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We downgraded our recommendation on ProAssurance Corp. (PRA - Analyst Report) to Neutral based on the ongoing weak macro cues that have been reducing investment portfolio and cash flow. Moreover, though the company has been expanding through acquisitions, risk of integration continues to hover in the upcoming quarters.

ProAssurance’s reported its second-quarter operating earnings of $53.7 million or $1.74 per share, which comfortably surpassed the Zacks Consensus Estimate of $1.26. This also compared favorably with earnings of $42.3 million or $1.29 per share in the prior-year quarter.

However, ProAssurance has been consistently suffering from higher underwriting, policy acquisition and operating expenses. These expenses surged 16.1% year over year in 2009 and 15.8% in 2010 followed by a 9.1% increase in the first half of 2011, thereby also deteriorating the underwriting ratio.

Although operating cash flow improved to $139.2 million in 2010 from $75.4 million in 2009, these were lower than $167.8 million in 2008. Operating cash flow further deteriorated in the first half of 2011 to $53.1 million from $75.9 million in the year-ago period, which again reflects a shady outlook in future. Going ahead, though the company has been expanding through acquisitions, risk of integration continues to hover in the upcoming quarters.

Nevertheless, ProAssurance group enjoys an A rating from A.M. Best, Moody’s and Fitch rating agencies, reflecting financial strength and a sturdy outlook. This also validates the company’s strong claims-paying ability and operating performance. The rating agencies have also recognized ProAssurance as one the nation’s largest publicly traded medical professional liability specialist insurance writer.

Despite a soft cycle in the medical liability business, ProAssurance has significantly expanded its geographic footprint through successful acquisition as well as the integration of companies and books of business. Also, its commitment to local market needs, personal service and local knowledge differentiates the company from its competitors both in organic growth and acquisition opportunities. The acquisition of American Physicians Service Group Inc. (APS) will further enable the company to penetrate the evolving hospital market.

Prudent capital management is another key strength for ProAssurance, which is reflected by a low-risk balance sheet and healthy loss reserves. Further, a strong expense management is also boosting the bottom-line results and operating dynamics. These are also being reflected in the company’s return on equity (ROE), which increased to 10.8% in the first half of 2011 as compared with 9.0% in the prior-year period. Going ahead, these factors should also help the company generate its targeted long-term average ROE of 12–14%.

Overall, though the intense price and product competition, weak rates loss cost trends and regulatory challenges limit the desired upside in the sector, we believe the benefits of stable ratings, geographic diversity, aggressive claims defense and strong financial position are likely to have a positive impact over time. These factors also pave way for stock repurchases, thereby retaining shareholders’ confidence in the stock.

As a result, the Zacks Consensus Estimate for the third quarter of 2011 is currently pegged at $1.74 per share, up about 35% year over year. However, earnings are expected to decline about 9% year over year to $6.24 per share for full-year 2011.

The quantitative Zacks Rank for ProAssurance is currently #3, indicating no directional pressure on the shares over the near term. Additionally, the company primarily competes with MontpelierRe Holdings Ltd. (MRH - Analyst Report) and PMI Group Inc. , both of which carry a long-term recommendation of Underperform.

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