,941,210			1,958,136
Two years later		1,308,498			1,459,056			1,566,305			1,602,547			1,746,441			1,827,703			1,889,611			1,902,147			1,884,269
Three years later		1,369,239			1,501,724			1,605,840			1,622,733			1,719,799			1,786,263			1,844,392			1,843,354
Four years later		1,413,644			1,557,058			1,630,971			1,612,897			1,696,843			1,753,011			1,796,744
Five years later		1,478,729			1,585,986			1,636,248			1,608,069			1,681,098			1,717,327
Six years later		1,505,789			1,601,882			1,642,881			1,603,408			1,652,283
Seven years later		1,522,153			1,616,442			1,645,017			1,583,407
Eight years later		1,538,558			1,620,582			1,628,848
Nine years later		1,543,298			1,609,908
Ten years later		1,534,875

Cumulative amount of reserves paid:
One year later		372,642			437,855			490,353			389,968			395,159			405,441			454,182			438,056			433,127			476,460
Two years later		654,045			759,313			742,476			642,066			673,385			716,150			773,324			721,607			725,439
Three years later		884,746			935,691			921,520			835,193			892,400			913,883			931,820			923,051
Four years later		1,005,199			1,051,788			1,042,755			979,233			1,025,007			1,035,537			1,061,440
Five years later		1,076,672			1,127,999			1,130,739			1,067,068			1,095,662			1,114,593
Six years later		1,130,754			1,187,789			1,189,524			1,113,655			1,144,355
Seven years later		1,172,272			1,230,143			1,224,529			1,148,924
Eight years later		1,204,801			1,253,632			1,250,660
Nine years later		1,222,778			1,275,425
Ten years later		1,238,786

Cumulative redundancy/ (deficiency)		(387,358	)		(385,528	)		(114,300	)		29,967			108,915			176,426			170,350			154,652			113,378			36,699
Cumulative redundancy/ (deficiency) expressed as a percent of year-end reserves		(33.8	%)		(31.5	%)		(7.5	%)		1.9	%		6.2	%		9.3	%		8.7	%		7.7	%		5.7	%		1.8	%
Cumulative redundancy/ (deficiency) excluding pre-1986 reserve development ⁽¹⁾		(336,211	)		(336,562	)		(73,004	)		64,143			138,038			198,110			187,728			166,576			122,979			40,076

(1)	Excludes business 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, or for certain business assumed by the Mutual Company effective January 1, 2010 and for workers compensation business for accident years 2011 and following. 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,
	2011			2010			2009
	(in thousands)

Reserves for losses and loss settlement expenses, beginning of the year	$	1,554,065		$	1,559,164		$	1,558,249


Incurred losses and loss settlement expenses:
Provision for insured events of the current year		713,697			639,234			588,575
Decrease in provision for insured events of prior years		(32,061	)		(50,129	)		(36,084	)


Total incurred losses and loss settlement expenses		681,636			589,105			552,491


Payments:
Losses and loss settlement expenses attributable to insured events of the current year		311,828			249,831			204,192

Losses and loss settlement expenses attributable to insured events of prior years		378,469			344,373			347,384


Total payments		690,297			594,204			551,576


Reserves for losses and loss settlement expenses, end of the year	$	1,545,404		$	1,554,065		$	1,559,164

See page 10 for reconciliation of net reserves to gross reserves.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $32.1 million in 2011, primarily due to lower-than-expected claims severity broadly experienced across casualty lines in accident years 2003 through 2008, partially offset by adverse development in accident years 2009 and 2010. The 2011 net favorable development consisted of $30.9 million in commercial lines and $1.2 million in personal lines.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $50.1 million in 2010, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2004 through 2008, partially offset by a slight amount of adverse development in accident years prior to 2000. The 2010 net favorable development consisted of $44.8 million in commercial lines and $5.3 million in personal lines.

Harleysville Group recognized net favorable development in the provision for insured events of prior years of $36.1 million in 2009, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2002 through 2006, partially offset by adverse development in accident year 2008 and accident years prior to 2002. A lower-than-expected level of claims severity was observed in personal lines in accident year 2008, which led to the recognition of $2.3 million of favorable development in this accident year in 2009. This amount was offset by the recognition in 2009 of $2.6 million of adverse development in commercial lines in accident year 2008, primarily related to a higher-than-expected level of commercial property severity in this accident year. The 2009 net favorable development consisted of $31.5 million in commercial lines and $4.6 million in personal 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, 2008 increase in Harleysville Group’s pooling participation from 72% to 80% is reflected in the first line of the 2008 column. Amounts of assets equal to increases in net liabilities were transferred to Harleysville Group from the Mutual Company and Pennland 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 2007 column of the “Cumulative amount of reserves paid” portion of the table reflects the assets transferred in conjunction with the 2008 increase in the pooling percentage from 72% to 80% 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.

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

HARLEYSVILLE GROUP BUSINESS


	Year Ended December 31,
	2001			2002			2003			2004			2005			2006			2007			2008			2009			2010			2011
	(dollars in thousands)

Net reserve for losses and loss settlement expenses	$	800,861		$	857,182		$	1,062,660		$	1,131,609		$	1,237,090		$	1,329,849		$	1,381,812		$	1,558,249		$	1,559,164		$	1,554,065		$	1,545,404
Net reserves re- estimated:
One year later		796,213			976,241			1,075,122			1,114,076			1,219,005			1,307,802			1,350,004			1,522,165			1,509,035			1,522,004
Two years later		909,048			1,015,209			1,091,322			1,114,813			1,217,825			1,271,651			1,313,605			1,474,723			1,460,781
Three years later		947,660			1,042,276			1,114,275			1,126,248			1,192,149			1,236,640			1,272,450			1,424,987
Four years later		975,978			1,076,597			1,129,270			1,114,016			1,171,926			1,205,060			1,231,630
Five years later		1,017,319			1,094,325			1,129,129			1,108,295			1,154,351			1,173,811
Six years later		1,033,702			1,102,679			1,132,577			1,099,587			1,128,598
Seven years later		1,042,431			1,112,468			1,129,307			1,080,885
Eight years later		1,053,696			1,110,801			1,113,670
Nine years later		1,052,509			1,099,560
Ten years later		1,043,069
Cumulative amount of reserves paid:
One year later		265,422			312,224			350,082			278,270			281,655			289,661			207,275			347,384			344,373			378,469
Two years later		465,001			541,063			529,126			456,921			479,720			422,565			427,529			572,095			575,524
Three years later		628,494			665,513			655,219			593,715			570,384			577,691			584,196			730,551
Four years later		712,677			746,455			740,251			706,410			673,410			672,885			685,193
Five years later		761,490			799,069			764,877			773,618			727,804			733,431
Six years later		798,172			811,558			808,844			808,758			764,059
Seven years later		802,680			842,381			834,719			834,275
Eight years later		825,643			859,043			852,925
Nine years later		837,895			873,779
Ten years later		848,003

Net cumulative redundancy/ (deficiency)		(242,208	)		(242,378	)		(51,010	)		50,724			108,492			156,038			150,182			133,262			98,383			32,061

Net cumulative redundancy/ (deficiency) expressed as a percent of year end reserves		(30.2	%)		(28.3	%)		(4.8	%)		4.5	%		8.8	%		11.7	%		10.9	%		8.6	%		6.3	%		2.1	%

Gross reserve	$	879,056		$	928,335		$	1,219,977		$	1,317,735		$	1,480,802		$	1,493,645		$	1,546,690		$	1,767,601		$	1,782,292		$	1,771,661		$	1,789,591
Ceded reserve		78,195			71,153			157,317			186,126			243,712			163,796			164,878			209,352			223,128			217,596			244,187

Net reserve	$	800,861		$	857,182		$	1,062,660		$	1,131,609		$	1,237,090		$	1,329,849		$	1,381,812		$	1,558,249		$	1,559,164		$	1,554,065		$	1,545,404


Gross cumulative redundancy/ (deficiency)	$	(387,261	)	$	(391,128	)	$	(124,098	)	$	12,637		$	68,346		$	120,194		$	121,696		$	124,583		$	100,773		$	33,969


Gross re-estimated	$	1,266,317		$	1,319,463		$	1,344,075		$	1,305,098		$	1,412,456		$	1,373,451		$	1,424,994		$	1,643,018		$	1,681,519		$	1,737,692
Ceded re-estimated		223,248			219,903			230,405			224,213			283,858			199,640			193,364			218,031			220,738			215,688

Net re-estimated	$	1,043,069		$	1,099,560		$	1,113,670		$	1,080,885		$	1,128,598		$	1,173,811		$	1,231,630		$	1,424,987		$	1,460,781		$	1,522,004

Note: The amount of cash and investments received equal to the increase in liabilities for unpaid losses and loss settlement expenses was $153,535,000 for the change in pool participation in 2008.

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. 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. 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 subsidiary. 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 $23.5 million above a retention of $1.5 million for homeowners losses and $23.0 million above a retention of $2.0 million for other property losses. Harleysville Group’s 2011 pooling share of such recovery would be $18.8 million above a retention of $1.2 million for homeowners losses and $18.4 million above a retention of $1.6 million for other property losses. In addition, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiary are reinsured under property catastrophe reinsurance treaties which provide the following coverage:


	Property Catastrophe Reinsurance Treaties
	Full Treaties	Harleysville Group’s Pooling Share

Retention	$60 million	$48 million

Coverage for Losses	71.45% of losses between $60 and $90 million	71.45% of losses between $48 and $72 million
	75.7% of losses between $90 and $200 million	75.7% of losses between $72 and $160 million
	80.34% of losses between $200 and $475 million	80.34% of losses between $160 and $380 million
	75% of losses between $475 and $525 million	75% of losses between $380 and $420 million

Maximum Recovery	$363.1 million for losses of $525 million or more	$290.5 million for losses of $420 million or more

The treaties 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 treaties. Harleysville Group has not purchased funded catastrophe covers.

Effective January 1, 2012, the Company’s subsidiaries and the Mutual Company and its wholly owned subsidiary renewed the top layer of its property catastrophe reinsurance program and decreased reinsurance coverage in the layer from 75% to 64.35%. Accordingly, effective January 1, 2012, pursuant to the terms of the property catastrophe treaties, the maximum recovery would be $357.8 million for any catastrophe involving an insured loss equal to or greater than $525.0 million. Harleysville Group’s pooling share of this maximum recovery would be $286.3 million for any catastrophe involving an insured loss of $420.0 million or greater.

There is reinsurance to protect Harleysville Group from large workers compensation losses on a per-life and occurrence basis above a retention of $2.0 million. As a result of the January 1, 2011 change to the pooling agreement, Harleysville Group’s pooling share of this retention for workers compensation losses occurring in 2011 would be zero. In addition, casualty reinsurance (including liability, umbrella and workers compensation subject to per-life maximums) is maintained under an excess of loss treaty affording recovery to $47.5 million above a retention of $2.5 million for each loss occurrence for commercial lines coverages and recovery of up to $48.5 million above a retention of $1.5 million for personal lines coverages. Additionally, a 30% participation on losses of $2.5 million in excess of $2.5 million is retained on commercial lines coverages. Harleysville Group’s 2011 pooling share of a recovery would be up to $37.4 million above a retention of $2.0 million for commercial lines and $38.8 million above a retention of $1.2 million for personal lines. The casualty reinsurance programs provide coverage for a terrorist event with no reinstatement provision.

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 the Mutual Company 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, 2011 to June 30, 2012, the required retention is $500,000.

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, 2011, there were approximately 1,300 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, 2011, 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 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, as a result of which Harleysville Group may hold some non-investment grade securities.

Following the execution of the Merger Agreement, the Company determined that it was prudent to sell its equity securities portfolio holdings to reduce risks that could negatively impact the Company’s ability to meet various financial covenant closing conditions set forth in the Merger Agreement. Such sales occurred in the fourth quarter of 2011.

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, 2011:


	December 31, 2011
	Amount		Percent
	(dollars in thousands)

Rating(1)
U.S. Treasury obligations	$	434,308		18.7	%
U.S. agency obligations(2)		286,304		12.4
Aaa		529,280		22.8
Aa		791,701		34.1
A		244,012		10.5
Baa		28,880		1.2
Not rated		5,671		0.3


Total	$	2,320,156		100.0	%

(1)	Ratings assigned by Moody’s Investors Services, Inc., or Standard & Poor’s if Moody’s rating not available.

(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 46%, 44% and 42% of the total investment portfolio at December 31, 2011, 2010 and 2009, 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, 2011:


	December 31, 2011
	Amount		Percent
	(dollars in thousands)

Fixed maturities:
U.S. Treasury obligations	$	442,324		17.8	%
U.S. agency obligations		8,354		0.3
Mortgage-backed securities		294,617		11.9
Obligations of states and political subdivisions		1,225,735		49.3
Corporate securities		515,876		20.7


Total fixed maturities		2,486,906		100.0


Equity securities		7		—


Total	$	2,486,913		100.0	%

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


	Year Ended December 31,
	2011			2010			2009
	(dollars in thousands)

Invested assets(1)	$	2,268,808		$	2,229,368		$	2,188,955
Investment income(2)	$	89,910		$	100,504		$	103,971
Average yield		4.0	%		4.5	%		4.7	%

(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, 2011:


	December 31, 2011
	Amount		Percent
	(dollars in thousands)
Due in(1)

1 year or less	$	66,608		2.7	%
Over 1 year through 5 years		1,060,027		42.6
Over 5 years through 10 years		637,752		25.6
Over 10 years		427,902		17.2

		2,192,289		88.1

Mortgage-backed securities		294,617		11.9


Total	$	2,486,906		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, 2011 was approximately 4.3 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 and workers compensation, 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. In this regard, the Merger must be approved by the Commissioner of Insurance of the Commonwealth of Pennsylvania under the Pennsylvania laws governing the regulation of insurance companies and insurance holding companies. Nationwide submitted a Form A application to the Pennsylvania Insurance Commissioner on November 10, 2011.

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 Act was extended again through December 31, 2014 in December 2007 and retitled as the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA) of 2007. Under the program, the federal government will pay 85% 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 is $100 million in 2011 through 2014. TRIPRA adds coverage for domestic acts of terror, in addition to foreign acts of terror covered under the previous 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. This percentage is 20% for 2011 through 2014. The following lines of business are excluded from coverage and are not to be included in the

deductible calculation: commercial auto, burglary and theft, surety, professional liability and farmowners’ multi-peril insurance. Based on the Company’s insurance subsidiaries 2011 earned premiums for lines subject to the Act, our 2012 deductible would be $89.3 million.

The Act and TRIPRA require 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 2014, 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 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, 2011, $65.1 million would be available for distribution to Harleysville Group Inc. in 2012 without prior approval. The Company’s insurance subsidiaries declared dividends of $19.3 million, $89.0 million and $57.0 million in 2011, 2010 and 2009, respectively. The Company’s insurance subsidiaries paid dividends of $43.4 million in 2011 ($24.1 million of which had been declared in 2010), $94.3 million in 2010 ($29.5 million of which had been declared in 2009), and $27.5 million in 2009.

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,
	2011			2010			2009			2011			2010
							(in thousands)

SAP amounts	$	43,736		$	68,429		$	90,892		$	628,670		$	695,475
Adjustments:
Deferred policy acquisition costs		(12,741	)		2,348			1,310			101,256			113,997
Deferred income taxes		(994	)		(760	)		(3,385	)		(23,961	)		(43,220	)
Unrealized investment gains											166,750			96,004
Pension		(1,584	)		(768	)		877			(70,599	)		(49,302	)
Non-admitted assets											3,436			4,382
Other, net		(2,100	)		(793	)		(1,308	)		14,503			10,114
Holding company(1)		(3,705	)		(1,558	)		(2,090	)		(66,499	)		(58,817	)


GAAP amounts	$	22,612		$	66,898		$	86,296		$	753,556		$	768,633

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

Business - 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 53% of the issued and outstanding common stock of Harleysville Group Inc. at December 31, 2011. 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, and was amended and restated effective January 1, 1994, under which Harleysville Group receives a management fee. The agreement was subsequently amended effective January 1, 2010 to include voluntary assumed reinsurance business written by the Mutual Company. Harleysville Group received $8.5 million, $5.8 million, and $5.1 million for the years ended December 31, 2011, 2010 and 2009, 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 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 $4.5 million for 2011, $4.4 million for 2010 and $4.2 million for 2009. 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 HIC New York in 1991, the Company borrowed $18.5 million from the Mutual Company. See Note 8 of the Notes to Consolidated Financial Statements. For additional information with respect to transactions with the Mutual Company, see Note 3 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, 2011, there were 1,717 employees. The Company considers its relationships with its employees to be good. They also provide a variety of services to the Mutual Company and its wholly owned subsidiaries. See “Business-Relationship with the Mutual Company” and Note 3 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 (the Exchange Act), are available free of charge on our website as soon as practicable after electronic filing of such material with, or furnishing it to, the U.S. Securities and Exchange Commission. This information may be read and copied at the Public Reference Room of the SEC at 100 F Street, N.E., Washington, D.C., 20549. The SEC also maintains an internet web site that contains reports, proxy statements, and other information about issuers, like Harleysville Group Inc., who file electronically with the SEC. The address of the site is http://www.sec.gov.

Item 1A.

Risk Factors.

For the Company’s risk factors, see “Management’s Discussion and Analysis - Risk Factors.”

Item 1B.

Unresolved Staff Comments.

None.

Item 2.

Properties

The buildings which house the headquarters of Harleysville Group and the Mutual Company in Harleysville, Pennsylvania are leased to the Mutual Company by a subsidiary of Harleysville Group. See “Business-Relationship with the Mutual Company.” The Mutual Company charges Harleysville Group for an appropriate portion of the rent under an intercompany allocation agreement. See “Certain Relationships and Related Transactions, and Director Independence,” Item 13 in Part III of this Form 10-K. The buildings containing the headquarters of Harleysville Group and the Mutual Company have approximately 220,000 square feet of office space. Harleysville Group also rents office facilities in certain of the states in which it does business.

Item 3.

Legal Proceedings.

Stockholder Lawsuits

Louisiana Municipal Police Employees Retirement System v. Harleysville Group Inc., et al.

On October 4, 2011, the Company, the Mutual Company, the Company’s directors, Nationwide and a subsidiary of Nationwide (Merger Sub) were named as defendants in a putative class action complaint in the Court of Chancery of the State of Delaware, captioned Louisiana Municipal Police Employees Retirement System v. Harleysville Group Inc., et al. That action, purportedly brought on behalf of a class of stockholders, alleges that the Company’s directors breached their fiduciary duties of care, loyalty, good faith, candor and independence. The complaint further alleges that the Company’s directors, through their acts, transactions and courses of conduct, are attempting to unfairly deprive stockholders of the true value of their investment in the Company. The complaint further alleges that there exists an imbalance and disparity of knowledge between our directors and our public stockholders which makes it inherently unfair for the Company’s directors to benefit from their own interests to the exclusion of maximizing stockholder value. The complaint further alleges that the Company’s directors failed to disclose to the plaintiffs all material information necessary to cast an informed stockholder vote on the proposed transaction. The complaint further alleges that Nationwide and Merger Sub aided and abetted the claimed breaches of fiduciary duties by our directors. The plaintiff seeks injunctive and other equitable relief, including a request that the court enjoin us from consummating the Merger, as well as damages, fees and costs. To date, by agreement of the parties, the Company has not filed an answer to this complaint.

Eric H. Berger v. Harleysville Group Inc., et al.

On October 6, 2011, the Company, the Mutual Company, the Company’s directors, Nationwide and Merger Sub were named as defendants in a putative class action complaint in the Court of Chancery of the State of Delaware, captioned Eric H. Berger v. Harleysville Group Inc., et al. That action, purportedly brought on behalf of a class of stockholders, alleges that the Company’s directors breached their fiduciary duties of care, loyalty, good faith, candor and independence. The complaint further alleges that the directors, through their acts, transactions and courses of conduct, are attempting to unfairly deprive our stockholders of the true value of their investment in the Company. The complaint further alleges that there exists an imbalance and disparity of knowledge between the Company’s directors and its public stockholders which makes it inherently unfair for the Company’s directors to benefit from their own interests to the exclusion of maximizing stockholder value. The complaint further alleges that the directors failed to disclose to the plaintiffs all material information necessary to cast an informed stockholder vote on the proposed transaction. The complaint further alleges that Nationwide and Merger Sub aided and abetted the claimed breaches of fiduciary duties by the Company’s directors. The plaintiff seeks injunctive and other equitable relief, including a request that the court enjoin the Company from consummating the Merger, as well as damages, fees and costs. To date, by agreement of the parties, the Company has not filed an answer to this complaint.

Consolidated Stockholder Lawsuits

The plaintiffs in both the Louisiana Municipal Police Employees Retirement System and the Berger cases are represented by the same law firm. On October 21, 2011, the Court of Chancery of Delaware entered an order agreed to by counsel for the plaintiffs and counsel for the Company, the Mutual Company, the Company’s directors, Nationwide and Merger Sub consolidating both cases. On January 3, 2012, the plaintiffs filed their Consolidated Amended Class Action Complaint, which adds allegations about the sale process, asserting that there was not a vigorous enough effort to find other buyers at a higher price together with alleged disclosure shortfalls, all by reference to the preliminary proxy statement filed by the Company with the SEC on December 23, 2011. To date, by agreement of the parties, the Company has not filed an answer to the Consolidated Amended Class Action Complaint.

Policyholder Lawsuits

After the announcement of the Merger Agreement, the Mutual Company received five letters on behalf of purported policyholders objecting to the merger of the Mutual Company into Nationwide (the Parent Merger). Six lawsuits were filed against the Mutual Company brought by purported policyholders challenging the proposed transaction. Initially, Nationwide was named as a defendant in three of these suits. Since their initial filing, three of the lawsuits against the Mutual Company have been dismissed and the remaining three consolidated into one action. For additional procedural history regarding the original policyholder actions, please see the Harleysville Group Definitive Proxy Statement, to be filed in March 2012.

On January 20, 2012, pursuant to a Court Order, plaintiffs filed a Consolidated Class Action and Derivative Complaint (the CCADC) on behalf of the three plaintiffs with continuing lawsuits against the Mutual Company. The CCADC contains nine claims variously stated as being derivative and/or class in nature: (1) declaratory and injunctive relief contending that the Merger and the Parent Merger (the Mergers) are fundamentally unfair; (2) declaratory and injunctive relief contending that the draft proxy statement for the policyholders-members of the Mutual Company, which was filed by the Mutual Company with the Pennsylvania Insurance Department on December 23, 2011, is materially misleading; (3) declaratory relief contending that the Merger Agreement prevents the Special Litigation Committee formed by the Mutual Company’s board of directors from performing its authorized function; (4) equitable relief contending that the Mutual Company has been effectively demutualized; (5) breach of duty by the Mutual Company’s directors; (6) aiding and abetting a breach of duty by the Mutual Company’s directors, Nationwide and Merger Sub; (7) unjust enrichment against the Mutual Company’s directors, the two directors of the Company who are only directors of the Company, the Mutual Company, Nationwide and Merger Sub; (8) constructive trust against the Mutual Company, Nationwide and Merger Sub; and (9) declaratory and injunctive relief to enjoin enforcement of allegedly unlawful provisions of the Merger Agreement against Nationwide and the Company. On January 31, 2012, all defendants filed preliminary objections to the CCADC. The preliminary objections are pending.

The Harleysville Mutual Special Litigation Committee

In response to the demands and complaints, the Mutual Company’s Board of Directors established a Special Litigation Committee to investigate the claims set forth in the demands and complaints and to determine the most appropriate actions for the Mutual Company to take in response to them. The Special Litigation Committee consists of three newly appointed independent directors of the Mutual Company. None of the members of the Special Litigation Committee own any stock of the Company. On February 8, 2012, the Court issued an Order which granted the Special Litigation Committee’s motion to have until March 1, 2012 to issue its report on its investigation.

On March 1, 2012, the Special Litigation Committee issued a report of its investigation, which concluded that: (1) the Mutual Company directors had fulfilled their fiduciary obligations and had not breached their duties of care and loyalty in negotiating and entering into the Merger Agreement with Nationwide; (2) the Merger Agreement transaction is intrinsically fair and satisfies the standards of both fair process and fair result; (3) the derivative claims filed by the plaintiffs lack merit; (4) it is in the best interests of the Mutual Company that the plaintiffs’ derivative claims be dismissed; (5) the Parent Merger is in the best interests of the Mutual Company, including its policyholders; and (6) substantial delay in the consummation of the Parent Merger would be damaging to the Mutual Company and, therefore, the Parent Merger should proceed without further disruption. On the same day, the Special Litigation Committee filed a motion to dismiss the derivative claims contained in the CCADC.

Other

On January 7, 2011, the South Carolina Supreme Court held in Crossmann v Harleysville Mutual Insurance Company (Opinion No. 26909, January 7, 2011) that a contractor’s or subcontractor’s negligent/faulty work does not constitute an “occurrence” under the applicable Commercial general liability policy. In May 2011, the South Carolina legislature passed legislation to overturn the Crossmann decision. The law purported to impact all pending and future claims. The constitutionality of the retroactive application of the legislation is now being challenged.

Item 4.

Mine Safety Disclosures

Not applicable.

PART II

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The stock of Harleysville Group Inc. is quoted on the NASDAQ National Market System, and assigned the symbol HGIC. At the close of business on March 8, 2012, the approximate number of holders of record of Harleysville Group Inc.’s common stock was 2,378 (counting all shares held in single nominee registration as one stockholder).

The payment of dividends is subject to the discretion of Harleysville Group Inc.’s Board of Directors which considers, among other factors, Harleysville Group’s operating results, overall financial condition, capital requirements and general business conditions each quarter. As a holding company, one of Harleysville Group Inc.’s sources of cash with which to pay dividends is dividends from its subsidiaries. Harleysville Group Inc.’s insurance company subsidiaries are subject to state laws that restrict their ability to pay dividends. See Note 9 of the Notes to Consolidated Financial Statements and “Business - Regulation.”

The following table sets forth the amount of cash dividends declared per share, and the high and low trading price as reported by NASDAQ for Harleysville Group Inc.’s common stock for each quarter during the past two years.


	High		Low		Cash Dividends Declared
2011
First Quarter	$	37.66	$	30.55	$	.360
Second Quarter		33.91		29.50		.360
Third Quarter		59.00		24.75		.380
Fourth Quarter		59.76		53.51		.000

	High		Low		Cash Dividends Declared
2010
First Quarter	$	35.33	$	30.98	$	.325
Second Quarter		34.21		30.55		.325
Third Quarter		33.41		30.31		.360
Fourth Quarter		37.81		32.22		1.800	⁽¹⁾

(1)	Includes a special dividend of $1.44 per share.

Securities Authorized for Issuance Under Equity Compensation Plans. See “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” Item 12 in Part III of this Form 10-K.

Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Issuer Purchases of Equity Securities ⁽¹⁾


Period	Total Number of Shares Purchased ⁽²⁾		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs

October 1 - October 31, 2011		1,492	$	59.00		-0-		554,916
November 1 - November 30, 2011		5,714	$	59.06		-0-		554,916
December 1 - December 31, 2011		144,421	$	58.50		-0-		554,916

Total		151,627

(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 December 31, 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.

(2)

In accordance with the terms of its Equity Incentive Plan, the Company acquired all of the above shares from employees in connection with stock option exercises and the vesting of restricted stock and restricted stock unit awards. 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 of stock awards.

Stock Performance Chart.

The following graph shows changes over the past five-year period (all full calendar-year periods) in the value of $100 invested in: 1) Harleysville Group common stock; 2) the NASDAQ National Market System index; and 3) the Peer Group index. All values are as of the last trading day of each year.

Comparison of 5-Year Cumulative Total Stockholder Return

LOGO


	2006		2007		2008		2009		2010		2011
Harleysville Group Inc.		100.00		104.31		105.61		100.66		126.05		199.73
NASDAQ National Market System Index		100.00		108.47		66.35		95.38		113.19		113.81
Peer Group Index		100.00		95.57		81.69		80.22		96.46		104.98

The year-end values of each investment shown in the preceding graph are based on share price appreciation plus dividends, with the dividends reinvested as of the day such dividends were ex-dividend. The calculations exclude trading commissions and taxes. Total stockholder returns from each investment, whether measured in dollars or percentages, can be calculated from the year-end investment values shown in the legend.

The graph was prepared by Zacks Investment Research, Inc. (Zacks). The NASDAQ National Market System index includes all U.S. Companies in the NASDAQ National Market System and the Peer Group index includes 28 NASDAQ Company stocks in SIC Major Group 633 (SIC 6330-6339: U.S. and foreign, fire, marine and casualty insurance). A complete list of these companies may be obtained from Zacks, 111 North Canal Street, Suite 1101, Chicago, Illinois 60606; (800)767-3771. Zacks reweights the indices daily, using the market capitalization on the previous trading day.

Item 6.

Selected Financial Data.

At December 31, 2011, the Mutual Company owned approximately 53% of the Common Stock of the Company. Harleysville Group Inc. and its wholly owned subsidiaries are engaged in property and casualty insurance. These subsidiaries are: Harleysville-Atlantic Insurance Company, Harleysville Insurance Company, Harleysville Insurance Company of New Jersey, Harleysville Insurance Company of New York, Harleysville Insurance Company of Ohio, Harleysville Lake States Insurance Company, Harleysville Preferred Insurance Company, Harleysville Worcester Insurance Company, and Harleysville Ltd., a real estate partnership that owns the home office. Harleysville-Atlantic Insurance Company and Harleysville Insurance Company of Ohio were merged into Harleysville Worcester Insurance Company in December 2011.


	Year Ended December 31,
	2011			2010		2009		2008			2007
	(in thousands, except per share data)
Income Statement Data⁽¹⁾:
Premiums earned	$	804,508		$	866,350	$	858,500	$	918,515		$	833,024
Investment income, net		95,401			103,313		106,649		113,555			110,827
Realized investment gains (losses)		75,478			597		2,293		(59,841	)		875
Total revenues		995,159			986,272		980,620		985,316			962,012
Income before income taxes		16,261			82,712		115,998		50,962			142,995
Income tax expense (benefit)		(6,351	)		15,814		29,702		8,643			42,941
Net income		22,612			66,898		86,296		42,319			100,054
Basic earnings per share	$	0.82		$	2.43	$	3.09	$	1.45		$	3.21
Diluted earnings per share	$	0.81		$	2.42	$	3.07	$	1.43		$	3.17
Cash dividends per share	$	1.10		$	2.81	$	1.25	$	1.10		$	0.88

Balance Sheet Data at Year End:
Total investments	$	2,616,301		$	2,661,476	$	2,639,814	$	2,473,592		$	2,358,473
Total assets		3,267,069			3,278,232		3,301,986		3,155,318			3,072,445
Debt		118,500			118,500		118,500		118,500			118,500
Shareholders’ equity		753,556			768,633		772,628		652,634			758,841
Shareholders’ equity per share	$	27.66		$	28.42	$	27.98	$	23.18		$	25.03

(1)

The Company’s insurance subsidiaries participate in an underwriting pooling arrangement with the Mutual Company and Pennland. Harleysville Group’s participation was 80% for 2008 through 2011 and 72% for 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3(a) of the Notes to Consolidated Financial Statements.

Item 7.

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 control of Harleysville Group Inc. (the Company) and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect on the Company and its wholly owned property and casualty insurance subsidiaries (collectively, 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. In addition, see “Management’s Discussion and Analysis - Risk Factors.”

Overview

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

•

net premium income;

•

investment income and realized investment gains (losses);

•

amounts paid or reserved to settle insured claims; and

•

other income and expense.

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

•

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

•

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

•

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

•

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

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

•

general interest rate levels and financial market conditions;

•

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

•

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

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

•

the quality of the risks underwritten by the Company;

•

the nature and severity of catastrophic losses;

•

the availability, cost and terms of reinsurance; and

•

underlying settlement costs, including medical and legal costs.

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

•

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

•

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

•

the interest rate on debt issued by the Company.

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

Critical Accounting Policies and Estimates

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require Harleysville Group to make estimates and assumptions (see Note 1 of the Notes to Consolidated Financial Statements). 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.

Liabilities 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. 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. If the Company does not intend to sell, or more likely than not will not be required to sell, a fixed maturity security whose fair value has declined below its cost, the amount of the decline below cost due to credit-related reasons is charged to earnings and the remaining difference is included in comprehensive income. Harleysville Group monitors its investment portfolio and at least quarterly reviews investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations consider, among other things, the magnitude and reasons for a decline, the prospects for the fair value to recover in the near term and Harleysville Group’s intent to retain the investment for a period of time sufficient to allow for a recovery in value. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future.

The severe downturn in the public debt and equity markets in 2008, 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 are written off and further analyses are performed to determine if an additional liability would need to be accrued.

Contingencies. Besides claims related to its insurance products, Harleysville Group is subject to proceedings, lawsuits and claims in the normal course of business. Harleysville Group assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will be consistent with those assessments.

The application of certain of these critical accounting policies to the years ended December 31, 2011 and 2010 is discussed in greater detail below.

Results of Operations

Harleysville Group underwrites property and casualty insurance in both the personal and commercial lines of insurance. The personal lines of insurance include both auto and homeowners, and the commercial lines include auto, commercial multi-peril and workers compensation. The business is marketed primarily in the eastern and midwestern United States through independent agents.

Historically, Harleysville Group’s results of operations have been influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry have been subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

Harleysville Group’s premium growth and underwriting results have been, and continue to be, influenced by market conditions. Insurance industry price competition has often made it difficult both to obtain and to retain properly priced personal and commercial lines business. It is management’s policy to continue to maintain its underwriting standards.

Property and casualty insurance premiums are established before the amount of losses and loss settlement expenses, or the extent to which inflation may affect such expenses, are known. Consequently, Harleysville Group attempts, in establishing rates, to anticipate the potential impact of inflation. In the past, inflation has contributed to increased losses and loss settlement expenses.

The key elements of Harleysville Group’s business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general as described above and factors unique to Harleysville Group as described in the following discussion.

Transactions with Affiliates

On September 28, 2011, the Company and Harleysville Mutual Insurance Company (the Mutual Company) entered into an agreement and plan of merger (the Merger Agreement) with Nationwide Mutual Insurance Company (Nationwide) under which a subsidiary of Nationwide would merge into the Company. Nationwide would acquire all of the publicly held shares of common stock of the Company for $60.00 per share in cash, and the Mutual Company would merge into Nationwide and the policyholders and members of the Mutual Company would become policyholders and members of Nationwide. The Mutual Company has also entered into a voting agreement with Nationwide (the Voting Agreement) under which the Mutual Company 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 activities and taking certain actions without Nationwide’s prior approval, including among others, the payment of stockholder 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 the first half of 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.

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). The pooling agreement provides for the allocation of premiums, losses, loss settlement expenses and underwriting expenses between Harleysville Group and the Mutual Company. Harleysville Group is not liable for any losses incurred by the Mutual Company or Company subsidiaries Harleysville Preferred Insurance Company (Preferred) and Harleysville Insurance Company of New Jersey (HNJ) prior to January 1, 1986, the date the pooling agreement became effective, or for certain business assumed by the Mutual Company effective January 1, 2010. Harleysville Group’s participation in the pool has been 80% since January 1, 2008.

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 transferred to the Mutual Company, which ceding commission reduced deferred policy acquisition costs.

Because the pooling agreement does not relieve Harleysville Group of primary liability as the originating insurer, there is a concentration of credit risk arising from business ceded to the Mutual Company. However, the pooling agreement provides for the right of offset and the amount of credit risk with the Mutual Company was not material at December 31, 2011 and 2010. The Mutual Company has an A. M. Best rating of “A” (Excellent).

On December 30, 2010, Harleysville Group Inc. acquired Mainland Insurance Company (Mainland) from the Mutual Company for $4,825,000 in cash. On December 31, 2010, HIC New York was merged into Mainland and Mainland’s name was changed to Harleysville Insurance Company of New York (HIC New York). As a result of this transaction, HIC New York was redomesticated from New York to Pennsylvania.

Harleysville Ltd. is a subsidiary of the Company and leases the home office to the Mutual Company, which shares the facility with Harleysville Group. Rental income under the lease was $4.5 million, $4.4 million and $4.2 million for 2011, 2010 and 2009, respectively, and is included in other income after elimination of intercompany amounts of $3.2 million, $3.0 million and $2.9 million in 2011, 2010 and 2009, respectively. The lease had a five-year term expiring December 31, 2009 and included a formula for additional rent for any additions, improvements or renovations. The lease was renewed for one-year periods expiring December 31, 2012, December 31, 2011 and December 31, 2010 under its prior terms. The Mutual Company is responsible for the building operating expenses including maintenance and repairs. The pricing of the lease was based upon an appraisal obtained from an independent real estate appraiser.

Harleysville Group provides certain management services to the Mutual Company and other affiliates. Harleysville Group received a fee of $8.5 million, $5.8 million and $5.1 million in 2011, 2010 and 2009, respectively, for its services under these management agreements. Effective January 1, 2010, the management agreement was amended to include voluntary assumed reinsurance business written by the Mutual Company. The level of fees has been approved by each state insurance department having jurisdiction. Under related agreements, Harleysville Group serves as the paymaster for the Harleysville companies, with each company being charged for its proportionate share of salary and employee benefits expense.

The Company’s insurance subsidiaries and the Mutual Company are parties to an Equipment and Supplies Allocation Agreement whereby equipment and supplies are shared between parties. Ultimate expense for such items is allocated to Harleysville Group based on its pooling participation. The Mutual Company has purchased and developed certain equipment and software which is expensed by Harleysville Group based on its pooling participation as the items are depreciated or amortized.

Intercompany balances are created primarily from the pooling arrangement (settled quarterly), allocation of common expenses, collection of premium balances and payment of claims (settled monthly). No interest is charged or received on intercompany balances due to the timely settlement terms and nature of the items.

Harleysville Group borrowed $18.5 million from the Mutual Company in connection with the acquisition of Harleysville Insurance Company of New York (HIC New York) in 1991. It was a demand loan with a stated maturity in March 1998 which had been extended to March 2005. In February 2005, the maturity was extended again to March 2012 and the interest rate became LIBOR plus 0.45%, which was a commercially reasonable market rate in 2005. Interest expense on this loan was $0.1 million, $0.1 million, and $0.3 million in 2011, 2010 and 2009, respectively.

Harleysville Group has no material relationships with current or former members of management other than compensatory plans and arrangements disclosed or described in the Company’s public filings.

Off Balance Sheet Arrangements

Harleysville Group has off-balance-sheet credit risk related to approximately $97.3 million and $99.6 million of premium balances due to the Mutual Company from agents and insureds at December 31, 2011 and 2010,

respectively. The Mutual Company bills and collects such receivables on behalf of Harleysville Group for efficiency reasons. Harleysville Group recognizes any associated bad debts, which have not been material.

2011 Compared to 2010

Premiums earned decreased $61.8 million, or 7.1%, for the year ended December 31, 2011 compared to 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 2.1% for the year ended December 31, 2011 compared to the prior year.

Premiums earned for commercial lines decreased $83.8 million, or 12.4%, compared to the prior year primarily due to the change to the pooling agreement described in the preceding paragraph. Excluding 2010 premiums earned on workers compensation business, premiums earned decreased 0.9% for the year ended December 31, 2011 compared to the prior year. Premiums earned for personal lines increased $22.0 million, or 11.6%, compared to the prior year primarily due to higher average premiums and greater policy counts.

Investment income decreased $7.9 million for the year ended December 31, 2011, primarily due to a lower investment yield on fixed income securities and lower average invested assets, partially offset by greater dividends on equity securities. Average invested assets were lower due to negative operating cash flow in 2011 and use of the proceeds from the sale of these investments to pay dividends in 2011 and 2010, and repurchase shares in 2010.

Net realized investment gains increased $74.9 million for the year ended December 31, 2011, compared to the prior year primarily due to gains on the sale of equity securities in 2011. In October 2011, the Company sold virtually all of its equity securities, at a gain of $62 million, in order to reduce potential volatility in statutory surplus. Prior to this sale, the Company recognized impairment charges of $3.6 million on equity securities. Impairment charges of $0.4 million were also recognized on fixed maturity securities the Company sold in 2011. There were no credit-related impairment charges in 2010.

Harleysville Group holds securities with unrealized losses at December 31, 2011 as follows:


					Length of Unrealized Loss
	Fair Value		Unrealized Loss		Less Than 12 Months
	(in thousands)

Fixed maturities:
Obligations of states and political subdivisions	$	8,976	$	19	$	19
Corporate securities		7,956		29		29

Total temporarily impaired securities	$	16,932	$	48	$	48

Of total fixed maturity securities with an unrealized loss at December 31, 2011, securities with a fair value of $11.0 million and an unrealized loss of $22,000 are classified as available for sale and are carried at fair value on the balance sheet while securities with a fair value of $6.0 million and an unrealized loss of $26,000 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 the expected call of a municipal bond and the widening of credit spreads on securities in the financial sector. Per the Company’s 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 worsening economic conditions, these investments may be written down in the income statement in the future.

The fair value and amortized cost of general obligation and special revenue bonds held by the Company as of December 31, 2011 is as follows:


	Fair Value		Amortized Cost
	(in thousands)

General obligation bonds	$	864,584	$	789,370
Special revenue bonds		363,576		336,982


Total	$	1,228,160	$	1,126,352

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	$	116,167	$	106,130		Aa
Water & sewer		97,839		91,071		Aaa
Transportation		48,759		45,294		Aa
Escrowed To Maturity/Pre-refunded		41,252		39,640		Aa


Total	$	304,017	$	282,135

Income before income taxes decreased $66.5 million for the year ended December 31, 2011 compared to the prior year. The decrease was primarily due to a greater underwriting loss in 2011 compared to 2010 and a decrease in investment income, partially off set by greater realized gains in 2011.

An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of (1) the ratio of incurred losses and loss settlement expenses to net earned premium, (2) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses to net written premium, and (3) the ratio of dividends to policyholders to net earned premium. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. Harleysville Group’s statutory combined ratio increased to 119.9% for the year ended December 31, 2011 from 102.5% for the year ended December 31, 2010. The combined ratio for 2011 includes 0.9% due to the impact of the statutory treatment of the ceding commission received on the unearned premiums transferred to the Mutual Company on January 1, 2011. Excluding the impact of the pool transfer, the statutory combined ratio was 119.0% for 2011. The increase in the combined ratio was primarily due to greater catastrophe losses, greater non-catastrophe weather losses and less favorable development in 2011. Net catastrophe losses increased to $93.2 million (11.6 points) for 2011 from $35.7 million (4.1 points) for 2010.

The statutory combined ratios by line of business for the year ended December 31, 2011 as compared to the year ended December 31, 2010 are shown below.


	For the Year Ended December 31,
	2011			2010
Commercial:
Automobile		105.4	%		100.0	%
Workers compensation					106.1	%
Commercial multi-peril		127.6	%		106.1	%
Other commercial		98.7	%		88.8	%
Total commercial		116.7	%		102.3	%
Total commercial without intercompany pooling transfer		115.4	%

Personal:
Automobile		119.4	%		104.9	%
Homeowners		148.9	%		108.2	%
Other personal		75.9	%		62.6	%
Total personal		129.3	%		103.5	%
Total personal and commercial		119.9	%		102.5	%
Total personal and commercial without intercompany pooling transfer		119.0	%

The commercial lines statutory combined ratio increased to 115.4% (excluding the impact of the pooling transfer) for the year ended December 31, 2011 from 102.3% for the year ended December 31, 2010. This increase was primarily due to unusually high catastrophe and non-catastrophe weather losses experienced in all four quarters of 2011. In the first quarter of 2011, unusually severe winter weather resulted in catastrophe and non-catastrophe losses that contributed to elevated loss activity, particularly in the Northeast and Mid-Atlantic regions. In the second quarter of 2011, all regions were significantly impacted by catastrophes, with the Southeast and Midwest regions being most adversely affected due to tornado and hail losses. In the third quarter of 2011, Hurricane Irene, Tropical Storm Lee, and other hail and windstorm events contributed to significant losses, particularly in the Northeast and Mid-Atlantic regions. In the fourth quarter of 2011, an unusual October snow event contributed to losses in the Mid-Atlantic and the Northeast regions. Catastrophe losses in the commercial lines represented 9.2 points of the combined ratio in calendar year 2011 compared to 2.6 points in calendar year 2010. The commercial automobile line of business also contributed to the overall increase in the commercial lines combined ratio in 2011. The increase in the commercial automobile combined ratio from 100.0% for the year ended December 31, 2010 to 105.4% for the year ended December 31, 2011 is primarily due to higher than expected frequency and severity in accident year 2011.

The personal lines statutory combined ratio increased to 129.3% for the year ended December 31, 2011 from 103.5% for the year ended December 31, 2010. The increase in the personal lines combined ratio for the year ended December 31, 2011 is primarily due to higher catastrophe and non-catastrophe weather losses affecting property coverages during 2011. The unusually severe weather described for commercial lines also impacted personal lines during 2011. Catastrophe losses in the personal lines represented 18.3 points of the combined ratio in calendar year 2011 compared to 9.7 points in calendar year 2010. The personal automobile line of business also contributed to the overall increase in the personal lines combined ratio in 2011. The increase in the personal automobile combined ratio from 104.9% for the year ended December 31, 2010 to 119.4% for the year ended December 31, 2011 is primarily due to higher than expected frequency and severity in accident years 2010 and 2011.

Reserves for unpaid losses and loss settlement expenses are estimated for case reserves and losses incurred but not reported (IBNR) separately. The sum of case reserves and IBNR represents the Company’s estimate of total unpaid loss and loss settlement expense. Case reserves are determined for each reported claim by the Company’s claims organization reflecting the known circumstances of the individual claim. The Company’s actuaries calculate IBNR by reducing their estimate of ultimate loss and loss settlement expense by cumulative paid loss and loss settlement expense and case reserves. Ultimate losses are re-estimated for each line of business on a quarterly basis using the most current loss and claim data as of the quarter end.

In addition to analyzing reserves on a line of business basis, reserving categories are identified and reviewed. For example, the following categories for the Commercial Auto Liability line of business are analyzed quarterly: Commercial Auto Liability Bodily Injury; Commercial Auto Liability Property Damage; and Commercial Auto Liability Excess. In the discussion that follows, these categories are referred to by the label “line of business.” In the course of our quarterly reserve estimation process, several standard loss reserving methods and procedures are utilized to derive estimates of ultimate loss for each line of business, including:

•

Paid Loss Development Method

•

Incurred Loss Development Method

•

Incurred Counts and Averages Method (Based on Exponential Fit of Severity)

•

Bornhuetter-Ferguson Method

Any individual method used to estimate loss reserves has its advantages and disadvantages based on trends, changes within the external business environment, changes in internal company processes and procedures and any bias that may be inherent in the methodology. The actuaries give consideration to the relative strengths and weaknesses of each of the methods to derive a selected point estimate within the range. Following is a general description of each of the methods used:

•

Paid Loss Development Method: The Paid Loss Development Method uses historical payment patterns to project future payments as of a given evaluation date to ultimate loss. Estimates using this method are not affected by changes in case reserving practices that might have occurred during the review period, but may be understated as this method does not take into account large unpaid claims. This method is also susceptible to any changes in the rate of claim settlements or shifts in the size of claims settled.

A number of indications of ultimate loss may be produced from the Paid Loss Development Method since a number of loss development factors (LDFs) may be selected. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections as judged appropriate, such as:

•

3-Year Average (straight average and loss-weighted average)

•

5-Year Average (straight average and loss-weighted average)

•

5-Year Excluding Highest and Lowest LDFs

•

All-Year loss-weighted average

•

Selected LDF Pattern (LDFs are selected for each evaluation based on the actuaries’ review of the historical development)

•

Incurred Loss Development Method: The Incurred Loss Development Method is similar to the paid method, but instead uses historical incurred (case reserves plus payments) patterns to project future incurred losses as of a given evaluation date to ultimate loss. In many cases, the incurred development method is preferred over the paid method as it includes the additional information provided by the aggregation of individual case reserves. The resulting LDFs tend to be lower and more stable than those of the paid development method. However, the incurred development method may be affected by changes in case reserving practices and any unusually large individual claims.

As with the Paid Loss Development Method, various indications of ultimate loss may be produced from the Incurred Loss Development Method. The actuaries produce and review several indications of ultimate loss using this method based on various LDF selections.

•

Incurred Counts and Averages Method: This method is used to estimate ultimate loss by separately estimating ultimate counts and severity (average loss per claim) components of ultimate loss. Both the ultimate claim counts and ultimate severity are estimated using a loss development factor approach similar to the Incurred Loss Development Method. For this reason, the same considerations discussed in the Incurred Loss Development Method apply to this method as well.

An ultimate severity is selected by fitting a curve to the historical ultimate severities indicated using the ratio of the ultimate loss and ultimate claim counts. This method yields ultimate severities that are based on the underlying historical trends in the data. Ultimate claim counts and ultimate severities are multiplied together to produce an estimate of ultimate losses.

This method is useful in more recent accident years where the data is not mature and is especially useful when loss development patterns are volatile or not well established.

•

Bornhuetter-Ferguson Method: The Bornhuetter-Ferguson Method is a blended method that explicitly takes into account both actual loss development to date and expected future loss emergence. Two versions of this method may be used: one based on paid loss and one based on incurred loss. This method uses the selected loss development patterns from the Development Methods to calculate the expected percentage of loss unpaid (or unreported). The expected component of the method is calculated by multiplying earned premium for the given exposure period by a selected a priori loss ratio. The resulting dollars are then multiplied by the expected percentage of unpaid (or unreported) loss described above. This provides an estimate of future loss payments (or reporting) that is then added to actual paid (or incurred) loss data to produce estimated ultimate loss.

Each of the methodologies described above (and their derivatives) are reviewed for each line of business. This approach allows the actuaries to identify and respond to the unique characteristics of each line of business. Further, since long-term historical data is reviewed, changes in development patterns within a line of business may likewise be identified and considered in the actuaries’ process of selecting ultimate loss.

An actuarial central estimate, which is management’s best estimate, of ultimate loss is selected for each line of business based on a review of the indications produced by the above methodologies. More consideration is given to those methods that the actuaries deem to be more appropriate in a particular situation. In addition, other metrics such as claim closing ratios, average case reserve levels, paid loss to incurred loss ratios, individual large loss information, and recent insurance pricing changes are reviewed to help the actuaries select the most appropriate estimates of ultimate loss.

The selection of the ultimate loss is based on information unique to each line of business and accident year and the judgment and expertise of the actuaries.

•

Short-Tail versus Long-Tail Lines of Business: The reserving methods described above are generally applied to each line of business, regardless of their classification as short-tail or long-tail. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The merits of an individual reserving method relative to the line of business and age of accident period are considered in the actuaries’ process of selecting ultimate loss.

Short-tail lines of business, by definition, develop to their ultimate value faster than long-tail lines of business. Property coverages including inland marine along with automobile physical damage coverages are considered short-tail lines of business. Automobile Liability, General Liability, Commercial Multi-Peril Liability and Workers’ Compensation are considered long-tail lines of business. For many liability claims, significant periods of time may elapse between the occurrence of the loss, the reporting of the loss, and the final settlement of the claim. Workers’ Compensation claims can result in providing medical benefits and wage replacement over the course of an injured worker’s lifetime.

In general, more consideration may be given to the results of the development methodologies for short-tail lines than to long-tail lines for accident periods of the same maturity. For example, the indicated ultimate loss using the Incurred Loss Development Method for the most recent accident year is generally considered more reliable for a short-tail line, such as Homeowners Property, than a long-tail line, such as Workers’ Compensation.

As mentioned previously, the selection of ultimate loss is based on information unique to each line of business and accident year subject to exceptions, such as the emergence of one or more unusually large claims in a particular accident period for a short-tail line. In this case, the indications produced by the development methods may be overstated (due to development of ultimate losses to amounts in excess of policy limits) and such information would be considered in the actuaries’ process of selecting ultimate loss.

•

Immature Accident Periods: The Paid Loss Development Method is generally given less consideration than the Incurred Loss Development Method for less mature accident periods since the relatively low magnitude of losses paid at early evaluations tends to result in less reliable indications from the Paid Loss Development Method. For long-tail lines of business, neither the Incurred nor the Paid Loss Development methods may receive significant consideration for the most recent accident period. This is due to the fact that the relatively low magnitude of losses either incurred or paid at early evaluations tends to result in less reliable indications from these methods.

In faster developing, short-tailed lines such as Auto Physical Damage, Special Property, Homeowners, Commercial Multi-Peril Property and Property Damage, the Paid Loss Development Method, the Incurred Loss Development Method and the Bornhuetter-Ferguson methods are primarily used as they typically produce tightly clustered projections for all accident years.

The estimation of loss reserves for long-tail lines such as Commercial Auto Liability, Commercial Multi-Peril Liability, and Workers Compensation is more complex and is subject to a higher degree of variability than for short-tail lines of business.

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


	December 31,
	2011		2010
	(in thousands)

Commercial:
Automobile	$	272,590	$	288,289
Workers compensation		307,453		370,838
Commercial multi-peril		679,849		634,145
Other commercial		144,983		143,070

Total commercial		1,404,875		1,436,342


Personal:
Automobile		87,714		78,505
Homeowners		49,955		36,427
Other personal		2,860		2,791

Total personal		140,529		117,723


Total personal and commercial		1,545,404		1,554,065

Plus reinsurance recoverables		244,187		217,596


Total liability	$	1,789,591	$	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 year ended December 31, 2011 by line of business:

Increase (Decrease) in the Estimated Ultimate Loss and Loss Settlement Expenses

Attributable to Insured Events of Prior Years

For the Year Ended December 31, 2011


				Accident Years
	Total			2010			2009			2008 and Prior Years
	(in thousands)

Line of Business
Commercial:
Automobile	$	(5,646	)	$	1,145		$	(544	)	$	(6,247	)
Workers compensation		(11,787	)		3,149			1,656			(16,592	)
Commercial multi-peril		(10,596	)		3,089			1,148			(14,833	)
Other commercial		(2,809	)		1,573			(1,950	)		(2,432	)

Total commercial		(30,838	)		8,956			310			(40,104	)

Personal:
Automobile		(70	)		6,283			670			(7,023	)
Homeowners		(867	)		1,026			828			(2,721	)
Other personal		(286	)		(72	)		(326	)		112

Total personal		(1,223	)		7,237			1,172			(9,632	)


Total net development	$	(32,061	)	$	16,193		$	1,482		$	(49,736	)

In 2011, Harleysville Group recognized net favorable development of $32.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across casualty lines in accident years 2003 through 2008, partially offset by adverse development in accident years 2009 and 2010.

A decrease in commercial automobile severity, primarily in accident years 2005 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. Slightly higher than expected severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $5.6 million of favorable prior year development was recognized in this line during 2011.

A decrease in workers compensation severity, primarily in accident years 2003 through 2008, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $11.8 million of favorable prior year development was recognized in this line during 2011.

A decrease in commercial multi-peril severity was widely observed during 2011, which led to the recognition of favorable development in most accident years prior to 2009. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these years. In aggregate, $10.6 million of favorable prior year development was recognized in this line during 2011.

A decrease in other commercial lines severity, primarily in accident years 2007 through 2009, was observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident year 2010, which led to the recognition of adverse development in this accident year. In aggregate, $2.8 million of favorable prior year development was recognized in this line during 2011.

A decrease in personal automobile severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $0.1 million of favorable prior year development was recognized in this line during 2011.

A decrease in homeowners severity in accident years 2008 and prior was widely observed during 2011, which led to the recognition of favorable development in these accident years. An increase in severity was observed in accident years 2009 and 2010, which led to the recognition of adverse development in these accident years. In aggregate, $0.9 million of favorable prior year development was recognized in this line during 2011.

A slight decrease in other personal lines severity was observed during 2011, primarily in accident year 2009. In aggregate, $0.3 of favorable prior year development was recognized in other personal lines during 2011.

In 2010, Harleysville Group recognized net favorable development of $50.1 million in the provision for insured events of prior years, primarily due to lower-than-expected claims severity broadly experienced across all casualty lines in accident years 2004 through 2008, partially offset by a slight amount of adverse development in accident years prior to 2000.

A decrease in commercial automobile severity was observed during 2010, which led to the recognition of $8.1 million of favorable development in this line during the year. Approximately $2.4 million of the favorable development experienced in this line during 2010 is related to the Company’s involuntary pools.

A decrease in workers compensation severity, primarily in accident years 2002 through 2007, was observed during 2010 and led to the recognition of favorable development for those accident years during the year. An increase in workers compensation medical severity in accident years 2001 and prior was observed during 2010, which led to the recognition of adverse development for those accident years during the year. An increase in severity in accident year 2009 was observed in this line during 2010, which led to the recognition of $1.2 million of adverse development during the year. In total, $8.2 million of favorable development was recognized in the workers compensation line during 2010. Approximately $2.6 million of the favorable development experienced in this line during 2010 is related to the Company’s involuntary pools.

In the commercial multi-peril line of business, a reduction in severity, primarily in accident years 2004 through 2009, led to the recognition of $18.9 million of favorable development during 2010.

A reduction in other commercial lines severity was widely observed during 2010, which led to the recognition of $9.6 million of favorable prior year development.

A reduction in personal automobile severity in accident years 2008 and prior was widely observed during 2010. Claim frequency in accident year 2009 increased, which led to $0.5 million of adverse development during the year. In total, $4.4 million of favorable prior year development was recognized in this line during 2010.

A reduction in homeowners severity was observed during 2010, especially in accident year 2006. Claim frequency and severity in accident years 2008 and 2009 were observed to increase slightly, which led to the recognition of $0.4 million and $0.1 million of adverse development in these years, respectively. In total, $0.3 million of favorable development was recognized in this line during 2010.

A reduction in other personal lines severity was observed during 2010, especially in accident year 2005. Severity in accident years 2008 and 2009 was observed to marginally increase, which led to the recognition of $0.1 million of adverse development in each accident year. In total, $0.7 million of favorable development was recognized in other personal lines during 2010.

The tables below break out the change in the estimate of ultimate losses between December 31, 2010 and December 31, 2011 for the 2010, 2009, 2008 and 2007 accident years into severity and frequency components for the major commercial and personal lines of business. Table 1 summarizes the Company’s percentage change in the estimate of ultimate loss and loss settlement expense by line of business between December 31, 2010 and December 31, 2011. Tables 2 and 3 summarize the Company’s percentage change in the estimate of ultimate severity and ultimate claim counts, respectively. The relationship between the three tables is as follows: (1+ the % change in estimated ultimate loss) = (1+ the % change in estimated ultimate severity) x (1+ the % change in estimated ultimate claim counts). The estimated ultimate severity is calculated as the ratio of estimated ultimate loss to estimated ultimate claim counts. The amounts underlying these tables are based on direct loss and claim experience minus ceded loss experience and exclude a small portion of losses associated with business assumed from involuntary pools.

Table 1

Percentage Increase (Decrease) in Ultimate Loss and Loss Settlement Expense

Between the Years Ended December 31, 2010 and December 31, 2011


	Accident Years
	2010			2009			2008			2007

Line of Business
Commercial:
Automobile		0.9	%		-0.4	%		-1.4	%		-1.0	%
Workers compensation		4.5	%		2.2	%		-2.8	%		-3.2	%
Commercial multi-peril		1.2	%		0.5	%		-0.9	%		-1.3	%
Other commercial		3.2	%		-4.1	%		-2.7	%		-4.8	%
Total commercial		1.8	%		0.1	%		-1.5	%		-1.8	%
Personal:
Automobile		8.4	%		1.1	%		-1.0	%		-0.9	%
Homeowners		1.6	%		1.7	%		-1.2	%		-2.6	%
Other personal		-1.4	%		-6.2	%		2.9	%		-1.0	%
Total personal		5.0	%		1.0	%		-0.9	%		-1.6	%

Total All Lines		2.5	%		0.3	%		-1.4	%		-1.8	%

Table 2

Percentage Increase (Decrease) in Ultimate Severity

Between the Years Ended December 31, 2010 and December 31, 2011


	Accident Years
	2010			2009			2008			2007

Line of Business
Commercial:
Automobile		1.1	%		-0.6	%		-1.3	%		-1.0	%
Workers compensation		4.0	%		1.6	%		-3.1	%		-3.3	%
Commercial multi-peril		4.4	%		1.2	%		-0.4	%		-1.0	%
Other commercial		8.9	%		-4.1	%		-3.0	%		-3.6	%
Total commercial		3.2	%		0.1	%		-1.4	%		-1.7	%
Personal:
Automobile		7.1	%		1.0	%		-1.0	%		-0.9	%
Homeowners		0.5	%		1.5	%		-1.2	%		-2.6	%
Other personal		-1.3	%		-6.0	%		2.7	%		-1.0	%
Total personal		3.9	%		0.9	%		-0.9	%		-1.6	%

Total All Lines		2.6	%		0.2	%		-1.4	%		-1.7	%

Table 3

Percentage Increase (Decrease) in Ultimate Claim Counts

Between the Years Ended December 31, 2010 and December 31, 2011


	Accident Years
	2010			2009			2008			2007

Line of Business
Commercial:
Automobile		-0.2	%		0.2	%		-0.1	%		0.0	%
Workers compensation		0.5	%		0.6	%		0.4	%		0.2	%
Commercial multi-peril		-3.0	%		-0.7	%		-0.5	%		-0.3	%
Other commercial		-5.2	%		0.0	%		0.2	%		-1.2	%
Total commercial		-1.3	%		0.0	%		-0.1	%		-0.1	%
Personal:
Automobile		1.2	%		0.1	%		0.1	%		0.0	%
Homeowners		1.1	%		0.2	%		0.0	%		-0.1	%
Other personal		-0.1	%		-0.2	%		0.2	%		0.0	%
Total personal		1.1	%		0.1	%		0.0	%		0.0	%

Total All Lines		-0.1	%		0.0	%		0.0	%		-0.1	%

These tables illustrate that the changes to the Company’s estimates of ultimate loss for prior accident years between December 31, 2010 and December 31, 2011 are primarily driven by the severity component of loss. In this context, the term “severity” does not refer to an actuarial assumption, rather, it refers to “severity” as a descriptive statistic derived from the ratio of estimated ultimate loss to estimated ultimate claim counts. In general, as estimates of the ultimate number of claims were relatively stable for the prior accident periods, the changes in estimates of ultimate loss are characterized as resulting from a reduction in severity.

In general, those lines of business with a relatively low underlying volume of data, such as other commercial lines and other personal lines, are subject to greater variability in both claim severity and claim count development.

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 December 31, 2011. Actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, have been consistently applied, after including consideration of recent case reserve activity, during the periods presented. Changes in the estimate of the liability for unpaid losses and loss settlement expenses reflect actual payments and evaluations of new information and data since the last reporting date. These changes correlate with actuarial trends.

The following table presents the liability for unpaid losses and loss settlement expenses by case and incurred but not reported (IBNR) reserves by line of business and a statistically determined range of estimates of the ultimate unpaid losses and loss settlement expenses incurred for each line of business as of December 31, 2011. The range of estimates around the actuarial central estimates is statistically determined in order to provide information regarding the variability of the actuarial central estimates. The statistical analysis is completed only on a basis that is net of reinsurance recoverables, as this appropriately reflects Harleysville Group’s risk profile based on the type and quality of its reinsurance. The range is determined using the Monte Carlo Simulation method. This method uses the Company’s actual historical loss data to estimate the mean and standard deviation of a statistical distribution for future loss development. There have been no adjustments made to the historical data. The Company’s application of the Monte Carlo Simulation assumes that loss development factors are normally distributed with a mean and standard deviation derived from the historical data.

Reserve ranges are determined using both paid and incurred loss development data with a 10,000 trial simulation run against each set of data for each line of business presented in the table below. Each simulation generates a unique set of loss development factors randomly generated from the normal distribution with mean and standard deviation as defined above. Each unique set of loss development factors, when applied to the data, produces

a unique reserve estimate. At the completion of the simulation, there are 20,000 unique reserve estimates which can be ordered from lowest to highest creating a range of reserve estimates. The resulting range produced by the simulation is used to create a reasonable representation of a 90% confidence interval using the 5% point as the low end of the range and the 95% point as the high end of the range. The 90% confidence interval represents the range of reserve estimates for which there is approximately a 90% probability that the actual reserve amount (which will not be known for many years) is contained within the defined range. The total commercial lines range and total personal lines range were developed as separate simulations using the means and standard deviations of the individual lines as inputs. Therefore, the 90% confidence interval for all lines of business is smaller than the straight sum of the individual lines of business 90% intervals.

The use of this technique to analyze reserve ranges assumes historical data has validity in predicting future outcomes. This assumption is consistent with a key assumption underlying much of insurance pricing and reserving theory.

Liability for Unpaid Losses and Loss Settlement Expenses (LAE)

at December 31, 2011


	Case		IBNR		LAE Liability		IBNR (Inc. LAE)		Total Liability		Statistically Determined Range of Estimates
	Case		IBNR		LAE Liability		IBNR (Inc. LAE)		Total Liability		High		Low
	(in thousands)

Line of Business
Commercial:
Automobile	$	95,774	$	127,245	$	49,571	$	176,816	$	272,590	$	327,518	$	207,987
Workers compensation		131,269		130,920		45,264		176,184		307,453		334,938		238,766
Commercial multi-peril		185,179		311,776		182,894		494,670		679,849		791,081		557,586
Other commercial		28,828		80,866		35,289		116,155		144,983		186,249		82,846

Total commercial		441,050		650,807		313,018		963,825		1,404,875		1,568,315		1,112,365


Personal:
Automobile		42,010		29,944		15,760		45,704		87,714		100,360		66,875
Homeowners		17,199		24,086		8,670		32,756		49,955		66,068		35,558
Other personal		975		1,489		396		1,885		2,860		2,891		1,686

Total personal		60,184		55,519		24,826		80,345		140,529		163,431		108,590


Total net liability		501,234		706,326		337,844		1,044,170		1,545,404


Reinsurance recoverables		166,033		76,239		1,915		78,154		244,187


Gross liability	$	667,267	$	782,565	$	339,759	$	1,122,324	$	1,789,591

Reinsurance recoverables were $245.9 million and $219.1 million at December 31, 2011 and 2010, respectively. Of these amounts, $137.7 million and $102.3 million, respectively, or 56% 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 the A.M. Best Company. Ceded reinsurance contracts do not relieve Harleysville Group’s primary obligation to its policyholders. Consequently, an exposure exists with respect to reinsurance recoverables to the extent that any reinsurer is unable to meet its obligation or disputes the liabilities assumed under the reinsurance contract. From time to time, Harleysville Group may encounter such disputes with its reinsurers. In addition, the creditworthiness of our reinsurers could deteriorate in the future due to adverse events affecting the reinsurance industry, such as a large number of major catastrophes.

Because of the nature of insurance claims, there are uncertainties inherent in the estimates of ultimate losses. Harleysville Group’s reorganization of its claims operation in recent years has resulted in new people and processes involved in settling claims. As a result, more recent statistical data reflects different patterns than in the past and gives rise to uncertainty as to the pattern of future loss settlements. There are uncertainties regarding future 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 December 31, 2011.

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

The income tax expense for the year ended December 31, 2011 includes the tax benefit of $13.3 million associated with tax-exempt income compared to $13.2 million in the prior year.

2010 Compared to 2009

Premiums earned increased $7.8 million, or 0.9%, for the year ended December 31, 2010 compared to the prior year primarily due to an increase of $21.2 million in premiums earned for personal lines, partially offset by a decrease of $13.4 million in premiums earned for commercial lines. The increase in premiums earned for personal lines was 12.6%, primarily due to new business writings and higher average premiums. The decrease in premiums earned for commercial lines was 1.9%, primarily due to lower average premiums, lower exposures and a decline in assumed premiums earned from involuntary pools.

Investment income decreased $3.3 million for the year ended December 31, 2010, primarily due to a lower investment yield on fixed income securities and short-term investments and a greater percentage of fixed income securities invested in tax-exempt securities. During the second half of 2010, Harleysville Group purchased an additional $50 million of equity securities in order to generate additional investment income. Investments were made in high-quality, large-cap companies with strong balance sheets and a history of paying and increasing their dividends. In 2011, Harleysville Group plans to add an additional $120 million to dividend paying equities, with $50 million of this amount resulting from a re-allocation of its broad-based equity index fund.

Net realized investment gains decreased $1.7 million for the year ended December 31, 2010, compared to the prior year. There were no credit-related impairment charges in 2010 and credit-related impairment charges of $1.5 million on non-equity securities in 2009. The 2009 impairment charges consisted of $0.5 million on bonds which were sold in 2010 and $1.0 million on structured investment vehicles.

Income before income taxes decreased $33.3 million for the year ended December 31, 2010 compared to the prior year. The decrease was primarily due to an underwriting loss in 2010 compared to an underwriting gain in 2009 and a decrease in investment income.

Harleysville Group’s statutory combined ratio increased to 102.5% for the year ended December 31, 2010 from 99.8% for the year ended December 31, 2009. The increase in the combined ratio was primarily due to greater catastrophe losses and greater non-catastrophe property losses in 2010, partially offset by greater favorable development in 2010. Net catastrophe losses increased to $35.7 million (4.1 points) for 2010 from $6.2 million (0.7 points) for 2009. The 2010 catastrophe losses were primarily due to a series of severe winter storms in the first quarter and several wind and hail events during the second and third quarters.

The statutory combined ratios by line of business for the year ended December 31, 2010 as compared to the year ended December 31, 2009 are shown below:


	For the Year Ended December 31,
	2010			2009

Commercial:
Automobile		100.0	%		91.4	%
Workers compensation		106.1	%		106.2	%
Commercial multi-peril		106.1	%		105.1	%
Other commercial		88.8	%		97.6	%
Total commercial		102.3	%		100.7	%
Personal:
Automobile		104.9	%		103.0	%
Homeowners		108.2	%		92.7	%
Other personal		62.6	%		81.1	%
Total personal		103.5	%		96.8	%

Total personal and commercial		102.5	%		99.8	%

The commercial lines statutory combined ratio increased to 102.3% for the year ended December 31, 2010 from 100.7% for the year ended December 31, 2009. This increase was primarily due to the commercial automobile line of business for which the statutory combined ratio increased to 100.0% for the year ended December 31, 2010 from 91.4% for the year ended December 31, 2009. The increase in the commercial automobile combined ratio is primarily due to the recognition of 4.5 points of favorable development from prior accident years in 2010, compared to the recognition of 10.9 points of favorable development from prior accident years in 2009. The commercial multi-peril line of business also contributed to the increase in the commercial lines statutory combined ratio in the year. The commercial multi-peril statutory combined ratio increased to 106.1% for the year ended December 31, 2010 from 105.1% for the year ended December 31, 2009, primarily due to a higher level of property losses compared to the prior year.

The personal lines statutory combined ratio increased to 103.5% for the year ended December 31, 2010 from 96.8% for the year ended December 31, 2009. The increase in the personal lines combined ratio for the year ended December 31, 2010 primarily relates to a higher incidence of personal lines catastrophe losses during 2010 (9.7 points) compared to the catastrophe losses in 2009 (1.0 points). Catastrophe losses in the homeowners line of business were significantly higher during 2010 (20.1 points) compared to 2009 (1.6 points).

Increase (Decrease) in the Estimated Ultimate Loss and Loss Settlement Expenses

Attributable to Insured Events of Prior Years

For the Year Ended December 31, 2010


				Accident Years
	Total			2009			2008			2007 and Prior Years
	(in thousands)

Line of Business
Commercial:
Automobile	$	(8,071	)	$	490		$	(402	)	$	(8,159	)
Workers compensation		(8,184	)		1,228			(391	)		(9,021	)
Commercial multi-peril		(18,945	)		(4,084	)		(1,722	)		(13,139	)
Other commercial		(9,626	)		(1,000	)		(3,346	)		(5,280	)

Total commercial		(44,826	)		(3,366	)		(5,861	)		(35,599	)

Personal:
Automobile		(4,356	)		506			(948	)		(3,914	)
Homeowners		(270	)		81			413			(764	)
Other personal		(677	)		92			109			(878	)

Total personal		(5,303	)		679			(426	)		(5,556	)


Total net development	$	(50,129	)	$	(2,687	)	$	(6,287	)	$	(41,155	)

In the commercial multi-peril line of business, a reduction in severity, primarily in accident years 2004 through 2009, led to the recognition of $18.9 million of favorable development during 2010.

A reduction in other commercial lines severity was widely observed during 2010, which led to the recognition of $9.6 million of favorable prior year development.

Other income increased $2.8 million for the year ended December 31, 2010 compared to the prior year primarily due to an increase in fee income received in connection with the National Flood Insurance Program and an increase in management fees received from the Mutual Company.

The income tax expense for the year ended December 31, 2010 included the tax benefit of $13.2 million associated with tax-exempt income compared to $11.1 million in the prior year.

New Accounting Standards

In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, “Fair Value Measurements and Disclosures.” ASU 2010-06 applies to all entities that are required to make disclosures about recurring or non-recurring fair value measurements. ASU 2010-06 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, 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 on or after December 15, 2011, and can be applied either prospectively or retrospectively. Early application is permitted at the beginning of an entity’s annual reporting period. The Company will adopt this guidance prospectively. During 2012, the Company estimates that pre-tax expenses will increase by approximately $20 million, as a lower amount of acquisition costs will be capitalized and amortization of the greater December 31, 2011 balance will continue.

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 the Company’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 will not 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. In December 2011, the FASB amended this guidance to postpone the requirement 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 and reinstate previous guidance related to such reclassifications. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively. Early adoption is permitted. The adoption of this ASU will not 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 will not have a material impact on the Company’s results of operations or financial position.

Liquidity and Capital Resources

Liquidity is a measure of the ability to generate sufficient cash to meet cash obligations as they come due. Harleysville Group’s primary sources of cash are premium income, investment income and maturing investments. Cash outflows can be variable because of uncertainties regarding settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, Harleysville Group maintains investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments. Harleysville Group models its exposure to catastrophes and has the ability to pay claims without selling held to maturity securities even for events having a low (less than 1%) probability. Even in years of greater catastrophe frequency, Harleysville Group generally has been able to pay claims without liquidating any investments. Harleysville Group has also considered scenarios of declines in revenue and increases in loss payments, and believes it has the ability to meet cash requirements under such scenarios without selling held to maturity securities. Harleysville Group’s policy with respect to fixed maturity investments is to purchase only those that are of investment grade quality.

Operating activities used net cash of $77.4 million and provided net cash of $98.2 million for 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 $142.6 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 $104.5 million and used net cash of $2.8 million for 2011 and 2010, respectively. The change is primarily due to net sales of investments in 2011 due to the use of cash by operating activities and financing activities.

Financing activities used net cash of $27.1 million and $95.6 million for 2011 and 2010, respectively. The decrease is primarily due to a decrease in dividends paid and a decrease in the purchase of treasury stock in 2011.

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.

The Company had $43.4 million of cash and marketable securities at December 31, 2011, which are available for general corporate purposes including dividends, debt service, capital contributions to subsidiaries, acquisitions and the repurchase of stock. On July 30, 2009, the Board of Directors authorized the Company to repurchase up to 800,000 shares of its outstanding common stock over a two year period in the open market or in privately negotiated transactions. Additionally, the Board authorized the Company to make purchases under the terms of a Rule 10b5-1 trading plan, which allows the Company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases or because its officers are in possession of material, non-public information. The Company repurchased shares in open market transactions from the public float, and did not repurchase shares from the Mutual Company. This program was completed on August 3, 2010. On August 6, 2010, the Board of Directors authorized the Company to repurchase up to an additional 800,000 shares of its common stock over a two year period under terms similar to the repurchase authorization of July 30, 2009. As of December 31, 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 December 31, 2011.

As a holding company, the Company’s principal source of cash for the payment of stockholder 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 declared dividends of $19.3 million and paid dividends of $43.4 million in 2011 ($24.1 million of which had been declared in 2010). The Company’s insurance subsidiaries declared dividends of $89.0 million and paid dividends of $94.3 million in 2010 ($29.5 million of which had been declared in 2009).

Applying the current regulatory restrictions as of December 31, 2011, $65.1 million would be available for distribution to the Company by its subsidiaries in 2012 without prior regulatory approval. See the Business-Regulation section of this Annual Report on Form 10-K, which includes a reconciliation of net income and shareholders’ equity as determined under statutory accounting practices to net income and shareholders’ equity as determined in accordance with accounting principles generally accepted in the United States of America. Also, see Note 9 of the Notes to Consolidated Financial Statements.

The National Association of Insurance Commissioners (NAIC) adopted 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 2011 statutory financial statements, the ratio of total adjusted capital to the Authorized Control Level for the Company’s six insurance subsidiaries at December 31, 2011 ranged from 406% to 721%.

The following summarizes Harleysville Group’s contractual obligations at December 31, 2011:


	Total		Less Than 1 Year		1-3 Years		4-5 Years		More than 5 Years
	(in thousands)
Contractual obligations:
Debt	$	118,500	$	18,500	$	100,000
Interest on debt	$	8,894	$	5,779	$	3,115
Gross liability for unpaid losses and loss settlement expenses	$	1,789,591	$	427,613	$	471,421	$	235,736	$	654,821

Total	$	1,916,985	$	451,892	$	574,536	$	235,736	$	654,821

The table above does not include capital lease obligations, operating lease obligations or purchase obligations as they are either not applicable or not material. The timing of the amounts for the gross liability for unpaid losses and loss settlement expenses is an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts stated above.

Risk Factors

You should consider carefully the following risks, as well as the other information contained in this 2011 Annual Report on Form 10-K. If any of the following events described in the risk factors below actually occur, our business, financial condition and results of operations could be materially adversely affected. You should refer to the other information set forth in this 2011 Annual Report on Form 10-K including our consolidated financial statements and the related notes.

Risks Related to the Property and Casualty Insurance Industry Generally

If our estimated liability for losses and loss settlement expenses is incorrect, our reserves may not be adequate to cover our ultimate liability for losses and loss settlement expenses and may have to be increased.

We are required to maintain loss reserves for our estimated liability for losses and loss settlement expenses associated with reported and unreported claims for each accounting period. We regularly review our reserving techniques and our overall amount of reserves and, based on our estimated liability, raise or lower the levels of our reserves accordingly. If our estimates are incorrect and our reserves are inadequate, we are obligated to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. Our reserve amounts are estimated based on what we expect our ultimate liability for losses and loss settlement expenses to be. These estimates are based on facts and circumstances of which we are aware, predictions of future events, trends in claims severity and frequency and other subjective factors. Although we use a number of actuarial methods to project our ultimate liability, there is no method that can always exactly predict our ultimate liability for losses and loss settlement expenses.

In addition to reviewing our reserving techniques, as part of our reserving process we also consider:

•

information regarding each claim for losses;

•

our loss history and the industry’s loss history;

•

legislative enactments, judicial decisions and legal developments regarding damages;

•

changes in political attitudes; and

•

trends in general economic conditions, including inflation.

If certain catastrophic events occur, including increased claims related to changing climate conditions, they could have a significant impact on our operating results and financial condition.

Results of property insurers are subject to weather and other events prevailing in any given year. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results for that year to be materially worse than for other years.

Our insurance subsidiaries have experienced, and are expected in the future to experience, catastrophe losses. It is possible that a catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the operating results and financial condition of our insurance subsidiaries, thereby limiting the ability of our insurance subsidiaries to pay dividends to us. The largest non-flood catastrophe to affect our results of operations was Hurricane Irene in the third quarter of 2011, which resulted in $28.0 million of losses. In 2010, we experienced losses totaling $37.7 million from twenty-seven different catastrophes. In 2011, we experienced losses totaling $91.5 million from twenty-five different catastrophes.

Various events can cause catastrophes, including severe winter weather, hurricanes, windstorms, earthquakes, hail, war, terrorism, explosions and fires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event.

Our insurance subsidiaries seek to reduce the impact on our business of a catastrophe through geographic diversification and through the purchase of reinsurance covering various categories of catastrophes, which generally excludes terrorism. Nevertheless, reinsurance may prove inadequate if:

•

a major catastrophic loss exceeds the reinsurance limit; or

•

an insurance subsidiary pays a number of smaller catastrophic loss claims that, individually, fall below the subsidiary’s retention level.

In addition, we use models developed by third party vendors in assessing our property exposure to catastrophe losses that assume various conditions and probability scenarios. These models do not necessarily accurately predict future losses.

We are heavily regulated in the states in which we operate and if we violate those regulations or if the regulations unreasonably restrict our ability to do business, or if they change significantly, it could have a material adverse effect on our business.

We are subject to extensive supervision and regulation in the states in which we transact business. The purpose of supervision and regulation is to protect individual policyholders and not stockholders or other investors. Our business can be adversely affected by private passenger automobile insurance regulations and any other regulations affecting property and casualty insurance companies. For example, laws and regulations can reduce or set rates at levels that we do not believe are adequate for the risks we insure. Other laws and regulations can limit our ability to cancel or refuse to renew policies and require us to offer coverage to all consumers. Changes in laws and regulations, or their interpretations, pertaining to insurance, including workers compensation, may also have a material adverse effect on our business. Although the federal government does not directly regulate the insurance industry, federal initiatives, such as federal terrorism backstop legislation, from time to time, also can impact the insurance industry.

Although we do not write health insurance, rules affecting health care services can affect other insurance that we write, including workers compensation and commercial and personal automobile and liability insurance. We cannot determine whether or in what form additional health care reform legislation may be adopted by the U.S. Congress or any state legislature. We also cannot determine the nature and effect, if any, that the adoption of health care legislation or regulations, or changing interpretations, at the federal or state level would have on us.

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law. Among other things, the Dodd-Frank Act established a Federal Insurance Office within the U.S. Department of the Treasury and empowered it to gather data and information regarding the insurance industry and insurers. We cannot predict what impact, if any, the Dodd-Frank Act or any other such legislation will have on us.

We currently write flood insurance which is reinsured by the National Flood Insurance Program (the NFIP). There have been various legislative proposals to reform or terminate the NFIP. We cannot currently determine whether or in what form legislation may be adopted concerning the NFIP and the effect this may have on us.

If demand for property and casualty insurance decreases, it could have a material adverse impact on our business.

Historically, the results of the property and casualty insurance industry have been subject to significant fluctuations over time due to competition and due to unpredictable developments, including:

•

natural and man-made disasters;

•

fluctuations in interest rates and other changes in the investment environment that affect returns on our investments;

•

inflationary pressures that affect the size of losses; and

•

legislative and regulatory changes and judicial decisions that affect insurers’ liabilities.

The demand for property and casualty insurance, particularly commercial lines, also can vary with the overall level of economic activity. Any of the foregoing could reduce the demand for property and casualty insurance, which would have a material adverse effect on our business, including on the amount of premiums earned in any fiscal quarter or fiscal year.

If we are unable to reduce our exposure to risks through reliable reinsurance or if the cost of reinsurance increases, our risk of loss, or the cost of controlling our risk of loss, will increase.

We transfer a portion of our exposure to selected risks to other insurance and reinsurance companies through reinsurance arrangements. Under our reinsurance arrangements, another insurer assumes a specified portion of our losses and loss adjustment expenses in exchange for a specified portion of policy premiums. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. Any decrease in the amount of our reinsurance will increase our risk of loss. Furthermore, we face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Therefore, the inability of any of our reinsurers to meet its financial obligations could materially and adversely affect our financial condition and results of operations.

The threat of terrorism and military and other actions may result in decreases in our net income, revenue and assets under management and may materially adversely affect our investment portfolio.

The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the financial markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of Harleysville Group, as well as a decrease in our shareholders’ equity, net income and/or revenue. The effects of changes related to Harleysville Group may result in a decrease in our stock price. The Terrorism Risk Insurance Act of 2002, which was originally extended in 2005 and extended again in 2007, requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims through 2014. In addition, some of the assets in our investment portfolio may be materially adversely affected by declines in the financial markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.

We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.

We can offer no assurances that the threats of future terrorist-like events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.

Certain changes in the accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies could have a material adverse impact on our reported net income.

We are subject to the application of U.S. GAAP and other accounting standards, which are periodically revised and/or expanded. As such, we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in material adverse impacts on our results of operations and financial condition.

If our investments lose value, our revenues, earnings and financial position will be materially adversely affected.

Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenues and earnings. Any significant decline in our investment income as a result of falling interest rates or general market conditions would have a material adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholders’ equity and our policyholders’ surplus, which could impact our ability to write additional business.

The volatility and disruption of the capital and credit markets and adverse changes in the global economy may negatively impact our business.

Adverse capital and credit market conditions could affect our ability to meet liquidity needs, as well as our access to capital and cost of capital. Further, if adverse regional, national or international economic conditions persist or worsen, we could experience decreased revenues and shareholders’ equity.

The capital and credit markets experienced extreme volatility and disruption in the recent past. The volatility and disruption in the markets exerted downward pressure on the availability of liquidity and credit capacity for certain issuers. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by continued disruptions in the capital and credit markets.

Continued deterioration in the public debt and equity markets could lead to investment losses.

The severe downturn in the public debt and equity markets in 2008, 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 substantial additional realized and unrealized losses in future periods, which could have a material adverse impact on our results of operations, financial condition, debt and financial strength ratings and ability to access capital markets.

If our financial strength ratings are reduced, we may be materially adversely impacted.

Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Ratings are not recommendations to buy, hold or sell our securities.

Although other agencies cover the property and casualty industry, we believe our ability to write business is most influenced by our financial strength rating from A. M. Best. According to A. M. Best, its ratings are designed to assess an insurer’s financial strength and ability to meet ongoing policyholder obligations. Currently, our rating from A. M. Best is “A”, or “excellent.” A rating below “A-” from A. M. Best could materially adversely affect the business we write. Both Moody’s and Standard & Poor’s also assign financial strength ratings to the Company. Our Moody’s rating is A3 and our Standard & Poor’s rating is A-. While we consider our financial strength ratings from these rating agencies important, we believe that they have less impact on our business compared to our financial strength rating from A. M. Best.

In addition to being assigned financial strength ratings, the Company is also assigned credit ratings. We consider our credit ratings from Moody’s and Standard & Poor’s to be most important with regard to our ability to access capital markets. Our current credit rating from Moody’s is Baa2 with a positive outlook while our Standard & Poor’s credit rating is BBB- with a positive outlook. We cannot be sure we will maintain our current investment grade credit ratings. An unfavorable change in our Moody’s or Standard & Poor’s credit rating to below investment grade could make it more expensive for us to access capital markets.

Risks Related to Our Company in Particular

Delay in the consummation of the Mergers 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 was made in September 2011, however, due to the need for a number of regulatory approvals, and approvals of the stockholders of the Company and the members of the Mutual Company and Nationwide, the Mergers are not expected to close until of the first half of 2012. While expected, the delay between

announcement and closing, and the risk that the transactions will not be consummated, 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;

•

the Company may be unable to grow its business or implement new business initiatives given the pendency of the Merger transactions; 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 activities and taking certain actions without Nationwide’s approval, which could prevent us from pursuing 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.

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

If the Merger is not completed, for any reason, including reasons beyond our control, our ongoing business is likely to 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;

•

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

•

the Company would need to re-evaluate its strategic alternatives and operational functions, including the need to establish retention programs to retain employees, evaluate its investment portfolio and re-establish its strategic path as a stand-alone company, and may not be successful in retaining employees and re-establishing its stand-alone operational functions.

We have incurred and will continue to incur substantial transaction and Merger-related costs in connection with the Merger.

We have incurred and expect to continue to incur a number of substantial non-recurring transaction fees and other costs associated with 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.

We face significant competition from other regional and national insurance companies, agents and from self-insurance, which may result in lower revenues.

We compete with local, regional and national insurance companies, including direct writers of insurance coverage. Many of these competitors are larger than we are and many have greater financial, technical and operating resources. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent several insurance companies.

The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be materially adversely impacted. There are more than 200 groups writing property and

casualty insurance in the United States, and we rank among the top 60 in size. Our most significant competitors vary significantly in our different lines of business and in the geographic markets in which we compete. The Internet also could emerge as a significant source of new competition, both from existing competitors using their brand name and resources to write business through this distribution channel and from new competitors.

We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, certain of our customers and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance.

A number of new, proposed or potential legislative or industry developments could further increase competition in the property and casualty insurance industry. These developments include:

•

programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage; and

•

changing practices caused by the Internet, which have led to greater competition in the insurance business and, in some cases, greater expectations for customer service.

New competition from these developments could cause the supply or demand for insurance to change, which could materially adversely affect our results of operations and financial condition.

If adverse conditions in the eastern and midwestern United States exist, our business would be disproportionately impacted.

We primarily write property and casualty insurance business in the eastern and midwestern United States. Consequently, unusually severe storms or other natural or man-made disasters that destroy property in these states could materially adversely affect our operations. Our revenues and profitability also are subject to prevailing economic and regulatory conditions in the states in which we write insurance. We may be exposed to risks of adverse developments that are greater than if we conducted business nationwide.

We depend on independent insurance agents, which exposes us to risks not applicable to companies with dedicated agents.

We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors’ insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be materially adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency’s ability to control growth and profitability, thereby adversely affecting our business.

If our insurance subsidiaries are not able to pay adequate dividends to us, our ability to meet our obligations and pay dividends would be adversely affected.

Our principal assets are the shares of capital stock of our insurance company subsidiaries. We principally rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations and for paying corporate expenses and dividends to stockholders. The payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as other regulatory restrictions. As a result, we may not be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our obligations or to allow us to pay dividends.

If insurance regulators determine that payment of a dividend to our holding company would be detrimental to an insurance subsidiary’s policyholders or creditors, because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends that would otherwise be permitted without prior approval.

Our subsidiaries are permitted under the terms of our debt agreement for our $100 million notes due 2013 to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by our subsidiaries to us. We cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund payments on these notes when due.

Although we have paid cash dividends in the past, we are currently restricted, under the Merger Agreement, from paying cash dividends, and we may not be able to pay cash dividends in the future.

We have a history of paying dividends to our stockholders when sufficient cash is available. However, under the Merger Agreement we are restricted from paying cash dividends to our stockholders without the consent of Nationwide, and did not pay a fourth quarter 2011 dividend. Further, any payment of future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section.

If our use of predictive modeling or other underwriting tools is not effective, our business could be materially adversely impacted.

We use predictive modeling and other underwriting tools in underwriting a significant portion of our commercial lines business. We believe these tools allow us to more accurately match underwriting risk with pricing to operate more profitably. If the tools do not accurately reflect the level of losses that we ultimately will incur, our ability to write business and our financial results could be materially adversely affected.

If our technology initiatives are not successful, or the benefits are not realized, our business could be materially adversely affected.

Our businesses are increasingly dependent on technology. Our inability to anticipate or manage problems with technology, or fully realize the expected benefits from investments in technology, could materially adversely affect our ability to write business and could materially adversely impact our financial results.

If we lose our key personnel our business could be materially adversely affected.

The success of our business is dependent, to a large extent, on our ability to attract and retain key employees, in particular our senior officers and key management, sales, information systems, underwriting, claims and corporate personnel. Competition to attract and retain key personnel is intense. Although we have change in control agreements with a number of key managers, in general, we do not have employment contracts or non-compete arrangements with, or key person insurance covering, our employees, including our key employees.

Applicable insurance laws and certain provisions in our certificate of incorporation make it difficult to effect a change of control of our Company, and the Mutual Company has significant influence over potential change of control transactions, which could affect our share value.

Under applicable insurance laws and regulations of the states in which our subsidiaries are domiciled, no person may acquire control of us unless that person has filed a statement containing specified information with the insurance commissioner of each state and obtains advance approval for such acquisition. Under applicable laws and regulations, any person acquiring, directly or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our common stock without obtaining advance approval of the insurance commissioner of each state would be in violation of applicable insurance laws and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the insurance commissioner of each such state.

In addition, many state insurance laws require prior notification to the state insurance department of a change of control of a non-domiciliary insurance company licensed to transact an insurance business in that state. Although these pre-notification statutes do not authorize the state insurance departments to disapprove the change of control, they authorize regulatory action - including a possible revocation of our authority to do business - in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change of control of us may require prior notification in the states that have pre-acquisition notification laws.

As of December 31, 2011, the Mutual Company owned approximately 53% of our outstanding common stock. The Mutual Company’s stock ownership and ability, by reason of such ownership, to elect our board of directors, provides it with significant influence over potential change of control transactions. Further, Section 203 of the Delaware General Corporation Law provides that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock, subject to certain exceptions. Section 203 may discourage a potential change of control transaction. Our Board of Directors is divided into three classes (A, B

and C). The current three-year terms of Class A, B and C directors expire in 2013, 2012 and 2014, respectively. This classification of our Board of Directors could have the effect of discouraging a potential change in control transaction.

Finally, our certificate of incorporation permits our board of directors to issue up to one million shares of preferred stock having such terms, including voting rights, as the board of directors shall fix and determine.

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk.

Interest Rate Risk

Harleysville Group’s exposure to market risk for changes in interest rates is concentrated in its investment portfolio and, to a lesser extent, its debt obligations. Harleysville Group monitors this exposure through periodic reviews of asset and liability positions. Estimates of cash flows and the impact of interest rate fluctuations relating to the investment portfolio are modeled regularly.

Principal cash flows and related weighted-average interest rates by expected maturity dates for financial instruments sensitive to interest rates are as follows:


	December 31, 2011
	Principal Cash Flows		Weighted-Average Interest Rate
	(dollars in thousands)

Fixed maturities and short-term investments:
2012	$	386,591		3.45	%
2013		212,204		4.58	%
2014		301,292		3.63	%
2015		346,558		3.39	%
2016		331,411		3.42	%
Thereafter		807,255		5.01	%


Total	$	2,385,311


Fair value	$	2,622,792


Debt:
2012	$	18,500		0.74	%
2013		100,000		5.75	%


Total	$	118,500


Fair value	$	121,822

Actual cash flows may differ from those stated as a result of calls and prepayments.

Equity Price Risk

Harleysville Group’s portfolio of equity securities, which is carried on the balance sheet at fair value, has exposure to price risk. Price risk is defined as the potential loss in fair value resulting from an adverse change in prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques.

The combined total of realized and unrealized equity investment gains (losses) was $(1.4) million, $27.7 million and $46.4 million in 2011, 2010 and 2009, respectively. During these three years, the largest total equity investment gain and (loss) in a quarter was $25.4 million (3rd quarter 2009) and $(34.7) million (3rd quarter 2011), respectively.

Item 8.

Financial Statements and Supplementary Data.


	Page
Consolidated Financial Statements

Consolidated Balance Sheets as of December 31, 2011 and 2010		53
Consolidated Statements of Income for Each of the Years in the Three-year Period Ended December 31, 2011		54
Consolidated Statements of Shareholders’ Equity for Each of the Years in the Three-year Period Ended December 31, 2011		55
Consolidated Statements of Cash Flows for Each of the Years in the Three-year Period Ended December 31, 2011		57
Notes to Consolidated Financial Statements		58

Report of Independent Registered Public Accounting Firm		86

HARLEYSVILLE GROUP

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	December 31,
	2011			2010
Assets
Investments:
Fixed maturities:
Held to maturity, at amortized cost (fair value $131,433 and $156,967)	$	124,935		$	148,362
Available for sale, at fair value (amortized cost $2,195,221 and $2,069,097)		2,361,971			2,165,101
Equity securities, at fair value (cost $7 and $191,095)		7			268,104
Short-term investments, at cost, which approximates fair value		129,388			79,909

Total investments		2,616,301			2,661,476
Cash		36			39
Premiums receivable		133,277			133,758
Reinsurance recoverables		245,948			219,149
Accrued investment income		25,629			26,910
Deferred policy acquisition costs		101,256			113,997
Prepaid reinsurance premiums		54,753			51,625
Property and equipment, net		12,763			13,312
Deferred income taxes		15,712			9,413
Other assets		61,394			48,553

Total assets	$	3,267,069		$	3,278,232

Liabilities and Shareholders’ Equity
Liabilities:
Unpaid losses and loss settlement expenses (affiliate $132,536 and $214,518)	$	1,789,591		$	1,771,661
Unearned premiums (affiliate $(14,201) and $32,935)		460,768			503,532
Accounts payable and accrued expenses		104,258			96,461
Due to affiliate		40,396			19,445
Debt (affiliate $18,500 and $18,500)		118,500			118,500

Total liabilities		2,513,513			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 2011, 35,448,861 and 2010, 34,987,829 shares; outstanding 2011, 27,246,172 and 2010, 27,044,836 shares		35,449			34,988
Additional paid-in capital		285,585			263,857
Accumulated other comprehensive income		63,571			80,506
Retained earnings		622,973			630,603
Treasury stock, at cost, 8,202,689 and 7,942,993 shares		(254,022	)		(241,321	)

Total shareholders’ equity		753,556			768,633

Total liabilities and shareholders’ equity	$	3,267,069		$	3,278,232


See accompanying notes to consolidated financial statements.
		53

HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)


	Year Ended December 31,
	2011			2010		2009
Revenues:
Premiums earned from affiliate (ceded to affiliate, $819,071, $783,340 and $730,699)	$	804,508		$	866,350	$	858,500
Investment income, net of investment expense		95,401			103,313		106,649
Realized investment gains, net:
Total other-than-temporary impairment losses		(3,967	)		—		(1,548	)
Portion of loss recognized in other comprehensive income		—			—		—
Other realized investment gains, net		79,445			597		3,841

Total realized investment gains, net		75,478			597		2,293

Other income (affiliate $9,814, $7,251 and $6,451)		19,772			16,012		13,178

Total revenues		995,159			986,272		980,620

Expenses:
Losses and loss settlement expenses (ceded to affiliate, $702,141, $540,619 and $476,641)		681,636			589,105		552,491
Amortization of deferred policy acquisition costs		205,783			220,150		216,470
Other underwriting expenses		77,228			84,227		85,349
Interest expense (affiliate $126, $137 and $290)		6,053			6,064		6,217
Other expenses		8,198			4,014		4,095

Total expenses		978,898			903,560		864,622

Income before income taxes		16,261			82,712		115,998
Income tax expense (benefit)		(6,351	)		15,814		29,702

Net income	$	22,612		$	66,898	$	86,296

Per common share:
Basic net income	$	.82		$	2.43	$	3.09

Diluted net income	$	.81		$	2.42	$	3.07

Cash dividend	$	1.10		$	2.81	$	1.25


See accompanying notes to consolidated financial statements.
		54

HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the years ended December 31, 2011, 2010 and 2009

(dollars in thousands)


	Common Stock				Additional Paid-in		Accumulated Other Comprehensive			Retained			Treasury
	Shares		Amount		Capital		Income (Loss)			Earnings			Stock			Total
Balance at December 31, 2008		34,254,581	$	34,254	$	231,715	$	(17,390	)	$	589,146		$	(185,091	)	$	652,634

Net income											86,296						86,296
Other comprehensive income, net of tax:
Unrealized investment gains, net of reclassification adjustment								74,976									74,976
Defined benefit pension plan:
Net actuarial loss adjustment								4,690									4,690

Other comprehensive income																	79,666

Comprehensive income																	165,962

Issuance of common stock:
Incentive plans		296,483		297		6,087											6,384
Dividend Reinvestment Plan		32,118		32		963											995
Tax benefit from stock compensation						571											571
Stock compensation						6,300											6,300
Purchase of treasury stock, 870,153 shares														(25,369	)		(25,369	)
Dividends declared											(34,849	)					(34,849	)

Balance at December 31, 2009		34,583,182		34,583		245,636		62,276			640,593			(210,460	)		772,628
Net income											66,898						66,898
Other comprehensive income, net of tax:
Unrealized investment gains, net of reclassification adjustment								19,878									19,878
Defined benefit pension plan:
Net actuarial loss adjustment								(1,648	)								(1,648	)

Other comprehensive income																	18,230

Comprehensive income																	85,128

Issuance of common stock:
Incentive plans		338,678		339		8,634											8,973
Dividend Reinvestment Plan		65,969		66		2,211											2,277
Tax benefit from stock compensation						1,013											1,013
Stock compensation						6,363											6,363
Purchase of treasury stock, 974,931 shares														(30,861	)		(30,861	)
Dividends declared											(76,888	)					(76,888	)

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

(Continued)

HARLEYSVILLE GROUP

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the years ended December 31, 2011, 2010 and 2009

(dollars in thousands)

(Continued)


	Common Stock				Additional Paid-in		Accumulated Other Comprehensive			Retained			Treasury
	Shares		Amount		Capital		Income (Loss)			Earnings			Stock			Total
Net income			$		$		$			$	22,612		$			$	22,612
Other comprehensive income, net of tax:
Unrealized investment losses, net of reclassification adjustment								(4,072	)								(4,072	)
Defined benefit pension plan:
Net actuarial loss adjustment								(12,863	)								(12,863	)

Other comprehensive loss																	(16,935	)

Comprehensive income																	5,677

Issuance of common stock:
Incentive plans		431,168		431		12,272											12,703
Dividend Reinvestment Plan		29,864		30		959											989
Tax benefit from stock compensation						2,108											2,108
Stock compensation						6,389											6,389
Purchase of treasury stock, 259,696 shares														(12,701	)		(12,701	)
Dividends declared											(30,242	)					(30,242	)

Balance at December 31, 2011		35,448,861	$	35,449	$	285,585	$	63,571

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

HARLEYSVILLE GROUP INC 10-K