Ben Claremon

UCLA Anderson MBA 2011

The Inoculated Investor

PMA Capital Corp. (NASDAQ: PMACA)

Date of Report 5/19/10 Shares Outstanding (Millions) 32.3
Current Price $7.15 Institutional Holdings 82.7%
52-Week Range $4.27-$7.65 Fiscal Year Ends 31-Dec
Average Daily Volume 107,000 FY 2009 Net Income (Millions) $21.2
FY 2009 EPS (Reported) $0.66 Book Value (Millions) $418.1
FY 2009 P/E 11.00x Market Cap. (Millions) $231.0
Dividend Yield 0% Price/Book Value .55x
Index Membership NASDAQ Industry P&C Insurance

BUSINESS DESCRIPTION:
PMA Capital Corporation, through its subsidiaries, provides workers’ compensation insurance products primarily in
the eastern part of the United States. It also provides a range of other commercial line insurance products and
various claims administration, risk management, loss prevention, and related services to self-insured clients under
fee for service arrangements, as well as to insurance carriers on an unbundled basis. While the company derives
most of its earnings from insurance underwriting, its fee-based business has recently become a larger contributor to
revenues and earnings. PMA Capital Corporation distributes its products through national, regional, local brokers
and agents, and direct sales representatives. The company was founded in 1915 and is headquartered in Blue Bell,
Pennsylvania.

INVESTMENT THESIS:
With the overhang from the discontinued operations gone, the company could become consistently profitable
on an EPS basis. PMACA put its excess and surplus lines business as well as its reinsurance business into run-off
in the 2002-2003 period. Since then, these businesses have had a huge negative impact on earnings. Since 2005
these businesses have led to about $107.1M in losses for PMACA, a fact that caused EPS and the company’s ROE
to be depressed for years. Fortunately, in December of 2009 PMACA finally sold off its run-off business and now is
able to quantify its remaining exposure to the policies included in these divisions. Specifically, approximately
starting in 2018 (the company’s estimate) and until 2052 (according to the company, losses could be potentially
spread out until 2052) PMACA has $34.3M in exposure to worker’s comp claims over and above a $33.3M
threshold. Also, PMACA has $11.6M in exposure to liability insurance guarantees over a threshold of $33.2M.
While it is impossible to accurately evaluate these exposures, the company has estimated the fair value to be $13M.
Accordingly, it is very likely that the performance of these discontinued operations, which has been a drag on
earnings and investor sentiment for years, will not impact PMACA’s earnings in the near future. In the meantime the
only obligation that PMACA has to these former divisions is a note payable in two equal installments of $5M in
June 2010 and June 2011 as a result of a $13.1M capital contribution agreement signed upon the closing of the sale.

Compelling valuation. Even though the stock is well above its 52 week low of $4.27, it is unclear whether the
market is appreciating the burden that has potentially been lifted from the shoulders of PMACA. For example,
excluding the $19.6M in costs and the $9.2M tax benefit associated with the run-off operations, in 2009 the
company earned $31.4M or about $.98 per share from continuing operations. With the stock around $7.15, this
implies a price to earnings ratio of 7.30x. On a trailing 12 month basis (the company reported EPS of $.25 for Q1
2010), the company earned $31.3M from continuing operations, implying a P/E multiple of 7.37x. After netting out
the tax benefit, these EPS figures have not been adjusted downward to reflect hypothetical income taxes because the
company has NOL carryforwards it can use to offset future income. The chart below breaks down the three buckets
of NOLs that the company can use over the coming years. Based on a conservative estimate of run-rate net income
of around $35M, it would likely take at least 7 years before the company began to pay income taxes.

NOL Breakdown* Expiration

$251.70 2021-2029
$15.7 2012
$10.3 AMT: does not expire
*The company indicated in its 2009 10-K that it does not expect to pay income tax in the near future

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations
 Ben Claremon
UCLA Anderson MBA 2011
The Inoculated Investor

It is important to remember that it is often misleading to exclude extraordinary items if they are likely to appear on
the income statement again. Accordingly, until the end of 2009 the case could have been made that the losses from
the discontinued operations should have been included when determining true EPS for PMACA. However, now that
the company will not be experiencing yearly losses from those operations, it seems more appropriate to exclude the
impact when determining the core earnings power of the company. In this case, given the fact that the company does
not anticipate paying income tax anytime soon, an estimate of about $1 in net income per share going forward seems
very reasonable.

In addition, the stock trades at .55x book value and .59x tangible book value. This compares very favorably to the
small cap P&C insurance industry averages (compiled by Capital IQ—See appendix 1) of about .87x book value and
1.03x tangible book value. This also compares favorably to the 6 year average multiple for PMACA of .63x and .
65x, respectively. It should be noted that these low average multiples for PMACA reflect the drag on earnings and
uncertainty from the run-off operations that are no longer major concerns. Therefore, now that the overhang is gone,
there is no reason that PMACA cannot trade closer to the .87x average price to book multiple of its peers.

The company has become consistently profitable in its underwriting.

Consolidated Combined Ratio

(In percentages) 2004 2005 2006 2007 2008 2009 Q1 2010 6 Yr Avg.
Loss & Dividend Ratio 74.9 72.6 71.3 69.5 69.3 70.1 72.9 71.3
Expense 30.5 30.7 30.8 30.2 28.2 28.3 22.1 29.8
Combined Ratio 105.4 103.3 102.1 99.7 97.5 98.4 95.0 101.1

The table above shows that after a number of years with a combined ratio over 100% (a fact that means the company
was experiencing underwriting losses) it appears that PMACA has righted the ship over the last 3 years. The
combined ratio from Q1 2010 is a bit misleading because, as the company indicates in its filings, due to seasonality
the first quarter has historically had a lower combined ratio than the subsequent quarters. However, the performance
over the last three years indicates that PMACA has successfully focused on profitable underwriting in determining
pricing and which risks to assume.

In fact, in the recently released 2009 10-K the management team indicated that PMACA would be willing to let its
renewal rates drop in the current soft pricing environment. This would imply that the company is focused on
generating profitable business as opposed to growth for the sake of growth. For example, as the chart below
indicates, even though renewal rates were up in Q1 2010 versus Q1 2009, net premiums earned were actually down
in both the worker’s comp and commercial line categories. This is despite a 2% increase in pricing on worker’s
comp policies. On the other hand, pricing of commercial lines was down 1% from Q1 2009, indicating that the
property and casualty marker is still very soft.

Worker's Comp Commercial Lines

Q1 2009 Q1 2010 Q1 2009 Q1 2010
Net Premiums Earned $93.8 $92.1 $9.1 $8.8
Pricing Change -4% 2% -2% -1%
Renewal Rates 79% 83% 89% 92%

The first takeaway from the first quarter results is that the company seems to be focusing on clients and risks that it
is already familiar with (as shown by the higher renewal rates) but is not aggressively searching for new business.
The other is that PMACA seems to have pricing power in writing worker’s comp policies as the renewal rates
climbed even though pricing was up 2% year on year. All in all is looks as though the company is navigating its way
through a very tough environment in a prudent fashion.

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations
 Ben Claremon
UCLA Anderson MBA 2011
The Inoculated Investor

Conservative investment portfolio. There are a number of insurance companies that derive a lot of their earnings
from the investment portfolio. Fairfax Financial Holdings (TSE:FFH) is a good example of such a company. Prem
Watsa’s adept portfolio management during the most uncertain periods of the financial crisis led to fantastic returns
that helped the company grow its book value substantially. While some investors do not mind investing a company
whose earnings are determined by the performance of the securities portfolio, others would rather focus on the core
insurance business. PMACA, for example, has a very conservative investment portfolio that does not add much to
earnings volatility. As shown below, the returns on the portfolio have been very pedestrian over the last few years:

Investment Portfolio 2007 2008 2009

Income $39.6 $36.1 $36.9
Realized Gains/Losses (1.7) 4.5 6.4
Unrealized Gains/Losses (0.2) (9.2) (5.9)
Change in Fair Value of Trading
Securities 3.2 0.0 0.0
Total $40.9 $31.4 $37.4
% Return 4.97% 4.06% 4.27%

The low returns are due to PMACA’s relatively conservative investment portfolio that is mostly invested in fixed
income securities:

Composition of Portfolio Q1 2010

At Fair Value Amount % Total
US Treasuries & Obligations $74.8 8.72%
Municipal Securities 99.3 11.58%
Short term Investments 25.9 3.02%
Other Investments 31.2 3.64%
Corporate Debt 253.2 29.52%
MBS/ABS 373.3 43.52%
Total $857.7 100%

The only number that stands out is that of the MBS/ABS portion of the portfolio. The truth is that the majority of
these are agency securities, but the portfolio does have some non-agency RMBS and CMBS exposure:

Q1 2010
ABS/MBS Breakdown Dollar Amount % Total Portfolio
CMBS $88.7 10.34%
RMBS (Agency) 215.6 25.14%
RMBS (Non-agency) 19.3 2.25%
Other ABS 49.7 5.79%
Total $373.3 43.52%

As of 3/31/2010, the CMBS portion had an average rating of AAA-, credit support of 29% and delinquencies within
the pool of 10%. Accordingly, these are clearly not the most toxic securities Wall Street has ever created but there is
some risk of loss if the commercial real estate market continues to see downward pricing pressure and increased
delinquencies for years to come. In addition, PMACA held $9.5M of Subprime/Alt-A backed securities that had an
average rating of AA+ as of March 31st. This is down from AAA- at the end of 2009, indicating that some of these
securities were downgraded during Q1 2010.

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations
 Ben Claremon
UCLA Anderson MBA 2011
The Inoculated Investor

Finally, investors have to look at the duration of fixed income securities. There are a number of very prominent
investors making not so inconsequential bets that interest rates in the US are going to go a lot higher in the coming
years. In that case, existing securities will be at risk of losing a substantial portion of their values. Since PMACA
holds its securities in an available for sale account, unrealized losses reduce Other Comprehensive Income while
other than temporary impairments and losses on sales actually negatively impact the income statement. Accordingly,
while the returns on short term securities may be meager, risk averse investors afraid of a spike in interest rates
would prefer to see a portfolio dominated by short term instruments that could be rolled over into higher yielding
securities upon maturity.

Fixed Income Maturities

($US millions) Fair Value % of Total Portfolio
2010 $34.7 4.33%
2011-2014 185.5 23.17%
2015-2019 106.3 13.28%
2020 and Thereafter 100.8 12.59%
MBS and other ABS 373.3 46.63%
Total $800.6 100%

On this front, it appears that PMACA is exposed to somewhat of a mixed bag of maturities, a circumstance that is
not uncommon for insurance companies that invest with a longer term outlook.

In summary, there is no question that there is some risk of capital destruction through losses in this portfolio.
However, the company’s focus on high quality fixed income securities as opposed to equities should lead to less
volatility in earnings or returns. Specifically, if the performance of the portfolio during the tumultuous late 2008 and
early 2009 period is any indication, PMACA should be relatively well-positioned to weather another financial storm.
In any case, investors should focus on the insurance operations in order to ascertain whether or not PMACA is a
quality company.

Recent history of accurate loss estimates.

Consolidated Loss and LAE* 2004 2005 2006 2007 2008 2009
Initial Net Liability $504.70 $468.00 $456.80 $444.80 $432.80 $458.20
Cumulative Paid $502.80 $438.80 $384.60 $306.90 $180.80
Net Liability Re-Estimated $508.60 $466.10 $453.30 $434.60 $434.50
Net Redundancy (Deficiency) ($3.90) $1.90 $3.50 $10.20 ($1.70)
% Redundant/Deficient -0.77% 0.41% 0.77% 2.29% -0.39%
*LAE stands for Loss Adjustment Expense

The above table shows how accurate PMACA has been in terms of estimating losses associated with the policies the
company has underwritten (clearly this was not the case with the run-off businesses). A deficiency indicates that
based on a re-estimate of the ongoing liability, the initial loss estimate was too low and a redundancy indicates that
the initial estimate was too conservative. The recent data show PMACA to be relatively accurate at estimating future
losses. While investors would rather see consistent redundancies, the company’s performance does not raise any
immediate red flags and suggests that investors can trust the current management team not to overreach for new
business.

INVESTMENT RISKS:

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations
 Ben Claremon
UCLA Anderson MBA 2011
The Inoculated Investor

1. Underwriting: If the company cannot continue its current streak of profitable underwriting years then
losses from either natural disasters, employee injuries or simple poor underwriting could limit EPS growth
or lead to operating losses.
2. Run-off operations: If PMACA were forced to increase the fair value of its remaining exposure to its
recently sold off discontinued operations, it could lead investors to continue to be uncertain about the stock.
As mentioned above, PMACA only has to cover losses above a relatively high threshold. But, if losses
from these operations are much higher than expected, PMACA will have to start making payments earlier
than the 2018 estimated date.
3. MBS Portfolio: Approximately 18.4% of the company’s investment portfolio is tied up in non-agency
MBS, CMBS and other ABS that could lose value if the real estate or credit markets experience further
stress, thus causing book value to decline.
4. Loss Estimates: The lack of cumulative redundancies (based on re-estimated losses) from 2008 indicates
that the company’s underwriting standards have recently not been conservative enough, a fact that could
lead to unexpectedly elevated future losses.
5. Ratings downgrade: PMACA is currently rated A- by AM Best and the company has indicated that a
downgrade below that could be harmful as customers would likely take their business to companies with
better credit ratings. However, with net debt to equity as of 3/31/10 of only 14.66% and the burden of the
run-off operations lifted, PMACA appears to be in a stable and non-risky condition when it comes to
capital.
6. Share Liquidity: Only about 100K shares of PMACA trade each day on the NASDAQ Exchange.
Accordingly, an investor interested in taking a large stake might have to build it up over time as to not
impact the stock price. Additionally, the low volume suggests that a large stakeholder would likely not be
able to get out of a position quickly without driving down the share price.
7. Worker’s comp focus: In Q1 2010, about 89% of the company’s net premiums earned were derived from
worker’s comp policies. While the company does seem to have some pricing power in this sector, losses are
notoriously hard to estimate and can be much larger than anticipated. As such, investors need to be aware
that PMACA is in the business of offering policies that need to be underwritten and priced very carefully.
Therefore, a history of prudent underwriting and a trustworthy management team are essential.

POTENTIAL CATALYSTS:
1. Takeover candidate: PMACA is trading at a fraction of book value even though the company has become
profitable on an EPS and on an underwriting profit basis. This could lead potential acquirers to be very
interested in PMACA. If the company was bought at 1x book value (a fair takeout multiple) that would
imply a price of almost $13 per share.
2. New investors circling the company: Recently a number of investment managers have increased their
stakes in PMACA. Specifically, Blackrock now owns a 6.58% stake in the company after holding just a
few shares previously. The top 7 funds/managers own about 43.5% of the company and the fact that many
have increased their stakes recently could indicate that they are very bullish on the prospects for PMACA
now that the run-off businesses are less of a factor.
3. Multiple expansion: Now that PMACA looks as though it will not suffer large continued losses from the
run-off businesses, it is likely that the market will eventually begin to appreciate the company’s core
earnings power and expand the multiples to book and earnings that PMACA trades at to reflect the
reduction in uncertainty.

RECOMMEDATION & ESTIMATED VALUE:

The first question a potential investor in PMACA should ask himself or herself is why would a company that has
traded well below book value for the last six years suddenly deserve to trade at a higher multiple? The answer is that
the run-off businesses that have led to over $100M in losses since 2005 are no longer likely to be a drag on earnings
or a source of continued uncertainty. There are only 3 Wall Street analysts covering this microcap stock, so the
company clearly does not receive a lot of fanfare. Therefore, with earnings picking up, underwriting standards
remaining high, and investors less concerned about the company, its is very possible that PMACA will eventually
trade at a book value multiple closer to the market multiple of .87x.

Further, the company also has built up over $250M in NOLs that can be used to offset taxable income and the
management team indicated recently that it does not expect to pay taxes in the near future. While it might take some

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations
 Ben Claremon
UCLA Anderson MBA 2011
The Inoculated Investor

time for investors to see the improving fundamentals, for an investor with a long term time horizon, a profitable
insurance company trading at .55x book value appears to offer a margin of safety compared to the valuations of the
peer set. Clearly, that margin of safety is necessary due to all of the risk factors listed above and the company’s
issues with the run-off operations over the last 7-8 years. But, with a depressed valuation the risk-reward profile for
this stock looks incredibly compelling due to limited potential downside but significant upside even if the company
only traded at an average market multiple.

Accordingly, it seems appropriate to assume that a .75x book value multiple represents both a conservative and fair
assessment of the company’s value. Applying this multiple to Q1 2010 book value of $12.94 per share produces an
estimate of intrinsic value of about $9.75. Currently the shares trade at a 36.4% discount to this conservative value, a
margin of safety that suggests that a buy recommendation is justified.

Appendix 1: (Source: Capital IQ)

Company Name P/Diluted EPS P/TangBV LTM - P/BV LTM - Latest

Before Extra LTM - Latest
Latest
First Acceptance Corp. (NYSE:FAC) NM 0.97x 0.53x

First Mercury Financial Corporation (NYSE:FMR) 5.63x 1.00x 0.78x

Hallmark Financial Services Inc. (NasdaqGM:HALL) 9.20x 1.41x 0.97x

Mercer Insurance Group Inc. (NasdaqGM:MIGP) 8.00x 0.71x 0.69x

Nymagic Inc. (NYSE:NYM) 3.73x 0.82x 0.82x

SeaBright Insurance Holdings Inc. (NYSE:SBX) 13.75x 0.67x 0.66x

Universal Insurance Holdings Inc. (AMEX:UVE) 6.75x 1.60x 1.60x

Summary Statistics P/Diluted EPS P/TangBV LTM - P/BV LTM - Latest

Before Extra LTM - Latest
Latest
High 13.75x 1.60x 1.60x
Low 3.73x 0.67x 0.53x
Mean 7.84x 1.03x 0.86x
Median 7.38x 0.97x 0.78x

Sources: Capital IQ, PMACA Company filings and presentations, Yahoo Finance, Google Finance, and Personal Calculations