PMA Capital Corporation Q2 2008 Earnings Conference Call Transcript

PMA Capital Corporation (PMACA)

Q2 2008 Earnings Call Transcript

August 1, 2008 8:30 am ET

Executives

William Hitselberger – EVP and CFO

Vincent Donnelly – President and CEO

Analysts

Randy Binner – FBR

Robert Paun – Sidoti & Co.

Matt Rohrmann – KBW

Peter Horn – Gates Capital

Scott Heleniak – RBC Capital Market

Beth Malone – KeyBanc

Presentation

Operator

Good morning, ladies and gentlemen, and welcome to PMA Capital second quarter 2008 earnings conference call. (Operator instructions) I would now like to turn the call over to William Hitselberger, Executive Vice President and CFO of PMA Capital Corporation. Mr. Hitselberger, you may begin.

William Hitselberger

Thank you, Tina. Good morning everyone. Thank you for joining us for PMA Capital's second quarter 2008 earnings conference call. Joining me on the call is Vince Donnelly, PMA Capital’s President and Chief Executive Officer. Before we begin, I have an important reminder for you about our earnings release.

Our earnings release and statistical supplements, which are available under the Investor Information section of our web site at www.pmacapial.com provides detailed reconciliations of our operating income by business segment to our net income computed under Generally Accepted Accounting Principles.

Although operating income does not replace GAAP net income, operating income is the financial measure that we use to evaluate and assess the performance of our businesses. As we define it, operating income is GAAP net income excluding net realized investment gains and losses and the results from our discontinued operations.

Today, Vince and I will be discussing PMA Capital’s second quarter 2008 financial results. Following our prepared remarks, Vince and I will be available to take questions.

As a reminder, any comments we make regarding future expectations, trends and market conditions, including premiums, revenue, earnings, cash flow, pricing, loss cost trends, and return on equity are forward-looking statements under the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from our current expectations. These factors are described in cautionary statement disclosures in our most recent reports on Form 8-K and Form 10-K filed and furnished with the Securities and Exchange Commission, including our Form 8-K dated July 31, 2008, which contains our Second Quarter 2008 Earnings Release.

With that, I'd like to turn the call over to Vince.

Vincent Donnelly

Thanks, Bill, and good morning to everyone and thank you for joining us today.

I would like to start by discussing the company’s performance in the second quarter of 2008, and after that, Bill will speak in detail to our operating results and our financial condition.

We produced another quarter of strength in operating results at PMA. We made continued progress and profitably growing our insurance and fee-based businesses, and improved our return on equity while continuing to maintain our underwriting standards. Our achievements in our ongoing operations included the following, at the PMA Insurance Group, the combined ratio in the second quarter improved to 99.5% from 101.6% in the second quarter last year, and the year to date combined ratio in 2008 improved to 97.2% from 99.9% in 2007.

We increased operating earnings by $3.5 million to $11.3 million in the second quarter of 2008 and by $6.2 million to $25 million for the first six months of this year. These increases included a $2.1-million pretax gain that we realized during the second quarter from the sale of a property we owned. Direct premium production excluding premium adjustments and fronting premiums increased modestly in the second quarter to $97 million, an increase of 2% during the first six months of 2008 to $243 million. And we entered into a new fronting arrangement in July, which we expect will favorably impact our underwriting results beginning in the third quarter.

With respect to our fee-based businesses, revenues increased to 13% of our total revenues for the first six months of 2008 compared to 7% of the same period last year. Organic revenue growth at PMA Management Corp was 26% in the quarter and 21% year-to-date. Our current year growth was also favorably impacted by the inclusion of Midlands which contributed $6 million and $14 million of revenues from the second quarter and first six months of 2008. And in June, consistent with our objective of expanding our fee-based business, we completed an acquisition of a service company which we will operate as PMA Management Corp of New England. In all, we are pleased with the continued progress of our businesses during the first half of 2008.

Let me provide some additional details. The PMA Insurance Group grew profitably and modestly increased premium production despite increasingly competitive market conditions in our marketing territories. The current market place has a number of challenges. There is softness in the insurance market, which can be characterized by increased pricing pressure, both for the new business and for renewals and clients generally looking for enhanced terms. Pricing continues to trend downward in workers' compensation and other commercial loans.

We continue to maintain our underwriting standards and differentiate ourselves from our competitors by delivering a high-quality level of service. For business written in the first six months of this year, our pricing on rate-sensitive Workers’ compensation business decreased by 7%. Nationally, according to the Council of Insurance Agents and Brokers, Workers' compensation pricing for the first half of 2008 has decreased by 12%.

As was discussed last quarter, the two states that have accounted for a large portion of our overall pricing decrease were New York and Florida. For business written in the six months and the June 30, 2008, our pricing on rate-sensitive Workers' compensation business decreased by 26% in New York and by 17% in Florida. The pricing reductions in both New York and Florida are mainly driven by manual loss cost changes filed by each respective states rating bureau which we believe are consistent with the loss trends in each state.

These two states collectively represent about 16% of our overall rate sensitive Workers' compensation business written in the first half of this year. Our pricing on rate-sensitive Workers' compensation business written outside of these two states decreased by 4%. Pricing on our rate sensitive Workers' compensation business in Pennsylvania declined 5% during the first six months of this year. In Pennsylvania we are affected by a 10.2% reduction in loss cost at the Pennsylvania Insurance Department approved earlier this year. While this resulted in lower file loss cost in Pennsylvania effective April 1, 2008, we will continue our practice of underwriting our business with a goal of achieving a reasonable level of profitability on each account. We continue to determine our business pricing through scheduled charges and credits that we file and use to limit the effect of file loss cost changes and had not experienced a decrease in premiums equal to the level of the loss cost reductions.

We also believe that the loss cost change should not significantly affect the profitability of our loss-sensitive broker business which represents about 42% of our Pennsylvania Workers’ compensation business.

Direct premiums written were down 11% for the quarter and 12 % for the first half of 2008, compared to the same period in 2008 due to reductions in fronting premiums of $13 million for the quarter and $23 million year-to-date. Direct premiums written for the first six months of this year were also down due to higher return premium adjustments of $13 million primarily from retrospectively rated policies that we write for loss-sensitive accounts.

The premium adjustments primarily reflect favorable loss experience on loss-sensitive products with the insured shares in the underwriting result of the policy. The return of premium represents favorable loss experienced on these accounts. Over 40% of our Workers’ compensation business is written on a loss-sensitive basis, and these types of policies, the customers’ shares, and the underwriting result of the policy are both favorable and unfavorable with us. These policies provide us with a greater degree of certainty in achieving our profit margin on an account-by-account basis.

Fronting premiums decreased in the second quarter and first six months of 2008 as a result of the termination of our agreement with Midwest in March of 2008. And although this termination resulted in a decrease in direct premiums written, this business will continue to have a positive impact on our 2008 operating results as we earn commissions until the underlying policies expire.

In July 2008, we entered into a fronting arrangement with Appalachian Underwriters who will underwrite and service Workers’ compensation policies using our approved forms and guidelines. The business produced will be primarily located in the Southeastern part of the United States. We will retain approximately 10% of the direct premiums and related losses on this business. We will also earn an administrative fee based upon the direct premium earned under the agreement as well as fees for providing claims services on the business. We expect that direct premiums written under this agreement will be between $20 million and $30 million on an annualized basis.

The combined ratios at The PMA Insurance Group improved 2.1 points in the quarter and 2.7 points in the first six months compared to the same periods last year. But the lower combined ratios for the quarter and first six months of the year compared to last year reflected improvements in the loss and loss adjustment expense ratio – expense and policy holder dividend ratios. The improved loss and loss adjustment expense ratios for both periods were primarily due to lower current auxiliary loss and loss adjustment expense ratios as compared to 2007.

The year-to-date loss and loss adjustment expense ratio also benefited from the favorable development in our loss-sensitive business which resulted in the retrospective premium adjustments reflected in our first quarter results.

Our current action at year loss and loss adjustment expense ratios benefited in 2008 from changes in the type of Workers' compensation products selected by our insurance. Pricing changes coupled with payroll inflation for the rate-sensitive Workers’ compensation business were below overall estimated loss trends.

We've estimated that our medical cost inflation to be 6.5% in the first half of this year compared to our estimated 8% for the first of 2007. This decline reflects a decrease in utilization as well our enhanced network and managed-care initiatives.

As I have commented in prior periods, we continue to focus on maximizing our preferred provider networks, individualized case management, prescription drug cost containment programs, and the evaluation of charges that are incurred outside of those networks. We are pleased that these containment techniques have tempered the impact of medical inflation and continued to contribute to an improved loss ratio.

In our fee-based business, we are seeing new market entrants and the soft insurance market is slowing the number of self-insured clients. We are also seeing increased price competition especially in the managed-care arena.

Despite these challenges, we have and expect to continue to organically grow our fee-based business. We are excited about the acquisition of PMA Management Corp of New England. The integration process is well underway and we are pleased with the strength of the existing management team and the similarity in service culture with our business.

PMA Management Corp of New England specializes in providing Worker’s compensation, risk management, and claims administration services to healthcare systems and public entity customers principally in Connecticut, a geographic area in which we previously had little penetration. We look forward to the continued growth of this business which currently generates $6 million in annual revenues.

We previously announced the execution of a definitive stock purchase agreement to sell our run-off operations and the filing of the Form-A with the Pennsylvania Insurance Department. We are assisting the buyer to ensure the Pennsylvania Insurance Department has the information it needs to review the transaction.

Before turning the discussion over to Bill, let me say that we are pleased with our progress in the first half of this year. We are continuing to profitably grow our insurance and our fee-based businesses in an increasingly competitive market place. We believe that we are in target to achieve a return on equity of between 5.5% and 6.5% on our ongoing businesses in 2008.

I will turn the discussion over to Bill now for a more detailed look at the operating results as well as a review of our capital position. Bill?

William Hitselberger

Thanks, Vince. For the second quarter of 2008, we reported a net income of $4 million or $0.13 per diluted share compared to net income of $491,000 or $0.01 per diluted share for the second quarter of 2007. Operating income increased to $4.6 million or $0.14 per diluted share for the second quarter of 2008 compared to $2.2 million or $0.07 per diluted share for same quarter last year.

For the first six months of 2008, we recorded net income of $10.9 or $0.34 per diluted share compared to net income of $3.8 million or $0.12 per diluted share for the same period last year. Operating income increased to $11.6 million or $0.36 per diluted share in the first half of 2008 compared to $6.5 million or $0.20 per diluted share in the same period a year ago. Included in that income and operating income for the three and six months and at June 30, 2008 was an after-tax gain of $1.4 million or $0.04 per diluted share from the sale of a property.

In my discussion on segment performance, I will focus on operating results. Please see Page 3 of our earnings release for the reconciliation of segment operating results to GAAP net income.

Now, let me turn to specific results of the PMA Insurance Group.

The PMA Insurance Group reported pre-tax operating income of $11.3 million for the second quarter compared to $7.8 million for the same period last year. Year-to-date, pre-tax operating income was $25 million compared to $18.7 million for the first half of 2007. Included in pre-tax operating income for the three and six months and at June 30, 2008 was a gain of $2.1 million which resulted from the sale of our branch office building in Harrisburg, Pennsylvania. We did it in order to move to a more modern and a leased facility. We continue to own our home office facilities and we own one smaller branch office building in Erie, Pennsylvania. The gain in the Harrisburg office sale is reported in other revenues.

Direct premium production increased moderately for the second quarter and increased 2% for the first half of 2008 compared to the same period last year. However, direct premiums written were down due to reduction and fronting premiums.

Direct premiums written for the first six months of 2008 were also down due to higher return premium adjustments of $13 million. These premium adjustments primarily reflect favorable loss experienced on loss-sensitive products where the insured shares in the under writing results of the policy. Direct written premium were $99 million for the second quarter of 2008 compared to $111 million for the second quarter of 2007. For six months ended June 30, 2008, direct written premium were $240 million compared to $272 million for the first six months in 2007.

Running premium were $2 million in the second quarter of 2008 and $10 million in the first half of 2008 compared to $15 million and $33 million for the same period a year ago. Excluding funding business, we were up 26 million of new business in the second quarter of 2008 and $60 million for the first half of 2008 compared to $26 million and$65 million during the same period last year.

Our renewal retention rate on existing Workers’ Compensation Account for both the second quarters of 2008 and 2007 was 84 % and our renewal retention rate was 85% for the first six months of 2008 and 2007.

Net written premiums was $79 million and $193 million for the three and six months ended June 30, 2008 compared to$82 million and $208 million during the same period a year ago.

Net written premiums for the six month end of June 30, 2008 were down primarily to the first quarter return premium adjustments.

The GAAP combined ratio for the second quarter 2008 was 99.5 compared to 101 .6 for the second quarter in 2007. The year-to-date combined ratio in 2008 was 97.2 compared to 99.9 in 2007. The improved loss in LAE ratio for both periods was primarily due to lower current taxes year loss in the LAE ratio which Vince discussed earlier.

Commissions earned under the primary arrangement reduced the current year ratio by 90 basis points for the first six months compared to 60 basis points for the same period in 2007as the ceding commissions earned on this business reduced our commission expense.

The year-to-date expense ratio offer benefit from reductions in premium-based paid assessment. The policy holders' dividend ratios were lower in the second quarter and first six months of 2008 compared to the same period a year ago.

The prior year period reflected better loss experience on participating policies which resulted in larger dividends on participating products for the policy holders may receive a dividend based to a large extent on their own loss experience.

Net investment income was $8.9 million in the second quarter compared to $9.6 million in the prior year quarter. For the first six months of 2008, net investment income was 18 million compared to $19.1 million in the first half of 2007. The decreases were due primarily to lower yields of approximately 40 basis points for the quarter and 30 basis points year-to-date.

Now I would like to comment on results for our fee-based business. For the second quarter of 2008, our fee-based business reported pre-tax operating income of $1.2 million compared to $601,000 for the same quarter last year.

For six months ended of June 30, 2008, the segment were put it $3.4 million compared to$1.4 million for the first six months of 2007. The increase primarily related to the inclusion of Midlands results in 2008. For the second quarter of 2008, revenues increases to $16 million up $8 million on the same period last year.

For the first half of 2008, total revenue increases $33 million compared to $16 million for the first half of 2007. The increases in the revenues related primarily to our acquisition of Midlands which accounted for $6 million of this growth in the quarter and $14 million year-to-date, and also through organic growth in revenues at PMA management Corp. which increased 26% for the quarter and 21% year-to-date compared to prior year. The total increase in revenue primarily reflected higher claim service revenues of $6 million and commission income of $3 million for the quarter and higher claim service revenues of $10 million and commission income of $7 million for the first half of the year.

As Vince noted, we completed the acquisition of PMA Management Corp of New England on June 30th 2008. On an annual basis, we expect per share earnings to increase by $0.02 as a result of this transaction. Beginning in the third quarter of 2008, we will report the operating result of PMA Management Corp of New England within our fee-based business segment.

Now I’d like to comment on our discontinued operation. Discontinued operations, formerly our run-off operations which consist of our former reinsurance and excess and surplus lines businesses, recorded an after-tax loss $188,000 and $2.6 million for the three and six months ended June 30 of 2008 compared to after-tax losses of $1 million and $2.6 million for the same period in 2007. The loss for the first six months of 2008 was due to the charge in that first quarter for adverse loss development.

And now let me turn my attention to the overall financial condition of PMA Capital. Our book value was $11.92 per share as of both June 30, 2008 and December 31, 2007. During the first six months of 2008, the unrealized position of our available for sale fixed-income portfolio decreased by $0.35 per share as a result of higher long-term market interest rate and also due to gains that we provided primarily in the first quarter of 2008. At June 30 the carrying value of available for sale, like the income portfolio, was 99% of amortized cost. The decrease in our unrealized position was substantially offset by our earnings to date in 2008.

We continue to review the investment portfolio in light of recent changing market condition and determined that no write-offs were necessary for our sub prime of credit or credit-enhanced securities. The fair value of our total invested assets from continuing operations was $790 million as of June 30, 2008. The investment portfolio’s average credit quality was AAA-, containing substantially all investment grade securities, and the portfolio has a duration of 3.8 years.

Of the $790 million, $18 million or 2% were residential mortgage-backed securities whose underlying collateral was either a sub prime or alternative A mortgage. The $18 million which includes $16 million of alternative A collateral and $2 million of sub-prime collateral had an estimated weighted average life of 2.9 years, with $6 million of this balance expected to pay-off within one year. And these securities had an average credit quality of AAA.

The portfolio also held securities with a fair value of $18 million or 2%, whose credit ratings were enhanced by various financial guarantee insurers. Of the credit-enhanced securities, $14 million were asset-backed securities, none of which were wrapped ABS CDO exposures with an average life of 4.1 years and with underlying collateral have internal rating of A.

We’ve also recently reviewed our exposure to Freddie Mac and Fannie Mae Securities in our investment portfolio. As of June 30, 2008, we had preferred stock issued by those entities that was carried at $918,000. At July 28, the market value of these preferred securities were $663,000. We have no other equity exposure to those entities. We hold $10 million of general obligation debt issued by the two agencies, substantially all of which has a maturity date in 2014 or sooner.

We also hold a $172 million of Freddie Mac and Fannie Mae-backed collateralized mortgage obligation, and mortgage-backed securities. The average credit quality of these securities is triple A and we currently do not believe there are any material impairment issues related to these securities.

Approximately 45% of our reinsurance recoverable balance of $817 million is collateralized and 2% of these recoverable balances are currently due to PMA for losses that we have already paid. We have $27.5 million in cash and short-term investments at our holding company and non-regulated subsidiaries at June 30, 2008. We believe that our current funds combined with our other capital sources will continue to provide us with sufficient funds to meet our foreseeable ongoing expenses and interest payments.

In the second quarter of 2008, we used some excess cash at our holding company to complete the TPA acquisition discussed earlier. We will continue to evaluate the best use of this excess capital at our holding company.

Statutory surplus for the insurance companies and the PMA Insurance Group was $352 million at June 30, 2008 compared to $335 million at the end of 2007. The PMA Insurance Group companies have the ability to pay $29.2 million in dividends without the prior approval of the Pennsylvania Insurance Department.

The statutory surplus of PMA Capital Insurance Company, our wholly-owned run-off reinsurance subsidiary which is being reported as it discontinued operations, was $38 million at June 30, 2008, compared to $48 million at December 31, 2007. That concludes our prepared remarks.

Vince and I would now welcome your questions, and for Tina, if you would, would you please open the lines for any questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of Randy Binner representing FBR. Please proceed.

Vincent Donnelly

Good morning, Randy.

Operator

Mr. Binner, can you check your mute function?

Randy Binner – FBR

I was on mute. I'm sorry, Vince. Can you guys hear me now?

William Hitselberger

Yes. We're fine.

Vincent Donnelly

Yes.

Randy Binner – FBR

Sorry about that. Hey, I was wondering if you could touch more on market competition. You mentioned that things are getting soft, but especially because you write more large case business, are you seeing some of the bigger players come down into spaces where they weren't previously being competitive?

William Hitselberger

Hi, Randy. Good morning. I think the fact is on every piece of business, whether it's in our larger account business or in our middle-market business, there is always quite a few players competing for a piece of business. So, I'd say that the larger pieces of the businesses we have are generally – we are competing with more of the national players and that's continued during this market and I would expect it's going to continue at least the balance of this year. So, we've not really seen a change in the players in the competitive landscape.

Randy Binner – FBR

Okay. And so what is – I think in the past, you've broken out your account sizes by mid-sized and then by large-sized and the last numbers I have with the mid-size was a little over 100,000, policy-size or premium, and then largest was 750. Have those numbers shifted as the market softened?

William Hitselberger

No. It really hasn't. The middle market business, what we internally call commercial markets, is – the average size is between $100,000 and $125,000 – that's continued. We certainly even in that space focus in on accounts of a size that are someone who's going to need the type of service that we provide. So, we continue to be focused there and there has really not been a subsequent change in that. In terms of our loss sensitive or our larger business for the most part, the actual premium size varies based on the program that they buy but I'd say on a standard – if they were to buy fully First Dollar insured program, those are probably still accounts that are somewhere between 750 and a million dollars, or a million dollar plus. And the actual premium again is going to be dictated by how much of the risk that they are willing to bear in that loss-sensitive product.

Randy Binner – FBR

Okay, that’s helpful. And then on the medical loss inflation number is interesting because it is low, so it’s lower than it has been in a while, the 6.5%. Can we just get more color on – I mean, I guess it seems like the loss mitigation techniques you are using are working, but do you think that is a level that other people are seeing in the Workers' Comp space, at least people you go up against in your main states?

William Hitselberger

I think, Randy, medical inflation is still a high number in the sense that it’s not a benign type of trend. But I’d say that the general – what we see is that when we look at overall medical numbers and I’d say for both Workers' Compensation and we will also take a look at what is happening in healthcare trends in the United States is those numbers are still high, but they certainly have been trended down slightly. So I cannot speak for what other competitors are actually reporting or believe their numbers are. I certainly think our number is at the average or slightly below that based on some of the things that we’ve been doing. So the 6.5 maybe on the low end of that range, but I do think the numbers have been trending slightly down. We also take a look at what is being filed by bureaus, by the NCCI or the individual state bureaus and I think those numbers have again trended slightly down.

Randy Binner – FBR

So, I mean, it could be the fact that more and more people in the market are focusing on managed care initiatives and networks, and keeping tighter control on all those things that –

William Hitselberger

Well I think, what is interesting at Workers' compensation is many, many states that we operate in anyway, are fee state schedules, so actually, there’s a – for example, in Pennsylvania, the fee schedule goes up, and the unit cost go up by the state average weekly wage, which is a low single-digit number. Now there's a lot of charges that are outside of the fee schedule that get a usual customary charge and I would say those procedures continue to increase as medical technology evolves.

I think the challenge for us and for all carriers is managing the utilization and we’re certainly very focused in working with our networks and working internally with our nursing staff and our claims staff to try to manage, even improve the management of the utilization piece, because I think that is the key that really is driving inflation rate in medical cost.

Randy Binner – FBR

Those are all helpful. I’ll drop back in the queue. Thank you.

William Hitselberger

Thanks, Randy.

Operator

The next question comes from the line of Robert Paun representing Sidoti & Company. Please proceed.

Robert Paun – Sidoti & Co.

Good morning.

William Hitselberger

Good morning.

Robert Paun – Sidoti & Co.

Can you provide some detail in terms of the reserve adjustments you made in the quarters, specifically I guess with accident years and lines of business?

William Hitselberger

Yes, Robert, I don't think we made any material reserve adjustments. The reserve adjustments that occurred on a year-to-date basis are primarily associated with the accident years 2005 and 2006, and those really associated with the premium returns that we have made in the first quarter of 2008. We also had a modest amount of reserve adjustments in our run-off operations in the first quarter. Second quarter, basically, the reported loss ratio, the accident year is pretty much thought [ph] on the calendar year, we do not see any adjustments in the second quarter.

Robert Paun – Sidoti & Co.

Okay, thanks. And given the financial condition and overall economic slowdown we are experiencing today, have you seen any change in the frequency of claims?

Vincent Donnelly

Robert, we continue to say that the frequency trends, I would say, are relatively benign. Last year, frequency was probably down about a percent for us and for the first six months we continue to see a similar trend. I certainly know that the rating bureaus across the country continue to forecast and project that those numbers are going to go down. There is an interesting correlation or different theories, I guess, what happens if in fact there's an economic slowdown with the frequency of claims. And in many ways this argument can be made as potentially there's a slowdown and pressure and the workforce is – workers continue to make sure that they hold on to their jobs and are more reluctant to leave the workforce even for modest injury, certainly people that get hurt that cannot work, no matter what the economy is, they're going to go on the workers' comp payroll.

So, we keep a close eye. Frequency is certainly one of the trends – a major loss trend in workers' compensation and we continue to look at that on a very, very frequent basis and we’ve not seen any substantial change in that in any of our territories or in any of our class of the business.

Robert Paun – Sidoti & Co.

Okay. Thanks. And one last question, I don’t know if I missed it, but can you give us an update on the sale of the run-off in terms of the schedule and timing and everything?

Vincent Donnelly

Sure, Robert. As you know, we entered into a contract with ARMA [ph] reinsurance to sell the run-off operations in the early part of the second quarter of 2008. They filed the Form A with the State Insurance Department in late May, and we are currently in the middle of a comment period that the State mandated. My expectation is that by the time we report our third quarter numbers, we'll have a conclusion with respect to the comment period. We’re optimistic that we'll have a decision with respect to the state reviewing and making and approval decision on the transaction.

Robert Paun – Sidoti & Co.

Okay. Thanks. That’s all I have.

Operator

The next question comes from the line of Matt Rohrmann representing KBW. Please proceed.

Matt Rohrmann – KBW

Gentlemen, good morning.

Vincent Donnelly

Hi, Matt.

William Hitselberger

Good morning.

Matt Rohrmann – KBW

Just a quick question, you guys have been doing a great job of taking up additional fee business as well as replacing some of that Midwest fronting agreement. What kind of opportunity do you see in the market for additional deals such as those?

Vincent Donnelly

Good morning Matt. We continue to – I think we reported last quarter – we continue to keep our eyes and ears open to opportunities and believe that there are still are other opportunities out there and believe that we will ultimately replace fully what the Midwest arrangement gave us. So, that is something that we continue to work on.

Matt Rohrmann – KBW

Okay. Great. And then any additional color you can provide us about Appalachian and kind of how they compared to Midwest other than the geographic difference?

Vincent Donnelly

Well, I think in many ways similar from the size of business they are going to produce through this arrangement, smaller workers' compensation policies of business that we normally would not underwrite in our other business. It's more diverse from a geographic perspective because it is through the Southeast.

The other very important thing that I think I mentioned in my comments is besides an opportunity for us to earn a fee, a commission for doing this, is we will be handling claims. So this now will be, in essence, a costumer of the PMA Management Corp. And I think that does two things for us. One, it's certainly another source of revenue for that business which we are continuing to look to grow. And secondly, it actually provides a territory that we are focused in on. I think our business in the management corp. is, if you look at the geographic break, one of the areas that is the lightest for us is in the Southeast. So this will continue to give us more critical mass there, improve our name and reputation in that territory, and we are looking to be able to build upon this to continue the growth momentum that we have in the management corp.

Matt Rohrmann – KBW

Great. Thanks very much.

Vincent Donnelly

Thanks Matt.

Operator

The next question comes from the line of Peter Horn representing Gates Capital. Please proceed.

Peter Horn – Gates Capital

Hi, guys. Congratulations on a great quarter. You guys have done a great job on the last couple of quarters and I was just curious why you haven’t been more aggressive in buying back stock. With discount to [ph] book value, I can’t imagine a better use of capital right now.

William Hitselberger

Peter, as you know, we did make some stock acquisitions in the third quarter of 2007. We continue to look at excess capital that we generated in the insurance operations. We do believe we have a modest amount of excess capital at the holding company. We continue to evaluate that alternative. The one thing I would tell you is I think we will have a much higher degree of comfort in our excess capital position once we conclude the sale of the run-off operations. So I think that as we move forward over the course of this year, certainly I think our comfort level and our ability to make some strategic decisions with that excess capital is going to improve.

Peter Horn – Gates Capital

Okay. Great. Thank you.

Operator

The next question comes from the line of Scott Heleniak representing RBC Capital Market. Please proceed.

Scott Heleniak – RBC Capital Market

Hi. Good morning.

William Hitselberger

Hey, Scott.

Vincent Donnelly

Good morning.

Scott Heleniak – RBC Capital Market

Most of my questions have been answered. I just have a couple here. You talked about the significant rate decreases you’ve seen in a lot of your States and now there’s a couple although it has really been – really significant, how has that changed in the way you’re thinking about where you’re doing business? In other words, are you pulling back because any one state because you think rates have come down a little too much compared to loss costs or do you think it’s all pretty similar?

Vincent Donnelly

Well, Scott, good morning. The two states that I referenced in my comments that for us has the most significant rate reduction is the State of Florida and State of New York. Both of those, we continue to believe, are very much in line with benefit reforms that have taken place. Florida had benefit reform a number of years ago and I think the market there – the rates are basically continuing to catch up with what’s happened in terms of the effects of that reform. So we still feel pretty comfortable in the State of Florida. With that said, that state along with all the other states is a competitive market but we feel fine about that state. It’s not good to be able to report to you or to others that states reducing rates by such a large number, 17%. But, we also believe that our actuaries when they evaluate the loss trends in there, I believe that’s consistent. New York, which is 26% for the first six months, reform took place October of – effectively really the latter part of 2007 and while we're less than a year into the reforms, we continue to believe that there is a strong correlation between what’s happening with rates there and what is the effect of the reform. So we’ve not really substantially changed in those states our appetite for that. Again, we believe both of those states as well as Pennsylvania and the others have robust competition and so I think our retentions continue to be strong. I think Bill reported on our new business. Our new business is slightly last than what it was a year ago. Our flow of business continues to be strong but we are committed to our underwriting standards and intend to continue to do that going forward.

Scott Heleniak – RBC Capital Market

Okay. The other thing on the states, this is just a general question, do you think the states are going to be quicker to react to raise rates when they realize the loss trends are too low compared to kind of what we saw at the beginning of the decade where a lot of workers' comp companies had hurt? Do you think they’ll take that into consideration more compared to the market?

William Hitselberger

Well, I certainly hope that the states – the regulatory system is balanced. It’s always easier for the regulators and the politicians to announce the fact that rates are going down. We would hope that as trends move up that they would be also not eager but certainly committed to raising those to keep a solid market and one that remains competitive. So, hopefully they’ve also learned from the past that you need a marketplace that has adequate rates and that they have a role in that. And so we certainly, in all of our states that we do business are active in terms of that process in making true that participation on rating bureaus and so forth like that, so that we know the state of the trends. We stay close to the trends but we also articulate what we are seeing in our data and what we – our voice in the marketplace. So I hope so and stay tuned. We'll have to see when we reach that point.

Scott Heleniak – RBC Capital Market

All right. And then one final question here. Any changes on the fixed income side? I guess just about every company we follow is talking about moving into munis, any new plans to do that in the near future or are you happy where you are now?

William Hitselberger

Well, actually Scott, we always would consider munis. The one thing that we have that differs us from other carriers is our tax position. We have a pretty significant NOL and what that does is it mitigates some of the benefits of investing in munis. With that said, we certainly have been working with our portfolio managers and evaluating the different opportunities that we see. I think certainly there's been a lot of volatility in the fixed income markets and I think our view is that there is going to be opportunities that open up for us in the third quarter but likely not in the municipal sector.

Scott Heleniak – RBC Capital Market

Okay. Thanks for the answer.

William Hitselberger

Thanks, Scott.

Operator

The next question comes from the line of Beth Malone representing KeyBanc. Please proceed.

Beth Malone – KeyBanc

Thank you. Good morning and congratulations on the quarter.

Vincent Donnelly

Good morning Beth.

William Hitselberger

Good morning Beth.

Beth Malone – KeyBanc

I was just interested that some of your exposures – you co-exposures to re-manufacturing and unemployment's going up and I know you've already spoken to the probability of higher losses, so what about, like demand for Worker’s comp? Is there sensitivity in your top line if employers fuse their head count or consolidate and have you seen that trend at all at this point?

Vincent Donnelly

Hi, Beth. Good morning. It’s Vince. I think two things there, one is within the manufacturing category, if you will, is our largest category but of course within that is pretty diverse in terms of different industry groups. Specifically to what we are seeing for the first six months of this year and we tracked this as well. We've not seen a drop off in the payroll. In fact payroll continues to modestly grow in the businesses that we have. Not only in the manufacturing but I'm saying all the classes that we have and that's something we keep a close eye on. I also would say that as I speak to our field people all the time, the demand for the business continues to be there. So we've not seen the effects of what people are reporting and news about a slow down in the economy and so forth, but that's something that we will continue to monitor and it's also why we are very conscious of having as a diverse broker business from a territory perspective but from industry groups. And so healthcare, for example, is a business that continues to grow for us and we think that's a business not only in this year but will continue to grow past 2008. So we'll keep an eye on it.

Beth Malone – KeyBanc

Okay. And if you look back at other recessions, because you all have been around for a while, did you ever see that incident or because of that diversity, you don't really get that trend?

Vincent Donnelly

Well, our mix of business, I have to say Beth, is changed. In prior to 1997, probably about 35% of our business was in construction. And so we had a different mix back in the '80s and the '90s, and since 1997 through this decade, we certainly have diversified a lot more of our portfolio to be a much more balanced one. So, I don't know. You are right, we've been around a long time, but our mix of business today is different than what it was back in that period of time.

William Hitselberger

The other thing I would add is that the difference between today and recessions of the past – not that we're in a recession today but – the other thing is that most of states have enacted benefit reforms that have severely reduced the incentive for employees to beyond benefit in the Workers’ comp system. So getting back to an earlier question, we think that the benefit reforms that have been enacted in many U.S. states have acted to tamper frequency that you would otherwise have expected to see in economic slowdowns.

Beth Malone – KeyBanc

Okay. And then on the new strategies, the fee-based business that you've been accumulating the last couple of years, is that business less stable than your core – just traditional underwritten workers’ comp business? I mean to say that once you get these contracts like the funding arrangements and stuff, do they tend to come and go as needs of the insurer you’re working with change, like once they get upgraded or something like that then you won’t have that revenue? Do you have to constantly work at finding new opportunities and expect the old opportunities to come off the books over time?

Vincent Donnelly

I guess that – let me separate when you talk about fee-based business and the bulk of our business is what I characterize as traditional third party administration in claims for self-insured types of clients, and we believe that that business gives a lot of stability to that. Whether an account or municipality or whatever moves into the self-insured arena, they generally stay there and don’t come back into the traditional market. They've made a decision for a variety of reasons including size to be out of the mainstream and traditional insurance. So we've seen a lot of stability there and expect to be going forward. I think your reference is to the Appalachian type of arrangement and so forth. We believe, for example I can speak to Appalachian. They have been in business for quite a long time. I think they have a strong flow of business and we certainly expect that the partnership that we have with them to be one that is – will be for quite a while because we provide paper for them and we provide claims administration, we provide guidelines for the rates and all those things and they continue to need that so I think it will be more of a question of how our relationship goes forward in terms of working together in synergy. But I think there'll always a need for that, and we’re in fact replacing somebody that they had that I think we bring to the table a lot more capabilities including their claim capability that they didn’t have before.

Beth Malone – KeyBanc

Okay. And then just one last question on the fee-based business. How is the competitive environment for that? It seems like a natural transition when pricing is tough to go to a more fee-based model. Are you one of many that are trying to access that market?

Vincent Donnelly

In the fee-based business, Beth, there is many, many, many competitors. Certainly there is a handful natural competitors out there that tend to focus a lot more on truing [ph] national accounts. That’s not our cup of tea so to speak. There is a number of regional players and then there is lots and lots of what we would characterize as mom and pop shops. And so there is a lot of competition but we’re not seeing – if your question is, are we seeing other insurance companies that we compete against moving in this direction? I’d say, no, we’re not seeing that. I think some of the national players, national insurance companies have TPAs that service again national accounts and service their own traditional book of business. So we’re not seeing entry that way. In my comments, I mentioned that we’re seeing new entrants. We’re seeing, for example, some of the managed-care companies enter this phase and so competition has increased there. I think they are looking at this as an opportunity potentially to round out their account that they have because they’re providing implicitly at least managed-care services. So can they build on that and provide more services to their customers? So that is an area where we’re seeing more competition, but I would say that they got to build the expertise to handle claims and they have to build the system to deal with the risk management systems which is a different type of technology or different systems than you have for managing medical.

Beth Malone – KeyBanc

Okay. All right. Well, thank you.

Vincent Donnelly

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Randy Binner as a follow-up representing FBR. Please proceed.

Randy Binner – FBR

Yes. Guys, thanks. Just a couple of follow-ups. First, Bill, on the investment portfolio, can you review – I don’t know if you talked about this before on conference calls about the impairment methodology you go through when you look at realized versus unrealized and then maybe some color on how much of the sequential increase or decrease rather in ALCI is related to interest rates versus credit specializing?

William Hitselberger

Yes, I would say that – Let me take the second question first, that’s little bit easier. With respect to the movement that we saw on the second quarter we talked with our portfolio managers. It’s almost exclusively related to the movement in the yield curve. We didn’t see it soften to (inaudible) of change associated with credit spread such as given the nature of the portfolio that we have. With respect to our methodology, what we do is we have obviously the computer database that has all of our securities in them and we keep historic records of market values and amortized costs.

What we do is we look for any particular movement in market on a relative basis in the quarter. We develop a screening system that then gives us a level of security that has movements. Generally what we focus on is securities where we seen – where amortized cost is greater that market value by 10%. Those are securities that we then individually screen. We discuss those securities with the portfolio managers. We look for any trends that we see in those securities and then we make a decision based on that whether or not to make an other-than-temporary impairment charge, financial securities. I think this is screening process is pretty consistent with what other people that have fixed income security. So –

Randy Binner – FBR

But there’s no – you don’t have like a below 80% for six months kind of –?

William Hitselberger

Well, I think that we certainly – I think, if we had a below 80% for six months that would be in our OTTI. We would be realizing that. Certainly the discussion, it occurs between the company and it’s auditors like in the face of a 20% decline that’s over six months, you would have a very hard time convincing an auditor that it was an other-than-temporary impairment.

Randy Binner – FBR

Okay. That’s great. And just one other question, I know were running long in the call, but there’s been a lot of conversation here about frequency of claims in a down economic environment, but Vince maybe if you can touch on this real quick? I guess from your comments, you aren’t really seeing payrolls come down so maybe you have not yet seen unemployment come through but as far as severity of claims go and then particularly getting people back to work in a soft economy, even if you haven’t seen it already maybe you could just share with us how you approach that, how you've seen that (inaudible) in past cycles?

Vincent Donnelly

Well, I think, – let me address what we are approaching and how we try to deal with that. We actually try to deal with that on the front end meeting when we write a piece of business is part of the discussion would be with the client is trying to get a sense of their approach to bringing people back to work and realize the economics has can change over time with their businesses but first and foremost, to make sure that the account has a philosophy about trying to get people back to work on some kind of light duty and so forth.

Secondly when a claim does happen, (inaudible) staff is – our claims staff and our nurse staff continue to be very passionate about working with the medical provider, working with the employer, and most importantly working with the injured worker to get them back. So and I’d say, we’ve not seen any change in the duration of claim or in terms of the severity of a claim if anything actually over the last twelve or eighteen months our indemnity and severity has actually come down slightly, and I say slightly, and that somehow perhaps – extra claims but has also, I think, a lot of the things our staff is focused in on in terms of working each of those claims. And so similar to my comments about the frequency about payroll, we will continue to monitor that and act accordingly but I expect a lot of the procedure we have in place and I think Bill’s comments before and responding to a prior question about the system is different today than it was ten or fifteen years ago in terms of –. There’s more guidelines put in place with the benefit reforms that –. There is criteria for people to stay at on the worker’s compensation roll. Clearly, people that are very injured are going to stay out of those claims. They’re going to be open but the system is –. There has been improvement in the overall worker’s compensation system in most of the states that should help that or mitigate a potentially uptakes in the severity that way.

Randy Binner – FBR

Thank you for the color.

Vincent Donnelly

You’re welcome.

Operator

There are no further questions at this time. I would now like to turn the call back to Mr. Hitselberger for any closing remarks.

William Hitselberger

Thanks, Katrina. This does conclude our conference call. I’d like to thank everybody for joining us and for your questions. And Katrina, if you could please proceed with the closing instructions?

Operator

Thank you. Ladies and gentlemen, this concludes today’s conference call. Should you require additional information about PMA Capital Corporation, please contact the Investor Relations Department of PMA Capital Corporation at [phone]. Thank you for your participation. You may now disconnect. Have a great day.

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