We have downgraded our recommendation on Amerisafe Inc. (AMSF">AMSF) to ‘Underperform’ from ‘Neutral’ based on its weak first quarter performance that questions its current sustainability factor. The company’s first-quarter operating earnings per share of 35 cents lagged the Zacks Consensus Estimate of 39 cents and 45 cents reported in the prior-year quarter.

Low underwriting profits coupled with higher expenses pulled down both the combined ratio and the operating ROE substantially. These factors also negated the marginal growth achieved in the top line.

While Amerisafe is at an inflection point, the company witnessed a drastic decline in earnings growth in the first quarter of 2011 given the inadequate growth in investment income owing to low investment yield, which was followed by increased loss and loss adjusted expenses. Moreover, higher underwriting expenses also held back the company’s underwriting profitability.

As a result, net income and operating income witnessed sharp declines in the recent quarter. Going ahead, increasing imbalance in underwriting profitability and sluggish investment yield inflate ample financial and operating risk, thereby attracting scrutiny of the company’s growth model in the upcoming quarters.

These issues have even marred the return on equity (ROE). The company’s financial objective is to produce an ROE of at least 15% over the long term while maintaining optimal operating leverage in its insurance subsidiaries.

However, the sluggish economic recovery and dampened macro factors have produced an operating ROE of 9.9% for 2010 against 15.4% in 2009, and 8.1% in the first quarter of 2011 versus 14.7% in the year-ago period. Being a significant growth measure, declining ROE further showcases declining earnings growth.

Moreover, adverse current accident year losses have weakened the combined ratio, which is a significant growth indicator in the insurance industry. Consequently, combined ratio has deteriorated to 93.3% in 2010 from 86.9% in 2009 and 81.4% in 2008. Combined ratio worsened further to 98.3% in the first quarter of 2011 against 91.5% in the year-ago quarter.

The workers compensation industry is cyclical in nature and influenced by many factors including price competition, natural and man-made disasters, changes in interest rates and general economic conditions.

Currently, the workers compensation insurance industry is in the midst of a soft market cycle, characterized by increased competition that results in lower premium rates, expanded policy coverage terms and higher commissions paid to agencies. Going ahead, any change in the workers compensation laws could also affect revenues.

Based on these factors, performance in the forthcoming quarters is expected to be sluggish and we anticipate some downside in the stock, in the near to intermediate term. This is also evident from the fact that over the past 30 days, no analysts covering the stock have raised their estimates for the second quarter of 2011. However, one out of six analysts covering the stock has lowered his estimate over the past 30 days.

Additionally, Amerisafe’s earnings in the second quarter of 2011 are expected to plunge by about 28% year over year to 38 cents. Meanwhile, according to the Zacks Consensus Estimate, a year-over-year decline of about 2% is estimated for 2011, at $1.52 per share.

Nevertheless, improved book value, prudent capital management, extended share repurchase plan and a strong financial strength rating augur a decent long-term growth. Overall, though the pricing environment has witnessed some improvement, the company is expected to face uncertainty for the next few quarters as the market weakness continues to hurt payrolls. Amerisafe competes with SeaBright Insurance Holdings ( ) and Employers Holdings Inc. ( EIG - Snapshot Report ) .

The quantitative Zacks Rank for Amerisafe is currently #5, indicating strong downward pressure on the shares over the near term.