Ben ClaremonUCLA Anderson MBA 2011The Inoculated Investor

PMA Capital Corp. (NASDAQ: PMACA)

Date of Report5/19/10Shares Outstanding (Millions)32.3Current Price$7.15Institutional Holdings82.7%52-Week Range $4.27-$7.65Fiscal Year Ends31-DecAverage Daily Volume 107,000FY 2009 Net Income (Millions)$21.2FY 2009 EPS (Reported)$0.66Book Value (Millions)$418.1FY 2009 P/E11.00xMarket Cap. (Millions)$231.0Dividend Yield0%Price/Book Value.55xIndex MembershipNASDAQIndustryP&C Insurance

BUSINESS DESCRIPTION:

PMA Capital Corporation, through its subsidiaries, provides workers’ compensation insurance products primarily inthe eastern part of the United States. It also provides a range of other commercial line insurance products andvarious 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 derivesmost of its earnings from insurance underwriting, its fee-based business has recently become a larger contributor torevenues and earnings. PMA Capital Corporation distributes its products through national, regional, local brokersand 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 profitableon 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 2005these businesses have led to about $107.1M in losses for PMACA, a fact that caused EPS and the company’s ROEto be depressed for years. Fortunately, in December of 2009 PMACA finally sold off its run-off business and now isable to quantify its remaining exposure to the policies included in these divisions. Specifically, approximatelystarting in 2018 (the company’s estimate) and until 2052 (according to the company, losses could be potentiallyspread out until 2052) PMACA has $34.3M in exposure to worker’s comp claims over and above a $33.3Mthreshold. 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 onearnings and investor sentiment for years, will not impact PMACA’s earnings in the near future. In the meantime theonly obligation that PMACA has to these former divisions is a note payable in two equal installments of $5M inJune 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 themarket 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 thecompany earned $31.4M or about $.98 per share from continuing operations. With the stock around $7.15, thisimplies a price to earnings ratio of 7.30x. On a trailing 12 month basis (the company reported EPS of $.25 for Q12010), the company earned $31.3M from continuing operations, implying a P/E multiple of 7.37x. After netting outthe tax benefit, these EPS figures have not been adjusted downward to reflect hypothetical income taxes because thecompany has NOL carryforwards it can use to offset future income. The chart below breaks down the three bucketsof NOLs that the company can use over the coming years. Based on a conservative estimate of run-rate net incomeof 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$15.72012$10.3AMT: 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 ClaremonUCLA Anderson MBA 2011The Inoculated Investor It is important to remember that it is often misleading to exclude extraordinary items if they are likely to appear onthe income statement again. Accordingly, until the end of 2009 the case could have been made that the losses fromthe discontinued operations should have been included when determining true EPS for PMACA. However, now thatthe company will not be experiencing yearly losses from those operations, it seems more appropriate to exclude theimpact when determining the core earnings power of the company. In this case, given the fact that the company doesnot anticipate paying income tax anytime soon, an estimate of about $1 in net income per share going forward seemsvery reasonable.In addition, the stock trades at .55x book value and .59x tangible book value. This compares very favorably to thesmall cap P&C insurance industry averages (compiled by Capital IQ—See appendix 1) of about .87x book value and1.03x 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 anduncertainty 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)

200420052006200720082009Q1 20106 Yr Avg.

Loss & Dividend Ratio74.972.671.369.569.370.172.971.3Expense30.530.730.830.228.228.322.129.8Combined Ratio105.4103.3102.199.797.598.495.0101.1

The table above shows that after a number of years with a combined ratio over 100% (a fact that means the companywas experiencing underwriting losses) it appears that PMACA has righted the ship over the last 3 years. Thecombined ratio from Q1 2010 is a bit misleading because, as the company indicates in its filings, due to seasonalitythe first quarter has historically had a lower combined ratio than the subsequent quarters. However, the performanceover 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 itsrenewal rates drop in the current soft pricing environment. This would imply that the company is focused ongenerating profitable business as opposed to growth for the sake of growth. For example, as the chart belowindicates, even though renewal rates were up in Q1 2010 versus Q1 2009, net premiums earned were actually downin both the worker’s comp and commercial line categories. This is despite a 2% increase in pricing on worker’scomp 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 CompCommercial LinesQ1 2009Q1 2010Q1 2009Q1 2010

Net Premiums Earned$93.8$92.1$9.1$8.8Pricing Change-4%2%-2%-1%Renewal Rates79%83%89%92%

The first takeaway from the first quarter results is that the company seems to be focusing on clients and risks that itis 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 ratesclimbed even though pricing was up 2% year on year. All in all is looks as though the company is navigating its waythrough a very tough environment in a prudent fashion.

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

Ben ClaremonUCLA Anderson MBA 2011The Inoculated Investor

Conservative investment portfolio.

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

Investment Portfolio200720082009

Income$39.6 $36.1 $36.9Realized Gains/Losses(1.7)4.5 6.4Unrealized Gains/Losses(0.2)(9.2)(5.9)Change in Fair Value of TradingSecurities3.2 0.0 0.0Total$40.9 $31.4 $37.4% Return4.97%4.06%4.27%

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

Composition of PortfolioQ1 2010

At Fair ValueAmount% Total

US Treasuries & Obligations$74.88.72%Municipal Securities99.311.58%Short term Investments25.93.02%Other Investments31.23.64%Corporate Debt253.229.52%MBS/ABS373.343.52%Total$857.7100%

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 2010ABS/MBS BreakdownDollar Amount% Total Portfolio

CMBS$88.710.34%RMBS (Agency)215.625.14%RMBS (Non-agency)19.32.25%Other ABS49.75.79%Total$373.343.52%

As of 3/31/2010, the CMBS portion had an average rating of AAA-, credit support of 29% and delinquencies withinthe pool of 10%. Accordingly, these are clearly not the most toxic securities Wall Street has ever created but there issome risk of loss if the commercial real estate market continues to see downward pricing pressure and increaseddelinquencies for years to come. In addition, PMACA held $9.5M of Subprime/Alt-A backed securities that had anaverage rating of AA+ as of March 31

. This is down from AAA- at the end of 2009, indicating that some of thesesecurities were downgraded during Q1 2010.

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