Palomar Holdings (NASDAQ:PLMR) is not your typical insurance company. While you may be familiar with home and auto insurance, Palomar provides insurance coverage in what it identifies as underserved markets -- markets that don't have much competition from older, more traditional insurance companies.

Palomar specializes in providing earthquake, wind, and flood insurance to businesses and individuals. It has done a great job of identifying underserved markets and creating insurance products for them while maintaining its profitability. Because of this focus on underserved markets, Palomar is able to serve the needs of customers that might go unfulfilled otherwise. And with strong growth on the top and bottom lines, Palomar has rewarded shareholders since it went public in April 2019.

Investors may have concerns that the stock is expensive today, and they may be worried about the impact from climate change and an active hurricane season in the Atlantic. However, a strong focus on conservative underwriting practices -- including reinsurance coverage to guard against excess liability -- is one way the company protects itself from catastrophe. Given the unique nature of this business and its effectiveness in underwriting policies, Palomar is a company you'll want to consider adding to your portfolio..

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Providing insurance to underserved markets

In 2014, Palomar recognized a problem with the earthquake insurance products available at the time -- while coverage was widely available for businesses, residents who wished to purchase earthquake coverage found that their options were limited and expensive. Earthquake insurance was the company's main insurance product early on, with most of its business coming from California. By the end of 2019, Palomar grew to become the state's fifth-largest provider of earthquake insurance coverage. 

Palomar has continued to seek out underserved markets, such as Hawaiian hurricane insurance. The company has seen the biggest growth in its commercial all-risk, commercial earthquake, and specialty homeowners products, with gross written premiums up 83.8%, 55.1%, and 30.4%, respectively, this year compared to the first half of 2019. Over that period, these products made up about 46% of total gross written premiums for the company. (Residential earthquake coverage still makes up the biggest chunk, at 41%, but that's down from 53% last year.) 

The company utilizes proprietary modeling techniques to analyze data at the ZIP code level, rather than basing rates on broad territorial pricing zones. By balancing automation with human expertise, Palomar has managed to underwrite more complex risks, which enables it to serve new markets.

Palomar finds itself indirectly competing with national insurance companies such as American International Group, Chubb, and State Farm, along with specialty property insurers such as Zephyr Insurance and GeoVera Holdings. It also competes with publicly managed enterprises such as the California Earthquake Authority and the National Flood Insurance Program. However, because of a strategic focus in underserved markets, Palomar has few direct competitors. 

The company has done a great job of expanding its product lines to grow premiums written while diversifying the risk in its insurance book. Palomar has managed to do all of this while maintaining solid combined ratios -- a key metric in the insurance industry.

Strong combined ratios with high retention rates bode well for this insurance provider

Combined ratio is used to measure profitability and operating performance. The combined ratio is the sum of operating costs and insurance claims divided by total premiums. A ratio below 100% means that a company is making an underwriting profit, while a ratio over 100% means the company is spending more on claims and operating expenses.

From 2017 to 2019, Palomar posted strong combined ratios of 92.9%, 71.6%, and 91.3% -- which shows that the company has done an effective job of underwriting policies in underserved markets while ensuring those policies are profitable. Through the first two quarters of 2020, Palomar's combined ratio is an impressive 66.1%. 

Premium retention rates have been strong as well. In the most recent quarter, the company reported a retention rate of 88%, highlighting rates over 92% in its products for residential earthquakes, all risks, and Hawaii hurricanes. High retention rates in its various product lines shows that customers are happy with the insurance coverage provided, a good sign.

Risk management is key to Palomar's future success

With a price-to-earnings ratio of 47.63, Palomar appears to be expensive. However the valuation may be justified, as Palomar has done an effective job of growing its top and bottom lines by expanding the types of insurance it provides over the years.

Palomar has managed to grow gross written premiums to $288.7 million in the trailing 12 months, up 140% since 2017. This has helped top- and bottom-line growth, with revenue and net income in the trailing 12 months coming in at $146.3 million and $42.1 million -- for a compound annual growth rate of 29.3% and 99.1%, respectively, since 2017. 

The biggest risk to Palomar is that climate change could increase the frequency and severity of extreme weather events. Severe and unpredictable catastrophic risks could reduce earnings and limit future underwriting, hurting the bottom line. In fact, the company recently released guidance that it expects catastrophe losses of $34 million to $38 million in the third quarter, due to four hurricanes making landfall in the U.S. 

Because of the natural disaster risk Palomar faces, it uses reinsurance coverage -- a form of insurance for insurance companies -- that protects it from excess liabilities due to a catastrophic event. This risk transference is a critical component of Palomar's strategy to focus on creating insurance products with attractive pricing dynamics and a favorable risk-to-return profile, and is a necessity if it wants to achieve top-line growth while expanding its products.

A high-growth insurance company

Palomar is a great insurance provider in underserved markets, and has created products that are in high demand from consumers -- commercial and residential alike -- as seen by the growth in gross written premiums. The company has done a great job of diversifying while maintaining steady combined ratios while hedging for risks with reinsurance coverage.

While the company faces risks due to potential catastrophic events, including continuing hurricane activity in the Atlantic this fall, it has maintained a conservative insurance book while managing to grow its top and bottom lines. Palomar could be worth a look for your portfolio.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.