<PAGE>
 
                                                                  EXHIBIT 10.17



                 AMENDMENT NO. 3 TO LETTER OF CREDIT AGREEMENT
                 ---------------------------------------------
                                        

          AMENDMENT NO. 3 (this "Amendment"), dated as of October 2, 1998, under
                                 ---------                                      
the First Amended and Restated Letter of Credit Agreement, dated as of March 14,
1997, among PENNSYLVANIA MANUFACTURERS CORPORATION, a Pennsylvania corporation
(the "Applicant"), the Banks party thereto, FIRST UNION NATIONAL BANK, as
      ---------                                                          
successor to CoreStates Bank N.A., as Co-Agent, and THE BANK OF NEW YORK, as
Issuing Bank and as agent for the Banks (in such capacity, the "Agent"), as
                                                                -----      
amended by Amendment No. 1, dated September 29, 1997 and Amendment No. 2, dated
September 28, 1998 (as so amended, the "Agreement").
                                        ---------   


                                   RECITALS
                                   --------

          A.  Capitalized terms used herein which are not defined herein shall
have the respective meanings ascribed thereto in the Agreement.

          B.  Pursuant to Consent No. 1, dated as of September 24, 1998, to the
Agreement, Required Banks consented to the PMA Cayman Sale (as defined below).

          C.  The Applicant has requested that the Agreement be amended to
permit it to issue the Capital Securities referred to below and the Banks
signing below are willing to approve such request subject to the terms and
conditions set forth below.

          Accordingly, in consideration of the terms and conditions hereinafter
set forth, and for other good and valuable consideration, the receipt and
adequacy of which are hereby acknowledged, the parties hereto agree as follows:

     1.   Section 1.1 of the Agreement is amended by adding the following
definitions in their appropriate alphabetical order:

          "Capital Securities" shall mean preferred securities in an aggregate
           ------------------                                                 
     face amount of up to $150,000,000 (i) to be issued by a Delaware business
     trust to be formed by the Applicant and (ii) guaranteed by the Applicant,
     the proceeds from the original issuance of which shall be used to purchase
     the Applicant's subordinated debentures issued under a subordinated
     debenture indenture.

              "Capital Securities Program Documents" shall mean, collectively,
               ------------------------------------                           
          all documents executed and delivered in connection
<PAGE>
 
          with the issuance of the Capital Securities and the subordinated
          debentures referred to in the definition of Capital Securities.

               "PMA Cayman Sale" shall mean the sale by Mid-Atlantic States
                ---------------                                            
          Investment Company of all of its capital stock in PMA Cayman.

               "Subordinated Debentures" shall have the meaning set forth in
                -----------------------                                     
          Section 7.2(x).

               "Subordinated Guaranty" shall have the meaning set forth in
                ---------------------                                     
          Section 7.2(x).

     2.   The definition of "Material Subsidiary" contained in Section 1.1 of
the Agreement is amended by adding "provided, however, that on and after the
consummation of the PMA Cayman Sale, PMA Cayman shall cease to be a Material
Subsidiary" prior to the "." at the end of such definition.

     3.   The proviso contained in the definition of "Contingent Obligation" in
Section 1.1 of the Agreement is amended to read as follows:

          provided, however, that, with respect to the Applicant and its
          --------  -------                                             
          Subsidiaries, the term Contingent Obligation shall not include (x) the
          Subordinated Guaranty, (y) endorsements for collection or deposit in
          the ordinary course of business or (z) obligations entered into by an
          Insurance Subsidiary in the ordinary course of its business under
          insurance policies or contracts issued by it or to which it is a
          party, including reinsurance agreements (and security posted by any
          such Insurance Subsidiary in the ordinary course of its business to
          secure obligations thereunder).

     4.   The definition of "Consolidated Net Worth" contained in Section 1.1
of the Agreement is amended in its entirety to read as follows:

               "Consolidated Net Worth" shall mean, at any time, the net worth
                ----------------------                                        
          of the Applicant and its Subsidiaries at such time, determined on a
          consolidated basis in accordance with Generally Accepted Accounting
          Principles plus the redemption value or liquidation preference (or, if
                     ----                                                       
          less, the original issuance price) of the Capital Securities but (i)
          excluding any preferred stock or other class of equity
 
                                      -2-
<PAGE>
 
          securities (other than the Capital Securities) that, by its stated
          terms (or by the terms of any class of equity securities issuable upon
          conversion thereof or in exchange therefor), or upon the occurrence of
          any event, matures or is mandatorily redeemable, or is redeemable at
          the option of the holders thereof, in whole or in part, and (ii)
          without regard to the requirements of Statement of Financial
          Accounting Standards No. 115 issued by the Financial Accounting
          Standards Board.

     5.   Clauses (i) and (ii) of the definition of "Indebtedness" contained in
Section 1.1 of the Agreement are amended to read as follows:

     (i)  all indebtedness of such Person for borrowed money or in respect of
     loans or advances (other than indebtedness in respect of the Subordinated
     Debentures), (ii) all obligations of such Person evidenced by notes, bonds,
     debentures (other than the Subordinated Debentures) or similar instruments,

     6.   Section 7.2 of the Agreement is hereby amended by deleting the word
"and" at the end of section 7.2(viii), by substituting "; and" for the period at
the end of 7.2(ix) and adding the following clause at the end thereof:

          (x) the Applicant may issue subordinated debentures (the "Subordinated
                                                                    ------------
     Debentures") to the trust issuing the Capital Securities in an aggregate
     ----------                                                              
     principal amount not to exceed $150,000,000 and, without duplication, may
     guaranty the payment of the Capital Securities on a subordinated basis (the
     "Subordinated Guaranty"), in each case in connection with the issuance of
      ---------------------                                                   
     the Capital Securities, provided that:

               (A)  no Default or Event of Default would exist before and after
     giving effect thereto, the representations and warranties set forth in
     Section 4 and in the other Credit Documents shall be true and correct
     (except to the extent that any such representation and warranty is
     expressly stated to have been made as of a specific date in which case such
     representation and warranty shall be true and correct as of such date) and
     the Agent shall have received a certificate of a financial officer of the
     Applicant, in form and substance satisfactory to the Agent, to the
     foregoing effects;

               (B)  the terms of the Capital Securities, Subordinated Debentures
     and the Subordinated Guaranty shall be in all material respects
     substantially as described in Appendix A to Amendment No. 3 to this

                                      -3-
<PAGE>
 
     Agreement or no less favorable to the Banks than as set forth in such
     Appendix A and in any event, shall contain the following features: (i)
     neither the Capital Securities nor the Subordinated Debentures shall by
     their terms mature or become mandatorily redeemable, or be redeemable or
     subject to any mandatory prepayment or repurchase requirement at the option
     of the holder, at any time on or prior to ten years after issuance of such
     securities, (ii) the Applicant shall have the right (so long as no event of
     default exists with respect to such securities) to defer the payment of
     interest on the Subordinated Debentures from time to time for a deferral
     period comprised of consecutive payment periods aggregating at least five
     years and, upon such election by the Applicant, the trust issuing the
     Capital Securities shall have a corresponding obligation to defer
     distributions with respect to the Capital Securities, and (iii) the Capital
     Securities, the Subordinated Debentures and the Subordinated Guaranty shall
     be fully subordinate and junior in right and time of payment to the
     Indebtedness evidenced by this Agreement and shall have other terms of
     subordination consistent with those prevailing in the market for similar
     subordinated securities as of the date of Amendment No. 3 to this
     Agreement; and

          (C)  the Agent and each Bank shall have received a certificate of an
     executive officer of the Applicant attaching true and complete copies of
     all Capital Securities Program Documents.

     7.   Section 8.1 of the Agreement is amended by substituting "; or" for the
period at the end of subsection (n) thereof and by adding a new subsection (o)
to read as follows:

          (o)  The occurrence of an event of default in respect of the Capital
     Securities or any other event shall occur or condition exist in respect
     thereof, the effect of which is to cause, or permit the holder of any
     Capital Security (or a trustee or agent on its or their behalf) to cause
     (with the giving of notice, lapse of time, or both), such Capital Security
     to become due, or to be prepaid, redeemed, purchased or defeased, prior to
     its stated maturity.

     8.   Section 5.1(b) of the Agreement is amended by adding the phrase "for
each fiscal year prior to the fiscal year in which the PMA Cayman Sale is
consummated," at the beginning of clause (iii) thereof.

     9.   Attachment A to Exhibit E-2 (Form of Covenant Compliance Certificate
(Statutory Financial Statements) is amended by adding to the end of Item 1(h)
thereof "(enter zero after the consummation of the PMA Cayman Sale)".

                                      -4-
<PAGE>
 
     10.  Paragraphs 1-9 of this Amendment shall not be effective until the
prior or simultaneous fulfillment of the following conditions: (the "Amendment
                                                                     --------- 
Effective Date"):
--------------

          (a)  the Agent shall have received this Amendment, duly executed by a
     duly authorized officer or officers of the Applicant, the Agent and
     Required Banks;

          (b)  the Agent shall have received a certificate of the Secretary or
     Assistant Secretary of the Applicant (i) attaching a true and complete copy
     of the resolutions of the Executive and Finance Committees of its Board of
     Directors authorizing this Amendment, in form and substance satisfactory to
     the Agent, (ii) certifying that its certificate of incorporation and by-
     laws have not been amended since March 14, 1997, or, if so, setting forth
     the same and (iii) setting forth the incumbency of its officer or officers
     who may sign this Amendment, including therein a signature specimen of such
     officer or officers;

          (c)  the Agent shall have received a copy of an amendment to the
     Revolving Credit Agreement, in form and substance satisfactory to it, which
     amendment shall have been executed by the Agents and Required Banks (as
     defined therein);

          (d)  the reasonable fees and expenses of Special Counsel incurred to
     date, shall have been paid; and

          (e)  the Agent shall have received such other documents as it shall
     reasonably request.

          11.  The Applicant hereby (i) reaffirms and admits the validity and
enforceability of the Agreement and the other Credit Documents and all of its
obligations thereunder, (ii) represents and warrants that there exists no
Default or Event of Default immediately after giving effect to this Amendment,
and (iii) represents and warrants that the representations and warranties
contained in the Credit Documents, including the Agreement as amended by this
Amendment (other than the representations and warranties made as of a specific
date), are true and correct in all material respects on and as of the date
hereof.

                                      -5-
<PAGE>
 
     12.  In all other respects, the Agreement and the other Credit Documents
shall remain in full force and effect.

     13.  This Amendment may be executed in any number of counterparts, each of
which shall be an original and all of which shall constitute one agreement. It
shall not be necessary in making proof of this Amendment to produce or account
for more than one counterpart signed by the party against which enforcement is
sought.

     14.  This Amendment is being delivered in and is intended to be performed
in the State of New York and shall be construed and enforceable and be governed
by, the internal laws of the State of New York without regard to principles of
conflict of laws.

     [signature pages follow]

                                      -6-
<PAGE>
 
          AS EVIDENCE of the agreement by the parties hereto to the terms and
conditions herein contained, each such party has caused this Amendment No. 3 to
the Letter of Credit Agreement to be executed on its behalf.


                                   PENNSYLVANIA MANUFACTURERS

                                   CORPORATION



                                   By:/s/Edward Hochberg
                                      _______________________

                                   Name:Edward Hochberg
                                        _____________________

                                   Title:Vice Presdent- Finance
                                         ______________________
<PAGE>
 
                    PENNSYLVANIA MANUFACTURERS CORPORATION

                 AMENDMENT NO. 3 TO LETTER OF CREDIT AGREEMENT

                                        

                                   THE BANK OF NEW YORK, Individually

                                   and as Agent and as Issuing Bank



                                   By:/s/Lizanne T. Eberle
                                      _________________________________

                                   Name:Lizanne T. Eberle
                                        _______________________________

                                   Title:Vice President
                                         ______________________________

                                      -2- 
<PAGE>
 
                    PENNSYLVANIA MANUFACTURERS CORPORATION

                 AMENDMENT NO. 3 TO LETTER OF CREDIT AGREEMENT

                                        

                                   FIRST UNION NATIONAL BANK,

                                   Individually and as Co-Agent



                                   By:/s/Thomas L. Stitchberg
                                      ________________________________

                                   Name:Thomas L. Stitchberg
                                        ______________________________

                                   Title:Senior Vice President
                                         _____________________________

                                      -3-
<PAGE>
 
                    PENNSYLVANIA MANUFACTURERS CORPORATION

                 AMENDMENT NO. 3 TO LETTER OF CREDIT AGREEMENT

                                        

                                   FLEET NATIONAL BANK



                                   By:/s/William A. Bagley
                                      ________________________________

                                   Name:William A. Bagley
                                        ______________________________

                                   Title:Senior Vice President
                                         _____________________________

                                      -4-
<PAGE>
 
                    PENNSYLVANIA MANUFACTURERS CORPORATION

                 AMENDMENT NO. 3 TO LETTER OF CREDIT AGREEMENT

                                        

                                   PNC BANK, NATIONAL ASSOCIATION



                                   By:/s/Kirk Seagers
                                      ________________________________

                                   Name:Kirk Seagers
                                        ______________________________

                                   Title:Vice President
                                         _____________________________

                                      -5-