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Philadelphia Consolidated Holdings Corporation (NASDAQ: PHLY) is an insurance holding company with assets of nearly $2.8 billion holding less than 1% of the total US Proprety and Casualty Insurance market, where it operates exclusively. It is included in the Russell 1000. Its subsidiaries' principal activities are to design, market and underwrite specialty commercial and personal property and casualty insurance products. Its target market includes, among others, homeowners' associations, rent-a-car industry, automobile leasing industry, non-profit organizations, the health, fitness and wellness industry, sports centers and selects classes of professional liability. The products^[1] of PHLY are marketed through 330 underwriting professionals and 38 regional offices located in the United States^[2].

PHLY is known for its firm control of its costs and combined ratios, its broad distribution network, and its innovative niche market strategy. Its successful management structure has been attributed to the fact that its managers own over 20% of the company shares, and their compensation tied to key performance ratios, which aligns their interests closely to that of their shareholders' in a business where day-to-day decisions determine long-run profitability. However, in the face of a weak economy fueling price competition, and in particular a depressed market in Insurance companies, PHLY also stepped up its acquisition efforts from 2007, using the new networks it acquired to increase sales. However, PHLY still has competitors of both the niche and the large variety, and is looking to its managers for new products as well as its actuarial team to further improve combined ratios.

Contents 1 Company Overview 1.1 Business and Financial Metrics 1.2 Business Segments 2 Key Trends and Forces 2.1 Catastrophe losses contribute to Earnings Uncertainty 2.2 Designing and Targeting Products in Underserved, Profitable Markets contributes to Organic Revenue Growth 2.3 Fine-tuned, Crowded Distribution Channel Growth generates strong Earnings Growth 2.4 Positive Operating Cash flow leads to growth in Investment Income 2.5 Strength in Underwriting increases, improving PHLY's combined ratio 2.6 Decrease in Management Ownership and Alignment of Interests can lead to a loss of control of Costs 2.7 Pricing Pressure and Low Transaction Costs impose a ceiling on Margins 2.8 Florida Class Action wins claims of over $5 million 2.9 Loss of Confidence in the Economy depresses share prices industry-wide 3 Competition 4 Market Share 5 References

[edit] Company Overview

Philadelphia Consolidated Holding Corp. is an insurance holding company with assets of nearly $2.8 billion, offering commercial, property, and casualty insurance. Commercial products - covering autos and business needs - contribute to 82% of sales. Personal homeowners' insurance, a business being phased out by the company, brings in a further 3.5%, and specialty products - insuring professional liability - add the remaining 14.5%. Philadelphia's insurance is sold by more than 8,700 retail brokers and independent agents and 134 preferred agents known as "Firemark producers", all supported by 38 regional offices, and direct and Internet sales. Philadelphia focuses on catering to customers with specialized insurance needs that are not widely met by the market. The company develops customized products to service these niches and strives to avoid price competition by focusing on products that have few close substitutes. Philadelphia maintains field offices to provide better agent service; this helps attract business^[4].

[edit] Business and Financial Metrics

• 2007 Gross written premium^[6] growth for commercial and specialty lines segments (18.7% and 7.7% increase respectively) were due to an increase in policy counts resulting from continued expansion of marketing efforts through PHLY's field organization and preferred agents, and the introduction of several new niche product offerings. This strong premium growth occurred despite realized average rate decreases for commercial and specialty lines renewal business of (3.6)% and (1.8)% respectively. ^[7]

• $84.6 million of the $218.8 million increase in total Commercial Lines segment of 2007 Gross written premiums was due to the introduction of several new niche product offerings, most notably the antique/collector vehicle commercial auto product, as well as the health and wellness business owner, professional sports and entertainment, religious organizations, camp operators, and affordable housing products in the commercial package product grouping. ^[8]

• For the Personal Lines segment, gross written premiums declined 38.9% during 2007 due to a restriction of business production which included not renewing all homeowners and rental dwelling policies providing windstorm coverage which expired in late 2007. This reduction was imposed following the 2005 hurricane season to reduce the company's exposure to catastrophe wind losses. ^[9]

• PHLY recorded a $117.2 million gain in pretax investment income from its portfolio in 2007, up 27.8% from $91.7 million in 2006. It hires external independent professional investment managers with the objective of realizing relatively high levels of investment income while generating competitive after-tax total rates of return within specific objectives and guidelines. Much of the investment assets (and therefore the investment income) come from reinvestment of cash flow from operating activities, which has seen strong growth with the company's continued expansion. ^[10]

Company	2005[11]	2006[12]	2007[13]
Revenue ($M)	$1,529.6	$1,253.8	$1,051.4
Total Losses and Expenses ($M)	$1,044.3	$819.1	$810.6
Combined Ratio	74.3%	68.3%	78.1%
Total Investments	$3,015.2	$2,433.6	$1,935.0
Net Investment Income ($M)	$117.2	$91.7	$63.7

[edit] Business Segments

PHLY operates solely within the United States through its 38 regional and field offices. Its business strategy is to design, market, and underwrite specialty commercial and personal property and casualty insurance products for select markets or niches by offering differentiated products through multiple distribution channels. The company's operations are classified into the following three reportable business segments which are organized around its three underwriting divisions:

• Commercial Products (82%): The Commercial Lines Underwriting Group has underwriting responsibility for the commercial multi-peril package, commercial automobile, specialty property and inland marine, and antique/collector car insurance products^[15].
  • Commercial Package: PHLY has provided Commercial multi-peril package policies to targeted niche markets for over 19 years. The primary customers for these policies include: non-profit organizations; social service agencies; condominium and homeowners associations; private, vocational and specialty schools; mental health facilities; day care facilities; religious organizations; health and fitness clubs and studios; sports leagues and camps; hotels and motels; golf and country retail shopping centers, business parks and medical facilities; professional and amateur sports associations and teams; entertainment parks/centers; campground and recreational vehicle park operators; and public entities. The package policies provide a combination of comprehensive liability, property and automobile coverage with limits of up to $1.0 million for casualty, $125.0 million for property, and umbrella limits on an optional basis of up to $15.0 million. PHLY has the ability to provide professional/management liability and general liability coverage in one policy, an important convenience factor to its producers and policyholders.
  • Commercial Automobile and Commercial Excess: PHLY has provided primary, excess, contingent, interim and garage liability; physical damage; and property insurance to targeted markets for over 41 years. The primary customers for these policies include: rental car companies; leasing companies; banks; and credit unions.
  • Specialty Property & Inland Marine: PHLY has provided property and inland marine coverage to targeted markets for the past 8 years. The primary customers for these policies include: nursing homes; hospitals; and commercial real estate developers.
  • Antique/Collector Car Program: PHLY has provided specialized automobile liability and physical damage insurance for the antique/collector car industry for over one year. Coverage includes enhancements to the standard automobile policy such as agreed value, inflation guard, auto show and medical reimbursement to meet the unique exposures associated with this industry.

• Personal Homeowners' Insurance (3.5%): The Personal Lines Underwriting Group has underwriting responsibility for personal property insurance products for the homeowners and manufactured housing market in Florida, and the National Flood Insurance Program for both personal and commercial policyholders. PHLY entered the personal lines property and casualty business through the acquisition of Liberty American in 1999. The personal lines segment includes specialized homeowners’ and manufactured housing property business in Florida, and the production and servicing of federal flood insurance under the National Flood Insurance Program (“NFIP”) for both personal and commercial policyholders. During 2007, PHLY restricted its personal lines business production by non-renewing all homeowners and rental dwelling policies providing windstorm coverage which expired between June 15, 2007 and December 31, 2007. This restriction was imposed to reduce its exposure to catastrophe wind losses. This was has been approved by the Florida Office of Insurance Regulation. The non-renewal process is expected to be completed by July 15, 2009. As of December 31, 2007, there were approximately 4,100 in-force policies with an aggregate in-force premium of approximately $3.2 million which expire between July 15, 2008 and December 31, 2008, which will not be renewed during 2008.^[16]

• Specialty Products (14.5%): The Specialty Lines Underwriting Group has underwriting responsibility for the professional and management liability insurance products. PHLY has provided comprehensive professional liability (errors and omissions) and management liability (directors and officers) policies to targeted classes of business for approximately 16 years. Its professional and excess liability policies provides errors and omissions coverage primarily for: accountants; and miscellaneous professionals (preferred classes include among others: computer technology, management and marketing consultants, and claims adjusters). Its management liability policy includes directors and officers, employment practices, fiduciary, workplace violence, and Internet liability coverage parts for: non-profit organizations; and private companies.^[17]

[edit] Key Trends and Forces

[edit] Catastrophe losses contribute to Earnings Uncertainty

PHLY recognized a $7.5 million net loss and loss adjustment expense estimate for the October 2007 California wildfires during 2007, a sum which was not incurred during 2006. ^[18] In the year ended 2005, PHLY recorded catastrophe losses of $3.9 million due to Hurricanes Dennis, Katrina, Rita, and Wilma.^[19] As of 2008, PHLY had already reported losses from hail, tornado and wind incidents in Summer 2008 totaling in a reduction of net income by $13 million. ^[20]The company also noted an increase in natural-damage claims not classified as catastrophes - highlighting the vulnerability of the company's exposure to risks from climate change^[21]. The Company began reducing its exposure to catastrophic weather losses from 2006 (resulting in a near halving of Personal Line business), but only expects to complete this process in June 2009.

[edit] Designing and Targeting Products in Underserved, Profitable Markets contributes to Organic Revenue Growth

PHLY targets markets that are both under-covered and niche oriented. Its 2007-2008 forays into outdoor recreation, antique and collector autos, sports and fitness, religious organizations and others all point to opportunities unearthed by management as underserved niches. 50%^[22] of its business represent 501c-3 or non-profit-type organizations, which are attractive risks to underwrite when in terms of frequency and severity aspects of claims in these lines of business. With no workers' comp underwriting, the tails associated with the package remain shorter than most, providing a higher degree of transparency around the company's reserve position.^[23] In 2008 alone it launched a comprehensive coverage product for apartments, designed for the above average, professionally managed and well maintained market rate apartment^[24], and a Business Auto Fleet product, offering coverage for automobile liability and physical damage^[25]. The goal of management is to add two or three new products per year, while maintaining a disciplined approach to adding new products to ensure risk management.^[26]

[edit] Fine-tuned, Crowded Distribution Channel Growth generates strong Earnings Growth

In addition to under-served markets, PHLY targets niche areas or products with crowded distribution channels. Unlike other insurance companies, PHLY emphasizes distribution of product. Its 5-point distribution model focuses on 30,000 cold calls per month through 300 licensed representatives, 13,000 broker relationships, 194 Firemark Preferred Agents, and Internet and wholesale marketing. PHLY searches for layered distribution channels where the firm can wield its marketing prowess and win business from less flexible competitors. This specific strategy pursues "layered" markets where larger competitors write business using Managing General Agents (MGAs). Due to the small account sizes PHLY underwrites, many larger competitors lack the commitment or time to develop substantial expertise in such markets. Therefore larger competitors may subcontract the underwriting to an MGA. However, in doing so, the broker receives a smaller commission, since the MGA must also be compensated. PHLY, on the other hand, possesses the underwriting expertise and broker relationships within these smaller niche-type markets, avoiding the need for the MGA. This results in higher commissions for the broker, and potentially, a greater incentive to transact business with PHLY.^[27] Its "Firemark" preferred agent program is growing at 15% per year as of 2008^[28].

[edit] Positive Operating Cash flow leads to growth in Investment Income

Total investments grew from $2,542.3 million at of December 31, 2006 to $3,121.5 million at December 31, 2007. Investment income grew from $91.7 million in 2006 to $117.2 million in 2007.The growth in investment income was primarily due to increased investments which arose from investing net cash flows provided from operating activities, even during a period in which the general level of interest rates increased and in which PHLY increased the average duration of its fixed income portfolio.^[29] 89% of PHLY's assets are invested in fixed income, and 11% in securities^[30]. The company has stated that it will allocate larger amounts of capital toward municipal securities, with the corresponding implications for risk of its Investment Income, which in 2007 made up a fifth of Net Income.

[edit] Strength in Underwriting increases, improving PHLY's combined ratio

The company is notable for its consistency in underwriting performance. Over 16 years, PHLY averaged a statutory combined ratio of 86.6%, ahead of the industry average of 105.0%^[31]. The company generated many of its returns over the years without the benefit of an actuarial staff. With the addition in 2002 of a full actuarial staff, underwriting results are expected to improve further. However investors need to consider the benefits of the hard market. ^[32] However, following past success, PHLY managers have committed to growing its revenue at a double-digit pace, despite a soft market. Investors are concerned that the company is under-pricing risk in order to reach this target and this pace of growth might eventually impact margins.

[edit] Decrease in Management Ownership and Alignment of Interests can lead to a loss of control of Costs

Directors and officers of PHLY collectively own close to 20% of the shares, and because managers risk their personal net worth, it is unlikely shareholders' capital will be destroyed via shabby underwriting. The compensation of management is also tied to EPS and combined ratio measures^[33]. PHLY's underwriting margin was close to 15% since 1994, which places it at the head of the underwriting class. However the firm's savvy risk selection and pricing are the result of seasoned managers executing daily. This powerful advantage can erode over time, and PHLY's competitive advantage can disappear with it.

[edit] Pricing Pressure and Low Transaction Costs impose a ceiling on Margins

Over time, policyholders tend to gravitate to the lowest-price policy. Philadelphia's agents, when faced with the prospect of lost business, will either press for lower prices or advise the policyholder to switch to a cheaper insurer. This constant pricing pressure coupled with minimal switching costs cast some doubt on Philadelphia's future success. However PHLY compensates for this by letting its best agents to share equally in its underwriting margins, luring productive agents to PHLY and offering a strong incentive for the agent to submit moneymaking risks. The price pressures have also meant that PHLY has benefited from the general industry consolidation. In March 2008 PHLY announced the acquisition of Gillingham and Associates, Inc., adding about 2.5% of its existing Gross Premiums Written to its 2008 figures, gain in access to 1,600 agency relationships over all 50 states^[34], which will serve as more channels for its broad distribution system.

[edit] Florida Class Action wins claims of over $5 million

In its 10-K, management noted receipt of a "class action complaint" against its personal lines subsidiaries regarding policies written in Florida. The complaint reflects an amount in "excess of $5.0M" ($0.04 per share after-tax) and regards alleged unfair business practices regarding claims between 2003 and 2006. This caused a sell-off of 9.0% in shares^[35]. The company believes the charges to be unwarranted.

[edit] Loss of Confidence in the Economy depresses share prices industry-wide

WIth a beta of 0.94^[37] against the general stock market, the performance of PHLY stock can greatly underperform despite strong fundamental growth. In a weak economy, sentiment for insurance stocks in general will be negative and even quality companies would have difficulty gathering a following under those circumstances.

[edit] Competition

Company	Rev. 2007 ($M)	Total Losses and Expenses ($M)	Combined Ratio	Total Investments	Net Investment Income ($M)
Philadelphia Consolidated Holding (PHLY)	$1,051	$810	78.1%	$1,935	$63.7
RLI Corp (RLI)[38]	$652	$405	71.4%	$1,878	$7.32
American International Group (AIG)[39]	$110,064	$101,121	90.3%	$697,268	$28,619
Tower Group, Inc. (TWGP)[40]	$411	$346	80%	$655	$5.14

[edit] Market Share

Philadelphia is too small to rank in the top 25 rankings of the US Property/Casualty Insurance market, however its size can still be compared with competitors like AIG.

[edit] References

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1. ↑ In the insurance industry, the insurance contracts and policies that are sold are typically referred to as products. Although they lack a similar tangible quality as our everyday consumer goods, the term implies all the elements of design, marketing, and other issues that go into the making of any product.
2. ↑ Thomson ONE Analytics Snapshot
3. ↑ PHLY 2007 Annual Report Item 6 Selected Financial Data
4. ↑ Piper Jaffray Company Note June 17, 2008
5. ↑ PHLY 2007 Annual Report Page 5
6. ↑ When a non-life insurance company closes a contract to provide insurance against loss, the revenues (premiums) expected to be received over the life of the contract are called gross premiums written. Insurance companies often purchase reinsurance to protect themselves against the risk of a loss above a certain threshold; the cost of reinsurance (reinsurance premiums) is deducted from gross premiums written to arrive at net premiums written. Under accrual-basis accounting, only premiums pertaining to the relevant accounting period are recognized as revenues. These premiums are called net premiums earned.
7. ↑ PHLY 2007 Annual Report Page 29
8. ↑ PHLY 2007 Annual Report Page 39
9. ↑ PHLY 2007 Annual Report Page 29
10. ↑ PHLY 2007 Annual Report Page 30
11. ↑ PHLY 2007 Annual Report
12. ↑ PHLY 2007 Annual Report
13. ↑ PHLY 2006 Annual Report
14. ↑ PHLY 2007 Annual Report Page 6
15. ↑ PHLY 2007 Annual Report
16. ↑ PHLY 2007 Annual Report
17. ↑ PHLY 2007 Annual Report
18. ↑ PHLY 2007 Annual Report Page 43
19. ↑ PHLY 2007 Annual Report Page 45
20. ↑ June 19 PR Newswire Article: Philadelphia Consolidated Holding Corp. Reports Losses on Weather Events
21. ↑ PHLY 2007 Annual Report
22. ↑ Piper Jaffray Company Note March 3, 2008
23. ↑ Piper Jaffray Company Note June 17, 2008
24. ↑ Insurance Journal Article, June 13, 2008
25. ↑ Insurance Business Review article, June 9 2008
26. ↑ PiperJaffray Company Note March 3, 2008
27. ↑ Piper Jaffray Company Note June 17, 2008
28. ↑ Piper Jaffray Company Note March 3, 2008
29. ↑ PHLY 2007 Annual Report
30. ↑ Ferris, Baker Watts Analyst Equity Research Report
31. ↑ Piper Jaffray Company Note June 17, 2008
32. ↑ Piper Jaffray Company Note June 17, 2008
33. ↑ PiperJaffray Company Note March 3, 2008
34. ↑ Piper Jaffray Comment: Acquisition Highlights Niche Focus
35. ↑ Piper Jaffray Company Note, March 3 2008
36. ↑ Google Finance Chart
37. ↑ Google Finance Statistics
38. ↑ RLI 2007 Annual Report
39. ↑ AIG 2007 Annual Report
40. ↑ TWGP 2007 Annual Report
41. ↑ National Association of Insurance Commissioners Property/Casualty Insurer Market Share information, accessed July 7 2008

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