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We are downgrading our recommendation on ProAssurance Corporation (PRA - Analyst Report) to Neutral based on volatility in its core business and poor investment income along with higher underwriting, policy acquisition and operating expenses.

ProAssurance reported second-quarter operating earnings per share of $1.92, striding ahead of the Zacks Consensus Estimate of $1.52 and the year-ago quarter’s earnings of $1.74. Operating earnings stood at $59.5 million, compared with $53.7 million in the prior-year quarter.

ProAssurance’s commitment to local market needs and personal service differentiates it from competitors both in the areas of organic growth and acquisition opportunities. The company has significantly expanded its geographic footprint through the successful acquisition and integration of companies.

The company’s financial size and strength have helped it become an attractive acquirer. The company is also trying to boost its operating efficiency by merging its subsidiaries in order to simplify its business structure.

Prudent capital management is another key strength for ProAssurance, which is reflected in the low-risk balance sheet and healthy loss reserves. All of the subsidiaries of ProAssurance exceed the minimum risk-based capital requirements specified by the National Association of Insurance Commissioners (NAIC).

Given its strong claims-paying ability, ProAssurance enjoys ratings of “A” from both A.M. Best and Fitch rating agencies as well as “A3” from Moody’s. Moreover, consistent profits by ProAssurance’s subsidiaries, its strong capital position, operating and financial flexibility, and a veteran management team prompted Fitch Ratings to affirm the issuer default rating of the holding company at “BBB+” and the insurer financial strength ratings of all insurance operating subsidiaries of ProAssurance at “A” with a stable outlook in September 2012.

However, ProAssurance’s core business has been witnessing substantial volatility over the past several years, which is reflected in the wide fluctuations in net premiums earned and written. These fluctuations are expected to continue in the future, given the inherent threats associated with the medical professional liability insurance sector related to price competition, legislative reform, loss cost trends and regulatory challenges.

Another major risk is associated with ProAssurance’s investment portfolio, which primarily consists of fixed income securities. The declining interest rate forces the company to reinvest its matured investments at comparatively lower interest rates, which leads to declining investment income. This is also validated by the net investment results (sum of net investment income and equity in earnings of unconsolidated subsidiaries) that declined 7.2% in the first half of 2012.

Moreover, ProAssurance has been consistently suffering from higher underwriting, policy acquisition and operating expenses. Additionally, the shifting of employees to the new processing centers opened in June 2012 added to expenses in the second quarter of 2012 since the company paid relocation bonuses to the relocating employees and termination benefits to those who could not relocate. Moreover, unrealized losses and higher loss reserves have led to declining operating cash flow.

ProAssurance, which competes with United Fire & Casualty Company (UFCS - Snapshot Report) and Montpelier Re Holdings Ltd. (MRH - Analyst Report), carries a Zacks #2 Rank (short-term Buy).

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