All about converts

PRA analysis – May 13, 2005

Summary

I estimate a 200 over Libor spread for PRA. The convert market implies a spread close to 700 over Libor using 107.5 v 39.46 and 20 vol. The market must be concerned about a cash takeover. Fitch has a BBB- rating for the company.

1) PRA is a well managed company that has one of the best operating metrics in the industry with a much lower combined ratio than the industry. They are disciplined with their underwriting policies and will pass over revenue growth opportunities that do not generate an acceptable ROE of at least 12%.

2) The industry structure is such that PRA has dominant market shares in several states, which should be good for pricing even in a down cycle. Local familiarity with the courts, judges and lawyers gives the company an advantage.

3) The major risks for the company include irrational pricing by competitors, a surge in claims that are not covered by loss reserves, and unfavorable tort/regulatory reform. These risks should be either unlikely or manageable by the company.

3) There is some risk of a takeover but PRA’s high valuation at 1.9x book value makes an acquisition unlikely. Berkshire Hathaway bought PRA’s competitor (Medical Protection) for 1.12X book value in May 2005. PRA bought NCRIC in February for 1.0x book value.

4) Dividends are also unlikely since the rating agencies want PRA to keep enough capital on the books to last through the next down cycle.

Business

PRA operates 2 segments: Professional Lines (73%) and Personal Lines (27%). Professional lines include selling medical professional liability insurance in 10 states. Personal lines include selling auto and homeowners insurance toMichiganteachers and educators. The main focus for investors is the professional line.

Professional Lines

This segment focuses on writing medical malpractice insurance policies for doctors, dentists and other healthcare providers. PRA provides medical professionals protection against claims arising from injury, disability, or death of patients. PRA is the fourth largest medical malpractice carrier with 5% market share and operates in 10 states mainly in the Southeast. PRA was formed from a de-mutualization in 1991 and has since grown through acquisitions.

Industry Background

Medical malpractice is a small, specialty part of the insurance market that is considered complex and risky. The industry started when doctors got together to form mutually owned insurance companies to provide them with protection against malpractice lawsuits. This was driven by the evolution of the patient/doctor relationship to a less-personal managed care environment where cost containment is the driving force with more abuses being reported. 

Over the years, these mutually owned insurance groups consolidated within their own states leading to the current market structure where there is no big dominant national medical malpractice firm. On the state level, however, the top 1 or 2 firms have dominant market share while the others split the rest. Market share shifts are hard to come by unless there is aggressive pricing or missteps by one of the competitors. Regulation is at the state level so PRA is diversified by operating in many states.

Medical malpractice insurance cycle

Insurance cycles in general move from hard markets (good pricing) to soft markets (poor pricing) as underwriting capacity moves from under-capacity to over-capacity. When business is good, insurers will allocate more capacity and attempt to gain market share. This leads to over-capacity forcing prices lower and thus causing insurers to leave the market. Then the cycle starts over again. Medical malpractice tends to have longer cycles than other insurance segments because of the long-tail nature of its claims. Long-tail refers to the long period of time between collecting the premium for insuring a risk and the ultimate payment of losses, often exceeding 5 years. This long tail allows the company to invest the premiums it collects interest until the losses are paid. By contrast, auto insurance is an example of a short tail product.

Litigation began to surge in the mid-1960s when jury awards began to escalate. Many insurers found it difficult to accurately predict future claims costs and to calculate the corresponding premium to charge to cover that uncertain liability. As a result, insurers pulled out of the market or reduced their capacity. The industry rebounded in the late 1970s as companies became more skilled at pricing but reached another crisis in the mid-1980s. Jury award began to skyrocket again but few players dropped out this time leading to a sustained period of poor profitability for the industry. The current hard cycle started in the 1999 and continues currently. Most analysts believe we are in the 6-7^th inning of this cycle. PRA management believes the cycle has reached a plateau and should be good for at least another 2 years. They believe the prolonged soft market of the 1980s and 1990s will lead to a longer hard market as many players still have the pain of the long soft market in their minds.

Insurance metrics

The combined ratio is the sum of the net loss ratio (loss divided by premiums) and the operating expense ratio (expenses divided by premiums). A combined ratio below 100% indicates profitable underwriting prior to investment income while a ratio above 100% indicates losses. For long-tail products, the combined ratio is usually more than 100% because of the higher investment income while the ratio is usually less than 100% for short-tailed products.

PRA has operated with a much lower combined ratio than the industry average.  

Personal Lines

PRA operates in this segment through its MEEMIC Holdings unit which was acquired in 1999 as part of the company’s acquisition of Professional Group. MEEMIC was founded as a mutual company byMichiganteachers and has provided personal lines insurance to the educational community since 1950. This unit does not fit in with PRA’s core medical malpractice unit but it has been performing so well that PRA has decided to keep the unit for now.

MEEMIC’s advantage is that it utilizes current and former teachers as captive agents to market and sell products to other education professionals. This target market provides a stable and attractive risk profile as proven by the company’s six year average combined ratio of 89.3%.

Management strategy

PRA’s primary focus is on ROE. They are disciplined underwriters and will not chase market share or revenue growth. The company has dominant market shares in a few states which forms the foundation of their business. They will look to enter new markets in adjacent states either through acquisitions or when a good opportunity presents itself. For example, management entered theOklahomamarket after the dominant carrier in that state had pricing problems and went bankrupt. The company will also enter new markets very slowly after years of studying them. Most recently, the company enteredArkansasandKentuckyby first serving them from nearby offices before building new infrastructure in those states. In February, the company agreed to acquire NCRIC for $70M in stock (1.0x book) to gain entry intoVirginiaandDelaware.

Regulatory issues

Regulations vary by state and range from pricing, legislative issues, tort reform issues, jury payouts, statute of limitations and many others. For pricing, the three models that states adopted are 1) market based rate 2) PRA exchanges rate increase proposals with the state and then negotiates a middle ground 3) PRA sets a market based rate that later gets adjusted. In general regulators are not very strict with pricing regulations.

InFlorida, doctors tried to fight back against malpractice lawsuits by putting limits on awards. The lawyers countered with a bill that would cause a doctor to lose his license after 3 malpractice judgments against him. According to PRA investor relations, this led to a battle where the lawyers absolutely crushed the doctors. PRA said they will have to adjust to the new legal environment where doctors may have to settle more lawsuits or risk an adverse judgment. However, PRA said that they do not see this happening in their other states.

Capital Structure and Credit Analysis

PRA has $28M in cash and $151M in debt. The company generates about $350M to $400M in free cash flow per year. They have $107.6M in converts and the rest in bank debt.

The converts are senior unsecured 3.9% due 6/30/23, callable 7/7/08 and putable 6/30/08. The converts are protected for dividends over 2.5c per share per quarter or 10c per share per year before 6/30/08 and protected for 0.625% of market cap per quarter or 2.5% of market cap after 6/30/08.

The converts are not takeover protected.

The converts are rated BBB- by Fitch and unrated by S&P and Moodys. I estimate the credit spread for PRA to be 200 over Libor, given that PRA a smaller company operating in one of the more risky insurance segments. The company is disciplined with pricing and should easily survive through the next down cycle. 

Dividend risk

In the past, PRA paid stock dividends because their float was low and they wanted to increase the share count. After their follow-on stock offering in 11/02, there was no longer a need to do that. They do not anticipate issuing a cash dividend or stock buyback in the near future. According to analysts, rating agencies want PRA to retain capital and would not look at dividends or buybacks favorably. Also, PRA said that they do not want to commit to a dividend given the cyclical nature of the industry.

Acquisition risk

The natural buyers for PRA are Berkshire Hathaway, AIG, or an international firm likeZurich. Many companies view medical malpractice as a small and complicated market that is not worth owning.Berkshirerecently bought GE’s medical protection unit and will unlikely buy PRA because there are too many overlaps. AIG has it own problems to manage. Additionally, PRA currently trades at 1.9X book value which would be too expensive for any potential acquirer. By contrast,Berkshirebought GE’s unit for 1.12x book value and PRA bought NCRIC for 1x book value.

However, CEO Derrill Crowe, who owns 8% of the company, is in his late 60s and may look to exit in a few years or given the right offer.

Risks

Berkshire Hathaway acquired the GE medical malpractice unit in May 2005.

There is a risk thatBerkshirewill provide the unit with more capital to go after market share. However,Berkshire’s strategy with their insurance unit is to make profits and will likely stay away from irrational pricing. Some analysts think that some business will shake out and could give PRA an opportunity to win those customers.

Insurance cycle ends abruptly and we enter a pro-longed soft market

There are no signs that the medical malpractice cycle will end in the next 12-18 months. A lot of capacity exited the market in the late 1990s, leaving a lower level of capacity. PRA said its average rate increases in 2005 is 12%. Many industry players still have the prolonged soft cycle fresh in their minds and are not willing to make any irrational moves.

Loss reserves are not enough

PRA management says that they are very conservative with their loss reserves by initially reserving high. Despite the surge in malpractice claims and the generous jury awards incurred by the industry, PRA has not taken a significant charge.

Legislative/tort reform

Overall, tort reform has been more favorable in recent years. However, the national tort reform seems dead and it is up to the individual state to decide. PRA has a diversified business and is not overly exposed to adverse regulations in any one state.