Small Cap Stocks

PMA Capital (PMACA) is an insurance company that has been undergoing a turnaround since 2004. We think that over the next twelve months, investors will finally feel comfortable that the worst is behind for the company and the focus will shift towards renewed growth opportunities for PMACA’s core workers’ compensation business, which has been operating since 1915. As investor sentiment changes towards the company, its shares could rise by 50%+ over the next two years with limited downside risk for investors.

Though the company still faces some risks, we think that with the shares currently trading at a discount to book value, and considering the company’s solid core business, the current valuation more than adequately reflects these risks. It is important to mention that PMACA’s shares are very thinly traded and that interested investors are advised to use limits when buying/selling the stock. The limited liquidity also provides opportunity for investors, since it has been possible to buy shares on temporary “liquidity” drops in the stock. In the full interest of disclosure, we began buying the stock for clients at an average price of $9.

Reinsurance Diversion Almost Sinks the Company
So what went wrong with PMACA? Simply put, the company diversified out of its main workers comp business, into re-insurance and other non-core insurance-lines. Growth was of course good at the start, but as is common in the insurance industry when companies venture out of their core markets, the company underestimated its loss reserves (i.e. Liabilities established by insurers and reinsurers to reflect the estimated cost of claims payments that the insurer or reinsurer believes it will ultimately be required to pay in respect of insurance or reinsurance it has written).

Starting in late 2003, the company began recognizing significant charges to increase the loss reserves for the reinsurance business for prior accident years. Following these charges announcement, A.M. Best Company, Inc. (“A.M. Best”) reduced the financial strength ratings of PMA Capital’s subsidiaries. Ratings downgrades present serious, and at times terminal, problems for insurance companies. After the downgrade The PMA Insurance Group’s ability to attract and retain workers comp. business was severely constrained and the company lost many key customers.

The Developing Turnaround
As a result of the above negative developments, PMACA brought in a new chief executive officer, changed its corporate structure to “separate” the reinsurance and workers’ comp. businesses, and decided to cease writing reinsurance business beginning what is termed a “run off” of the reinsurance business. In November 15, 2004, after approving of these dramatic corporate changes, A.M. Best restored The PMA Insurance Group’s financial strength rating. The rating restoration enabled the company to increase new business written and business retention rates in 2005. In 2006, the company has continued to wind-down the run-off re-insurance business, reinvigorate the core workers comp. business, while continuing to grow fairly new Third Party Administrator business.

Back to Growth
Now that PMACA is finally “back in business”, and on more stable financial footing, there are numerous things that can now go right for the company over the next two years.

Firstly, the company will likely continue to be able to extract capital from its run-off reinsurance business and return that capital shareholders. What is happening is that PMACA has been able to “buy out” many of their major insured parties from the run-off reinsurance business via what is called commutation transactions. In a commutation transaction, the insured agrees to settle their claims in advance against PMA in exchange for an upfront payment which is at a discount to the potential liability. These types of transactions significantly improve the financial profile of the run-off operations by decreasing liabilities and increasing excess capital. Interestingly, on May 3, 2006, the Pennsylvania Insurance Department (the “Department”) approved an extraordinary dividend in the amount of $73.5 million from the run-off operations, which PMCA used to reduce debt. We expect continued special dividends from the run-off business in the coming two years. This will help the company pay down debt and ultimately re-instate the common stock dividend.

With regards to the core workers comp business, it is important to note that even though this is a mature and highly competitive industry with little growth, PMACA could still show above-average premium growth since it still has a ton of business to regain. Before the ratings downgrade in 2003, the company had grown to about $512 million in net written premiums for its core workers comp insurance business. Net written premiums in the same line of business were only $335 million in 2005. Clearly, with time, the company can regain a significant portion of this lost premium income. At the same time, the company has a fast-growing Third Party Administrator (TPA) business which will also add to profits in the coming years. The TPA provides various claims administration, risk management, loss prevention and related services, primarily to self-insured clients under fee for service arrangements. This business allows PMACA to expand and diversify its revenue base to include services that do not provide for any insurance risk.

Conclusion
Overall, we think that despite the fact that PMACA does not have the huge potential upside that some turnarounds in technology provide, we think the stock offers solid appreciation potential with much more limited downside and risks than our usual tech recommendations. This is not a company that faces any terminal risk due to the possibility that its product will become obsolete. We like to add solid financial businesses at cheap valuations to our portfolios since they mitigate some of the volatility and risk associated with an otherwise strong weighting towards technology names. And sometimes boring can be quite profitable.