FIRST MERCURY FINANCIAL CORP - FORM 10-Q

Attached files

file	filename
EX-10.34 - EX-10.34 - FIRST MERCURY FINANCIAL CORP	k48528exv10w34.htm
EX-31.(B) - EX-31.(B) - FIRST MERCURY FINANCIAL CORP	k48528exv31wxby.htm
EX-32.(B) - EX-32.(B) - FIRST MERCURY FINANCIAL CORP	k48528exv32wxby.htm
EX-31.(A) - EX-31.(A) - FIRST MERCURY FINANCIAL CORP	k48528exv31wxay.htm
EX-32.(A) - EX-32.(A) - FIRST MERCURY FINANCIAL CORP	k48528exv32wxay.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______________ to _______________

Commission File Number 001-33077

FIRST MERCURY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)


Delaware		38-3164336
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

29110 Inkster Road Suite 100 Southfield, Michigan (Address of Principal Executive Offices)		48034 (Zip Code)

Registrant’s telephone number, including area code: (800) 762-6837

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of shares of Common Stock, par value $0.01, outstanding on November 6, 2009 was 17,174,906.

TABLE OF CONTENTS


Item		Page
PART I — FINANCIAL INFORMATION
1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets		3
Condensed Consolidated Statements of Income		4
Condensed Consolidated Statements of Stockholders’ Equity		5
Condensed Consolidated Statements of Cash Flows		6
Notes to Condensed Consolidated Financial Statements (Unaudited)		7
2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
3. Quantitative and Qualitative Disclosures about Market Risk		47
4. Controls and Procedures		47

PART II — OTHER INFORMATION
1. Legal Proceedings		48
2. Unregistered Sales of Equity Securities and Use of Proceeds		48
6. Exhibits		48
EX-10.34
EX-31.(A)
EX-31.(B)
EX-32.(A)
EX-32.(B)

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

PART I. — FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets


	September 30,			December 31,
	2009			2008
	(Unaudited)
	(Dollars in thousands,
	except share and per share data)
ASSETS

Investments
Debt securities	$	631,033		$	495,799
Equity securities and other		32,224			15,089
Short-term		10,754			32,142

Total Investments		674,011			543,030
Cash and cash equivalents		16,205			31,833
Premiums and reinsurance balances receivable		52,468			56,398
Accrued investment income		5,940			5,400
Accrued profit sharing commissions		13,841			11,315
Reinsurance recoverable on paid and unpaid losses		167,802			135,617
Prepaid reinsurance premiums		59,784			48,921
Deferred acquisition costs		26,310			27,369
Intangible assets, net of accumulated amortization		37,642			39,351
Goodwill		25,483			25,483
Deferred federal income taxes		—			2,161
Other assets		23,771			16,775

Total Assets	$	1,103,257		$	943,653


LIABILITIES AND STOCKHOLDERS’ EQUITY

Loss and loss adjustment expense reserves	$	448,265		$	372,721
Unearned premium reserves		150,655			147,849
Long-term debt		67,013			67,013
Funds held under reinsurance treaties		67,093			49,419
Premiums payable to insurance companies		31,363			27,831
Reinsurance payable on paid losses		1,179			1,167
Deferred federal income taxes		14,504			—
Accounts payable, accrued expenses, and other liabilities		15,713			16,016

Total Liabilities		795,785			682,016

Stockholders’ Equity
Common stock, $0.01 par value; authorized 100,000,000 shares; issued and outstanding 17,174,906 and 17,836,337 shares		172			178
Paid-in-capital		153,752			161,957
Accumulated other comprehensive income (loss)		16,306			(3,027	)
Retained earnings		139,090			103,028
Treasury stock; 130,600 and 33,600 shares		(1,848	)		(499	)

Total Stockholders’ Equity		307,472			261,637

Total Liabilities and Stockholders’ Equity	$	1,103,257		$	943,653

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Income
(Unaudited)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
	(Dollars in thousands, except share and per share data)
Operating Revenue
Net earned premiums	$	51,512		$	49,092		$	155,539		$	139,222
Commissions and fees		7,445			4,757			23,916			15,896
Net investment income		7,540			5,571			21,105			15,635
Net realized gains (losses) on investments (1)		13,766			(7,128	)		25,204			(8,714	)
Other-than-temporary impairment losses on investments (1)		(292	)		(3,476	)		(426	)		(3,701	)

Total Operating Revenues		79,971			48,816			225,338			158,338


Operating Expenses
Losses and loss adjustment expenses, net		30,345			27,537			96,301			76,713
Amortization of deferred acquisition expenses		13,960			10,798			40,889			28,107
Underwriting, agency and other expenses		10,169			8,999			28,919			26,599
Amortization of intangible assets		559			553			1,709			1,466

Total Operating Expenses		55,033			47,887			167,818			132,885


Operating Income		24,938			929			57,520			25,453
Interest Expense		1,446			1,440			4,278			4,380
Change in Fair Value of Derivative Instruments		(171	)		(64	)		(401	)		110

Income (Loss) From Continuing Operations Before Income Taxes		23,663			(447	)		53,643			20,963
Income Taxes		8,018			(948	)		17,707			5,592

Income From Continuing Operations		15,645			501			35,936			15,371
Income (Loss) From Discontinued Operations, Net of Income Taxes		—			(447	)		—			23,106

Net Income	$	15,645		$	54		$	35,936		$	38,477


Basic Net Income Per Share:
Income From Continuing Operations	$	0.90		$	0.03		$	2.03		$	0.84
Income (Loss) From Discontinued Operations		—			(0.02	)		—			1.27

Total	$	0.90		$	0.01		$	2.03		$	2.11


Diluted Net Income Per Share:
Income From Continuing Operations	$	0.89		$	0.03		$	1.99		$	0.82
Income (Loss) From Discontinued Operations		—			(0.02	)		—			1.23

Total	$	0.89		$	0.01		$	1.99		$	2.05


Weighted Average Shares Outstanding:
Basic		17,144,077			18,206,904			17,537,754			18,190,915

Diluted		17,486,020			18,726,246			17,877,126			18,778,070


(1)		2008 amounts were reclassified to conform to current period’s presentation.

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity
(Unaudited)


							Accumulated
							Other
	Common			Paid-in			Comprehensive			Retained			Treasury
	Stock			Capital			Income (Loss)			Earnings			Stock			Total
	(Dollars in thousands)
Balance, January 1, 2008	$	180		$	165,836		$	1,177		$	62,187		$	—		$	229,380
Exercise of stock options		3			597			—			—			—			600
Stock-based compensation expense		—			1,602			—			—			—			1,602
Stock-based compensation excess tax benefits		—			1,135			—			—			—			1,135
Common stock repurchased and held in treasury		—			—			—			—			(499	)		(499	)
Common stock repurchased and retired		(2	)		(3,221	)		—			—			—			(3,223	)
Comprehensive income:
Net income		—			—			—			38,477			—			38,477
Other comprehensive loss, net of tax
Unrealized holding losses on securities arising during the period, net of tax of $5,750		—			—			(10,678	)		—			—			(10,678	)
Change in fair value of interest rate swap, net of tax of $35		—			—			(65	)		—			—			(65	)
Less reclassification adjustment for losses included in net income, net of tax of ($1,251)		—			—			2,323			—			—			2,323

Total other comprehensive loss		—			—			—			—			—			(8,420	)

Total comprehensive income		—			—			—			—			—			30,057

Balance, September 30, 2008	$	181		$	165,949		$	(7,243	)	$	100,664		$	(499	)	$	259,052


Balance, January 1, 2009	$	178		$	161,957		$	(3,027	)	$	103,028		$	(499	)	$	261,637
Issuance of restricted stock		1			(1	)		—			—			—			—
Exercise of stock options		1			8			—			—			—			9
Stock-based compensation expense		—			2,288			—			—			—			2,288
Stock-based compensation excess tax benefits		—			(21	)		—			—			—			(21	)
Common stock repurchased and held in treasury		—			—			—			—			(1,349	)		(1,349	)
Common stock repurchased and retired		(8	)		(10,479	)		—			—			—			(10,487	)
Payment of shareholder dividend		—			—			—			(873	)		—			(873	)
Comprehensive income:
Net income		—			—			—			35,936			—			35,936
Cumulative effect of adoption of FASB ASC 320-10 at April 1, 2009		—			—			(999	)		999			—			—
Other comprehensive income, net of tax
Unrealized holding losses on securities arising during the period having credit losses recognized in the condensed consolidated statements of income, net of tax $422		—			—			(783	)		—			—			(783	)
Unrealized holding gains on securities arising during the period having no credit losses recognized in the condensed consolidated statements of income, net of tax ($12,377)		—			—			22,986			—			—			22,986
Change in fair value of interest rate swaps, net of tax of $268		—			—			(498	)		—			—			(498	)
Less reclassification adjustment for gains included in net income, net of tax of $739		—			—			(1,373	)		—			—			(1,373	)

Total other comprehensive income		—			—			—			—			—			20,332

Total comprehensive income		—			—			—			—			—			56,268

Balance, September 30, 2009	$	172		$	153,752		$	16,306		$	139,090		$	(1,848	)	$	307,472

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
(Unaudited)


	Nine Months Ended
	September 30,
	2009			2008
	(Dollars in thousands)
Cash Flows from Operating Activities
Net Income	$	35,936		$	38,477
Less: Income from discontinued operations		—			23,106

Income from continuing operations		35,936			15,371
Adjustments to reconcile income from continuing operations to net cash provided by operating activities
Depreciation and amortization		3,051			2,549
Realized (gains) losses on investments		(25,204	)		8,714
Other-than-temporary impairment losses on investments		426			3,701
Deferrals of acquisition costs, net		1,060			(10,073	)
Deferred income taxes		5,716			(6,011	)
Stock-based compensation expense		2,288			1,602
Increase (decrease) in cash resulting from changes in assets and liabilities
Premiums and reinsurance balances receivable		3,930			5,740
Accrued investment income		(540	)		(353	)
Accrued profit sharing commissions		(2,526	)		4,649
Reinsurance recoverable on paid and unpaid losses		(32,185	)		(36,330	)
Prepaid reinsurance premiums		(10,863	)		4,234
Loss and loss adjustment expense reserves		75,544			79,395
Unearned premium reserves		2,806			16,506
Funds held under reinsurance treaties		17,674			9,757
Reinsurance payable on paid losses		12			(3,236	)
Premiums payable to insurance companies		3,532			(1,206	)
Other		(14,051	)		(3,297	)

Net Cash Provided By Operating Activities — Continuing Operations		66,606			91,712
Net Cash Provided By Operating Activities — Discontinued Operations		—			1,928

Net Cash Provided By Operating Activities — Total		66,606			93,640

Cash Flows From Investing Activities
Cost of short-term investments acquired		(238,579	)		(425,261	)
Proceeds from disposals of short-term investments		259,966			410,493
Cost of debt and equity securities acquired		(215,156	)		(207,143	)
Proceeds from debt and equity securities		121,256			113,138
Acquisition, net of cash acquired		—			(18,869	)
Cost of fixed asset purchases		—			(543	)

Net Cash Used In Investing Activities — Continuing Operations		(72,513	)		(128,185	)
Net Cash Provided By Investing Activities — Discontinued Operations		—			41,830

Net Cash Used In Investing Activities — Total		(72,513	)		(86,355	)

Cash Flows From Financing Activities
Stock issued on stock options exercised		9			600
Purchase of common stock		(10,487	)		—
Payment of shareholder dividend		(873	)		—
Cash used for excess tax benefits		(21	)		—
Purchase of treasury stock		(1,349	)		(3,722	)
Net borrowings under credit facility		3,000			—

Net Cash Used In Financing Activities		(9,721	)		(3,122	)


Net Increase (Decrease) In Cash and Cash Equivalents		(15,628	)		4,163
Cash and Cash Equivalents, beginning of period		31,833			18,432

Cash and Cash Equivalents, end of period	$	16,205		$	22,595

Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest	$	4,137		$	4,559
Income taxes	$	8,100		$	18,400

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying condensed consolidated financial statements and notes of First Mercury Financial Corporation and Subsidiaries (“FMFC” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Readers are urged to review the Company’s 2008 audited consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2008 for a more complete description of the Company’s business and accounting policies. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. Such adjustments consist only of normal recurring items. Interim results are not necessarily indicative of results of operations for the full year. The consolidated balance sheet as of December 31, 2008 was derived from the Company’s audited annual consolidated financial statements.

Significant intercompany transactions and balances have been eliminated.

Use of Estimates

In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements, and revenues and expenses reported for the periods then ended. Actual results may differ from those estimates. Material estimates that are susceptible to significant change in the near term relate primarily to the determination of the reserves for losses and loss adjustment expenses and valuation of intangible assets and goodwill.

Recently Issued Accounting Standards

On July 1, 2009, the FASB issued Topic 105, “Generally Accepted Accounting Principles” which established the “Accounting Standards Codification” (ASC) as the single official source of authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to guidance issued by the Securities and Exchange Commission (SEC). All other nongrandfathered, non-SEC accounting literature not included in the ASC is deemed nonauthoritative. The ASC supersedes all existing, non-SEC accounting and reporting standards applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles (GAAP). The ASC is effective for interim and annual reporting periods ending after September 15, 2009. As the ASC reorganizes GAAP literature but does not change GAAP, the implementation of the ASC did not have a material impact on the Company’s financial statements.

In May 2009, the FASB issued new accounting guidance related to subsequent events. This new guidance establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. It provides direction for the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. We adopted the new guidance during the second quarter of 2009, and its application had no impact on our condensed consolidated financial statements. We evaluate subsequent events through the date the accompanying financial statements were issued, which was November 9, 2009.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Concluded)

separately from realized gains and losses on the face of the income statement. In addition to the changes in measurement and presentation, the new guidance is intended to enhance the existing disclosure requirements for other-than-temporary impairment and requires all disclosures related to other-than-temporary impairments in both interim and annual periods. The adoption of the new guidance in the second quarter of 2009 resulted in a $1.0 million increase in Retained Earnings, which was offset by a corresponding decrease in Accumulated other comprehensive income (loss) of the same amount.

In April 2009, the FASB issued new accounting guidance pertaining to the determination of fair value of assets and liabilities when volume and activity level have significantly decreased and for transactions that are not orderly. Under the new guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any, weight on that transaction price as an indicator of fair value. The adoption of this guidance in the second quarter of 2009 did not have a material effect on the Company’s results of operations, financial position, or liquidity.

In April 2009, the FASB issued new accounting guidance which requires disclosures about the fair value of financial instruments in interim and annual financial statements. The adoption of this guidance in the second quarter of 2009 is included in Note 11, “Fair Value Measurements” to the condensed consolidated financial statements.

During the first quarter of 2009, the Company adopted various accounting standards related to business combinations, noncontrolling interests in consolidated financial statements, disclosures about derivative instruments and hedging activities, participating securities and undistributed earnings and fair value measurements and disclosures. The adoption of the new standards did not have a material effect on the Company’s results of operations, financial position, or liquidity.

2. MERGERS AND ACQUISITIONS

American Management Corporation

On February 1, 2008, we completed the acquisition of all of the issued and outstanding shares of common stock of American Management Corporation (“AMC”). AMC is a managing general agency (“MGA”) that has focused primarily on the niche fuel-related marketplace for over 20 years. In addition, AMC owns and operates American Underwriters Insurance Company (“AUIC”), a single state, non-standard auto insurance company domiciled in the state of Arkansas, and AMC Re, Inc. (“AMC Re”), a captive reinsurer incorporated under the laws of Arkansas. AMC underwrites premiums for third party carriers and for AUIC. The acquisition gave the Company access to an established and experienced specialty admitted underwriting franchise with a definable niche market.

The cash purchase price was $38.1 million, which was financed through cash on hand. We incurred $0.8 million in acquisition related costs, which are included in the initial cost of the investment of $38.9 million. In connection with the acquisition, the Company and the seller entered into an escrow agreement whereby $4.0 million of the cash purchase price was escrowed with a major financial institution to partially secure the majority selling shareholder’s indemnity obligations of up to $12.0 million under the stock purchase agreement.

The results of operations of AMC and the estimated fair value of assets acquired and liabilities assumed are included in our consolidated financial statements beginning on the acquisition date. The estimated excess of the purchase price over the net tangible and intangible assets acquired of $13.4 million was recorded as goodwill in the amount of $25.5 million. We have completed the valuations of certain tangible and intangible assets acquired with the new business and have finalized the allocation of the excess of the purchase price over the net assets acquired. The acquired goodwill is not expected to be deductible for income tax purposes and has been allocated to AMC as a reporting unit.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

2. MERGERS AND ACQUISITIONS — (Concluded)

The following table represents the final allocation of the purchase price to assets acquired and liabilities assumed at the acquisition date:


	$ in thousands
Assets Acquired
Investments	$	8,988
Cash and cash equivalents		20,012
Premiums receivable		19,570
Other assets		1,133
Goodwill		25,483
Intangible assets:
Agent relationships		9,150
Tradename		2,130
Customer relationships		520

Total Assets Acquired	$	86,986


Liabilities Assumed
Premiums payable to insurance companies	$	23,218
Loss and loss adjustment expense reserves		4,490
Unearned premium reserves		1,734
Deferred federal income taxes		3,917
Accounts payable, accrued expenses, and other liabilities		14,745

Total Liabilities Assumed		48,104


Net Assets Acquired	$	38,882

Agent relationships are being amortized as the economic benefits of these intangible assets are utilized over their estimated useful lives of approximately 18 years. The tradename is being amortized on a straight-line basis over its estimated useful life of 20 years. The customer relationships are being amortized on a straight-line basis, which approximates the utilization of the economic benefits of these assets, over their estimated useful lives of 15 years.

In connection with the AMC acquisition, we entered into an operating lease agreement for real property in Conway, Arkansas with an entity owned by the former majority shareholder and current president of AMC. The lease term is for ten years, with annual rent of approximately $0.5 million, payable in monthly installments.

3. DISCONTINUED OPERATIONS

On June 27, 2008, the Company sold all of the outstanding shares of capital stock of ARPCO Holdings, Inc. and its subsidiaries (“ARPCO”) for a purchase price of $43.0 million. The net assets disposed of in the transaction were $7.2 million and were principally intangible assets.

The operating results of discontinued operations included in the accompanying Condensed Consolidated Statements of Income are as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008		2009		2008
			(Dollars in thousands)
Revenues	$	—	$	—	$	—	$	5,884
Income Before Income Taxes	$	—	$	—	$	—	$	3,533

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding for the period. Diluted net income per share reflects the potential dilution that could occur if common stock equivalents were issued and exercised.

The following is a reconciliation of basic number of common shares outstanding to diluted common and common equivalent shares outstanding:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
	(Dollars in thousands, except share and per share data)
Income from Continuing Operations	$	15,645		$	501		$	35,936		$	15,371
Income from Discontinued Operations		—			(447	)		—			23,106

Net income as reported		15,645			54			35,936			38,477
Net income allocated to unvested restricted stock shares		(141	)		(0	)		(316	)		(154	)

Net income available to common	$	15,504		$	54		$	35,620		$	38,323

Weighted-average number of common and common equivalent shares outstanding:

Basic number of common shares outstanding		17,144,077			18,206,904			17,537,754			18,190,915

Dilutive effect of stock options		341,943			516,236			339,372			580,948
Dilutive effect of unvested restricted stock		—			3,106			—			6,207

Dilutive number of common and common equivalent shares outstanding		17,486,020			18,726,246			17,877,126			18,778,070


Basic Net Income Per Common Share:
Income from Continuing Operations	$	0.90		$	0.03		$	2.03		$	0.84
Income from Discontinued Operations		—			(0.02	)		—			1.27

Total	$	0.90		$	0.01		$	2.03		$	2.11


Diluted Net Income Per Common Share:
Income from Continuing Operations	$	0.89		$	0.03		$	1.99		$	0.82
Income from Discontinued Operations		—			(0.02	)		—			1.23

Total	$	0.89		$	0.01		$	1.99		$	2.05


Anti-dilutive shares excluded from diluted net income per common share		1,112,688			932,188			1,112,688			932,188

On January 1, 2009, we adopted new FASB accounting guidance which requires that unvested restricted stock with a nonforfeitable right to receive dividends be included in the two-class method of computing earnings per share. The adoption of this guidance did not have a material impact on our reported earnings per share amounts.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS

The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at September 30, 2009 by major security type were as follows:


			Gross Unrealized
	Amortized Cost		Gains		Losses			Market Value
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	3,776	$	146	$	—		$	3,922
Government agency mortgage-backed securities		101,160		4,491		(8	)		105,643
Government agency obligations		989		39		—			1,028
Collateralized mortgage obligations and other asset-backed securities		109,734		5,176		(2,996	)		111,914
Obligations of states and political subdivisions		189,101		11,661		(60	)		200,702
Corporate bonds		137,912		11,317		(700	)		148,529

Total Debt Securities		542,672		32,830		(3,764	)		571,738
Preferred stocks		1,416		50		(193	)		1,273
Short-term investments		10,754		—		—			10,754

Total	$	554,842	$	32,880	$	(3,957	)	$	583,765

The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at December 31, 2008 by major security type were as follows:


			Gross Unrealized
	Amortized Cost		Gains		Losses			Market Value
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	5,256	$	307	$	—		$	5,563
Government agency mortgage-backed securities		82,548		2,422		(39	)		84,931
Government agency obligations		3,163		76		—			3,239
Collateralized mortgage obligations and other asset-backed securities		71,378		337		(7,087	)		64,628
Obligations of states and political subdivisions		205,425		5,634		(694	)		210,365
Corporate bonds		89,383		1,499		(3,874	)		87,008

Total Debt Securities		457,153		10,275		(11,694	)		455,734
Preferred stocks		1,416		—		(367	)		1,049
Short-term investments		32,142		—		—			32,142

Total	$	490,711	$	10,275	$	(12,061	)	$	488,925

Impairment of Investment Securities

Impairment of investment securities results when a market decline below cost is other-than-temporary. The other-than-temporary write down is separated into an amount representing the credit loss which is recognized in earnings and the amount related to all other factors which is recorded in other comprehensive income. Management regularly reviews our fixed maturity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost or amortized cost of the security, as appropriate, the length of time the investment has been below cost or amortized cost and by how much, our intent to sell a security and whether it is more-likely-than-not we will be required to sell the security before the recovery of our amortized cost basis, and specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment (OTTI) losses result in a reduction of the cost basis of the underlying investment. Significant changes in these factors we consider when evaluating investments for impairment losses could result in a change in impairment losses reported in the consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS — (Continued)

context of overall risk monitoring, changing information and market conditions. Management of the Company’s investment portfolio is outsourced to third party investment managers, which is directed and monitored by our investment committee. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available-for-sale.

Investment managers are required to notify management of rating agency downgrades of securities in their portfolios as well as any potential investment valuation issues no later than the end of each quarter. Investment managers are also required to notify management, and receive prior approval, prior to the execution of a transaction or series of related transactions that may result in a realized loss above a certain threshold. Additionally, investment managers are required to notify management, and receive approval, prior to the execution of a transaction or series of related transactions that may result in any realized loss up until a certain period beyond the close of a quarterly accounting period.

Under current accounting standards, an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered in circumstances where (1) an entity has the intent to sell a security, (2) it is more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more-likely-than-not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more-likely-than-not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.

The table below represents the gross and net presentation of other-than-temporary impairment losses on investments:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(Dollars in thousands)
Other-than-temporary impairment losses on investments:
Total losses	$	(761	)	$	(3,476	)	$	(1,631	)	$	(3,701	)
Portion of losses recognized in accumulated other comprehensive income		469			—			1,205			—

Other-than-temporary impairment losses on investments	$	(292	)	$	(3,476	)	$	(426	)	$	(3,701	)

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS – (Continued)

The following table presents a roll-forward of the credit component of OTTI on debt securities recognized in the Consolidated Statements of Income for which a portion of the OTTI was recognized in other comprehensive income for the period July 1, 2009 through September 30, 2009:

Additions for

OTTI

Additions for

Adjustments

September 30,

July 1, 2009

Securities

OTTI

to Book

2009

Cumulative

Where No

Securities

Reductions Due

Value of

Cumulative

OTTI Credit

Credit Losses

Where Credit

to Sales or

Credit-

OTTI Credit

Losses

Were

Losses Have

Intend/Required

Impaired

Losses

Recognized

Been

to Sell of

Securities due

Recognized

for Securities

Prior to

Recognized Prior to

Credit-Impaired

to Changes in

for Securities

Still Held

July 1, 2009

Securities

Cash Flows

Still Held

(Dollars in thousands)

Debt securities:

Mortgage-backed securities, collateralized mortgage obligations and passthrough securities

261

252

—

553

All other corporate bonds

569

—

569

Total debt securities

830

252

—

1,122

Additions for

OTTI

Additions for

Adjustments

September 30,

April 1, 2009

Securities

OTTI

to Book

2009

Cumulative

Where No

Securities

Reductions Due

Value of

Cumulative

OTTI Credit

Credit Losses

Where Credit

to Sales or

Credit-

OTTI Credit

Losses

Were

Losses Have

Intend/Required

Impaired

Losses

Recognized

Been

to Sell of

Securities due

Recognized

for Securities

Prior to

Recognized Prior to

Credit-Impaired

to Changes in

for Securities

Still Held

April 1, 2009

Securities

Cash Flows

Still Held

(Dollars in thousands)

Debt securities:

Mortgage-backed securities, collateralized mortgage obligations and passthrough securities

164

389

—

553

All other corporate bonds

569

—

569

Total debt securities

733

389

—

1,122

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS – (Continued)

The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at September 30, 2009:


	Less than 12 Months					Greater than 12 Months
	Fair Value					Fair Value
	of					of
	Investments					Investments
	With		Gross			With		Gross
	Unrealized		Unrealized			Unrealized		Unrealized
	Losses		Losses			Losses		Losses
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	—	$	—		$	—	$	—
Government agency mortgage-backed securities		1,680		(1	)		194		(7	)
Government agency obligations		—		—			—		—
Collateralized mortgage obligations and other asset-backed securities		6,351		(262	)		14,157		(2,734	)
Obligations of states and political subdivisions		—		—			3,645		(60	)
Corporate bonds		1,252		(1	)		8,542		(699	)

Total Debt Securities		9,283		(264	)		26,538		(3,500	)
Preferred Stocks		—		—			313		(193	)

Total	$	9,283	$	(264	)	$	26,851	$	(3,693	)

The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at December 31, 2008:


	Less than 12 Months					Greater than 12 Months
	Fair Value					Fair Value
	of					of
	Investments					Investments
	With		Gross			With		Gross
	Unrealized		Unrealized			Unrealized		Unrealized
	Losses		Losses			Losses		Losses
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	—	$	—		$	—	$	—
Government agency mortgage-backed securities		3,902		(37	)		326		(2	)
Government agency obligations		—		—			—		—
Collateralized mortgage obligations and other asset-backed securities		48,125		(5,143	)		5,963		(1,944	)
Obligations of states and political subdivisions		14,063		(427	)		8,809		(267	)
Corporate bonds		42,402		(2,549	)		12,824		(1,325	)

Total Debt Securities		108,492		(8,156	)		27,922		(3,538	)
Preferred Stocks		832		(78	)		216		(289	)

Total	$	109,324	$	(8,234	)	$	28,138	$	(3,827	)

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS – (Continued)

Below is a table that illustrates the unrecognized impairment loss by sector. The increase in spread relative to U.S. Treasury Bonds was the primary factor leading to impairment for the periods ended September 30, 2009. All asset sectors were affected by the overall increase in spreads as can be seen from the table below. In addition to the level of interest rates, we also look at a variety of other factors such as direction of credit spreads for an individual issue as well as the magnitude of specific securities that have declined below amortized cost.


	Unrealized
	Loss at
Sector	September 30, 2009
	(Dollars in thousands)
Debt Securities
U.S. Treasuries	$	—
U.S. Agencies		—

U.S. government securities		—


Government agency mortgage-backed securities		(8	)


Government agency obligations		—


MBS Passthroughs		(23	)
CMOs		(1,331	)
Asset Backed Securities		(631	)
Commercial MBS		(1,011	)

Collateralized mortgage obligations and other asset-backed securities		(2,996	)


Obligations of states and political subdivisions		(60	)


Corporate Bonds		(700	)
High Yield Bonds		—

Corporate Bonds		(700	)


Total Debt Securities		(3,764	)

Preferred Stocks		(193	)
Short-term investments		—

Total	$	(3,957	)

At September 30, 2009, there were 108 unrealized loss positions with a total unrealized loss of $4.0 million. This represents approximately 0.7% of quarter end available-for-sale assets of $583.8 million. This unrealized loss position is a function of the purchase of specific securities in a lower interest rate or spread environment than what prevails as of September 30, 2009. Some of these losses are due to the increase in spreads of select corporate bonds or structured securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of the core fixed income portfolio excluding cash, convertible securities, and equity is approximately 3.6 years. We do not intend to sell and it is not expected we will need to sell these temporarily impaired securities before maturity. In light of our growth over the past 24 months, liquidity needs from the portfolio are minimal. As a result, we would not expect to have to liquidate temporarily impaired securities to pay claims or for any other purposes. There have been certain instances over the past year, where due to market based opportunities, we have elected to sell a small portion of the portfolio. These situations were unique and infrequent occurrences and in our opinion, do not reflect an indication that we intend to sell or will be required to sell these securities before they mature or recover in value.

The most significant risk or uncertainty inherent in our assessment methodology is that the current credit rating of a particular issue changes over time. If the rating agencies should change their rating on a particular security in our portfolio, it could lead to a reclassification of that specific issue. The vast majority of our unrecognized impairment losses are investment grade and “AAA” or “AA” rated securities. Should the credit quality of individual issues decline for whatever reason then it would lead us to reconsider the classification of that particular security. Within the non-investment grade sector, we continue to monitor the particular status of each issue. Should prospects for any one issue deteriorate, we would potentially alter our classification of that particular issue.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS – (Continued)

The table below illustrates the breakdown of impaired securities by investment grade and non-investment grade as well as the duration that these sectors have been trading below amortized cost. The average duration of the impairment has been greater than 12 months. The unrealized loss of impaired securities as a percent of the amortized cost of those securities is 9.9% as of September 30, 2009.


	% of Total			Total		Total		Average Unrealized Loss			% of Loss
	Amortized Cost			Amortized Cost		Unrealized Losses		as % of Amortized Cost			> 12 Months
				(Dollars in thousands)
Non Investment Grade		19.0	%	$	7,615	$	1,859		24.4	%		98.7	%
Investment Grade		81.0			32,477		2,098		6.5			88.5

Total		100.0	%	$	40,092	$	3,957		9.9	%		93.3	%

The majority of these securities are “AAA” or “AA” rated. Of the $1.9 million of unrealized loss within non-investment grade, CMOs accounted for 43.0% of this loss. Within CMOs 80.2% were collateralized by prime loans with the balance in Alt-A and sub-prime. The next highest percent of the loss within non-investment grade were Alt-A and sub-prime home equity asset-backed securities at 33.9% of the loss. The remaining portion of the loss, or 23.1% within non-investment grade was a financial corporate issue rated BB+ by Standard and Poors. These issues are continually monitored and may be classified in the future as being other than temporarily impaired.

The highest concentration of temporarily impaired securities is CMOs at 33.6% of the total loss. Within CMOs, 72.4% are rated AAA, including the 60.4% of the CMO exposure that is agency issued, and have primarily been affected by the general level of interest rates as well. The next largest concentration of temporarily impaired securities is Commercial MBS at approximately 25.5% of the total loss. These securities are all AAA rated and have been affected primarily by the widening of spreads within this sector and/or the general level of interest rates. The next largest concentration of temporarily impaired securities is Corporate Bonds at approximately 17.7% of the total loss. Within Corporate Bonds 98.6% are rated investment grade or better, and their temporary impairment results primarily from the widening of credit spreads.

For the nine months ended September 30, 2009, we sold approximately $4.8 million of market value of fixed income securities excluding convertibles, which were trading below amortized cost while recording a realized loss of $0.2 million. This loss represented 3.3% of the amortized cost of the positions. These sales were unique opportunities to sell specific positions due to changing market conditions. These situations were exceptions to our general assertion regarding our ability and intent to hold securities with unrealized losses until they mature or recover in value. This position is further supported by the insignificant losses as a percentage of amortized cost for the respective periods.

Hybrid Instruments

As of September 30, 2009 and December 31, 2008, the market value of convertible securities accounted for as hybrid instruments was $66.1 million and $43.5 million, respectively. Convertible bonds and bond units had a market value of $58.0 million and $39.0 million and were included in Debt securities in the Condensed Consolidated Balance Sheets at September 30, 2009 and December 31, 2008, respectively. Convertible preferred stocks had a market value of $8.1 million and $4.5 million and were included in Equity securities and other in the Condensed Consolidated Balance Sheets at September 30, 2009 and December 31, 2008, respectively. The Company recorded an increase in the fair value of the hybrid instruments of $9.3 million and $16.1 million in Net realized gains on investments for the three and nine months ended September 30, 2009. As of September 30, 2009 and December 31, 2008, there were no convertible securities that were not accounted for as hybrid instruments in accordance with FASB ASC guidance.

Alternative Investments

The Company has $12.0 million invested in a limited partnership, which invests in high yield convertible securities. The market value of this investment was $12.3 million at September 30, 2009. In addition, the Company invested $10.0 million in another limited partnership, which invests in distressed structured finance products. The market value of this investment was $11.8 million at September 30, 2009. The Company elected the fair value option for these investments in accordance with FASB ASC guidance. The change in fair value of these investments is allocated between Net investment income and Net realized gains (losses) on investments in the Condensed Consolidated Statements of Income. For the three months ended September 30, 2009, the Company recorded $0.4 million in Net investment income and $12.4 million in Net realized gains (losses) on investments related to these alternative

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. INVESTMENTS – (Concluded)

investments. For the nine months ended September 30, 2009, the Company recorded $1.4 million in Net investment income and $21.1 million in Net realized gains (losses) on investments related to these alternative investments. These investments are recorded in Equity securities and other in the Condensed Consolidated Balance Sheets.

6. INCOME TAXES

At September 30, 2009 and December 31, 2008, current FASB accounting guidance, which clarifies accounting for uncertainty in income taxes recognized in an entity’s financial statements, did not have an impact on our financial position or results of operations, and we have taken no tax positions which would require additional disclosure. Although the IRS is not currently examining any of our income tax returns, tax years 2006, 2007 and 2008 remain open and are subject to examination.

The Company files a consolidated federal income tax return with its subsidiaries. Taxes are allocated among the Company’s subsidiaries based on the Tax Allocation Agreement employed by these entities, which provides that taxes of the entities are calculated on a separate-return basis at the highest marginal tax rate.

Income taxes in the accompanying unaudited Condensed Consolidated Statements of Income differ from the statutory tax rate of 35.0% primarily due to state income taxes, non-deductible expenses, and the nontaxable portion of dividends received and tax-exempt interest.

7. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

The Company establishes a reserve for both reported and unreported covered losses, which includes estimates of both future payments of losses and related loss adjustment expenses. The following represents changes in those aggregate reserves for the Company during the periods presented below:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(Dollars in thousands)
Balance, beginning of period	$	426,908		$	324,502		$	372,721		$	272,365
Less reinsurance recoverables		146,157			113,909			128,552			91,444

Net Balance, beginning of period		280,751			210,593			244,169			180,921


AUIC net reserves, date of acquisition		—			—			—			4,490

Incurred Related To
Current year		31,645			32,382			101,972			81,558
Prior years		(1,300	)		(4,845	)		(5,671	)		(4,845	)

Total Incurred		30,345			27,537			96,301			76,713


Paid Related To
Current year		6,461			4,010			10,900			6,348
Prior years		13,266			7,273			38,201			28,929

Total Paid		19,727			11,283			49,101			35,277


Net Balance		291,369			226,847			291,369			226,847
Plus reinsurance recoverables		156,896			129,403			156,896			129,403

Balance, end of period	$	448,265		$	356,250		$	448,265		$	356,250

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

8. REINSURANCE

Net written and earned premiums, including reinsurance activity, were as follows:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(Dollars in thousands)
Written Premiums
Direct	$	77,607		$	72,746		$	228,619		$	224,720
Assumed		4,201			4,253			13,588			13,399
Ceded		(35,483	)		(27,453	)		(92,615	)		(77,828	)

Net Written Premiums	$	46,325		$	49,546		$	149,592		$	160,291


Earned Premiums
Direct	$	77,907		$	70,985		$	226,125		$	209,208
Assumed		4,529			4,422			13,276			12,405
Ceded		(29,907	)		(26,566	)		(81,752	)		(82,063	)
Earned but unbilled premiums		(1,017	)		251			(2,110	)		(328	)

Net Earned Premiums	$	51,512		$	49,092		$	155,539		$	139,222

The Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company customarily collateralizes reinsurance balances due from unauthorized reinsurers through funds withheld, grantor trusts, or stand-by letters of credit issued by highly rated banks.

The Company’s 2009 and 2008 ceded reinsurance program includes quota share reinsurance agreements with authorized reinsurers that were entered into and are accounted for on a “funds withheld” basis. Under the funds withheld basis, the Company records the ceded premiums payable to the reinsurer, less ceded paid losses and loss adjustment expenses receivable from the reinsurer, less any amounts due to the reinsurer for the reinsurer’s margin, or cost of the reinsurance contract, as a liability, and reported $67.1 million and $49.4 million as Funds held under reinsurance treaties in the accompanying Condensed Consolidated Balance Sheets at September 30, 2009 and December 31, 2008, respectively. As specified under the terms of the agreements, the Company credits the funds withheld balance at stated interest crediting rates applied to the funds withheld balance. If the funds withheld liability is exhausted, interest crediting would cease and additional claim payments would be recoverable from the reinsurer.

Interest cost on reinsurance contracts accounted for on a funds withheld basis is incurred during all periods in which a funds withheld liability exists or as otherwise specified under the terms of the contract and is included in Underwriting, agency and other expenses. The amount subject to interest crediting rates was $22.8 million and $20.2 million at September 30, 2009 and 2008, respectively.

9. SHARE REPURCHASE PROGRAM

On August 20, 2009, the Board of Directors of the Company authorized a share repurchase plan to purchase up to 1.0 million shares of common stock through open market or privately negotiated transactions. The repurchase program expires on August 20, 2010. During the three months ended September 30, 2009, the Company did not repurchase any shares of common stock under the August 2009 share repurchase plan. As of September 30, 2009, the Company had 1.0 million shares of remaining capacity under the share repurchase program. Shares purchased under the program are retired and returned to the status of authorized but unissued shares.

The Company’s prior share repurchase program, announced in August 2008, originally authorized the repurchase of up to 1.5 million shares of the Company’s outstanding common stock. During the three months ended September 30, 2009, the Company repurchased the remaining 413,665 shares of common stock for $5.4 million at an average cost of $13.06 per share. These purchases fulfilled the remaining capacity of the Company’s 1.5 million share repurchase plan.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

10. STOCK COMPENSATION PLANS

The 1998 Stock Compensation Plan (as amended, the “1998 Plan”) was established September 3, 1998. Under the terms of the plan, directors, officers, employees and key individuals may be granted options to purchase the Company’s common stock. Option and vesting periods and option exercise prices are determined by the Compensation Committee of the Board of Directors, provided no stock options shall be exercisable more than ten years after the grant date. All outstanding stock options under the plan became fully vested on August 17, 2005 under the change in control provision in the plan. Of the 4,625,000 shares of the Company’s common stock initially reserved for future grant under the 1998 Plan, shares available for future grant totaled 2,443,387 at September 30, 2009, however, on May 13, 2009, the Company adopted an amendment to the 1998 Plan prohibiting the issuance of any additional awards under the 1998 Plan.

The First Mercury Financial Corporation Omnibus Incentive Plan of 2006 (the “Omnibus Plan”) was established October 16, 2006. The Company reserved 1,500,000 shares of its common stock for future granting of stock options, stock appreciation rights (“SAR”), restricted stock, restricted stock units (“RSU”), deferred stock units (“DSU”), performance shares, performance cash awards, and other stock or cash awards to employees and non-employee directors at any time prior to October 15, 2016. On May 13, 2009, the Company’s stockholders approved the amendment and restatement of the Omnibus Plan to increase the number of shares authorized for issuance thereunder by 1,650,000 shares, which brings the total number of shares reserved under the Omnibus Plan to 3,150,000. All of the terms of awards made under the Omnibus Plan, including vesting and other restrictions are determined by the Compensation Committee of the Company’s Board of Directors. The exercise price of any stock option will not be less than the fair market value of the shares on the date of grant.

During the three months ended September 30, 2009, the Company granted 25,000 stock options and 25,000 shares of restricted stock to employees under the Omnibus Plan. During the nine months ended September 30, 2009, the Company granted 222,500 stock options and 118,500 shares of restricted stock to employees under the Omnibus Plan. The stock options and shares of restricted stock awarded during such period vest in three equal installments over a period of three years. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. During the nine months ended September 30, 2009, the Company granted 19,704 shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of restricted stock vested immediately, but are not transferable for one year after the grant date, and stock-based compensation was recognized immediately. During the three months ended September 30, 2008, the Company did not make any stock option grants under the Omnibus Plan. During the nine months ended September 30, 2008, the Company granted 374,500 stock options to employees. During the three and nine months ended September 30, 2008, the Company granted 10,000 and 55,500 shares of restricted stock, respectively, to employees under the Omnibus Plan. The stock options and shares of restricted stock vest in three equal installments over a period of three years. Stock-based compensation is recognized over the expected vesting period of the stock options and shares of restricted stock. During the nine months ended September 30, 2008, the Company granted 12,124 shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of restricted stock vested immediately, but were not transferable for one year after the grant date, and stock-based compensation expense was recognized immediately. Shares available for future grants under the Omnibus Plan totaled 1,860,036 at September 30, 2009.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

10. STOCK COMPENSATION PLANS (Continued)

The following table summarizes stock option activity for the nine months ended September 30, 2009 and 2008.


	1998 Plan					Omnibus Plan
				Weighted Average					Weighted Average
	Number of Options			Exercise Price		Number of Options			Exercise Price
Oustanding at January 1, 2008		927,775		$	2.24		573,688		$	19.10
Granted during the period		—			—		374,500			16.38
Forfeited during the period		(5,088	)		4.86		(12,700	)		18.77
Exercised during the period		(302,575	)		1.80		(3,300	)		17.00
Cancelled during the period		—			—		—			—

Outstanding at September 30, 2008		620,112		$	2.49		932,188		$	18.02

Oustanding at January 1, 2009		431,050		$	2.82		932,188		$	17.93
Granted during the period		—			—		222,500			13.04
Forfeited during the period		—			—		(42,000	)		16.71
Exercised during the period		(5,088	)		1.62		—			—
Cancelled during the period		—			—		—			—

Outstanding at September 30, 2009		425,962		$	2.83		1,112,688		$	17.00

Exercisable at:
September 30, 2008		620,112		$	2.49		152,566		$	18.80
September 30, 2009		425,962			2.83		447,793			18.27

The aggregate intrinsic value of fully vested options outstanding and exercisable under the 1998 Plan was $4.5 million at September 30, 2009. There was $0.1 million of aggregate intrinsic value of options expected to vest under the Omnibus Plan at September 30, 2009.

The total intrinsic value of stock options exercised was $0.1 million for the nine months ended September 30, 2009.

The number of stock option awards outstanding and exercisable at September 30, 2009 by range of exercise prices was as follows:


	Options Outstanding						Options Exercisable
			Weighted-Average		Weighted-Average				Weighted-Average
Range of	Outstanding as of		Remaining		Exercise Price Per		Exercisable as of		Exercise Price Per
Exercisable Price	September 30, 2009		Contractual Life		Share		September 30, 2009		Share
1998 Plan
$1.51 - $1.95		314,037	3.37 Years		$	1.71		314,037	$	1.71
$4.86 - $6.49		111,925		1.05		5.97		111,925		5.97

Total		425,962		2.76		2.83		425,962		2.83


Omnibus Plan
$10.98 - $14.93		361,000	9.07 Years		$	13.69		45,829	$	14.93
$17.00 - $20.75		751,688		6.77		18.59		401,964		18.65

Total		1,112,688		7.52		17.00		447,793		18.27

As of September 30, 2009, there was approximately $4.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Omnibus Plan. That cost is expected to be recognized over a weighted-average period of 2.0 years.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

10. STOCK COMPENSATION PLANS (Concluded)

The fair value of stock options granted during the nine months ended September 30, 2009 and 2008 were determined on the dates of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:


	Nine Months Ended
	September 30,
	2009			2008
Omnibus Plan
Expected term		6.0			6.0
Expected stock price volatility		41.64	%		29.78	%
Risk-free interest rate		2.22	%		3.12	%
Expected dividend yield		0.08	%		—
Estimated fair value per option	$	5.57		$	5.79

The expected term of options was determined based on the simplified method per FASB accounting guidance for stock compensation. Expected stock price volatility was based on an average of the volatility factors utilized by companies within the Company’s peer group with consideration given to the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term.

The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made. The Company recognized stock-based compensation expense of $0.7 million and $2.3 million for the three and nine months ended September 30, 2009, respectively. The Company recognized stock-based compensation expense of $0.6 million and $1.6 million for the three and nine months ended September 30, 2008, respectively.

11. FAIR VALUE MEASUREMENTS

Our available-for-sale investment portfolio consists of fixed maturity and equity securities and short-term investments, and is recorded at fair value in the accompanying Condensed Consolidated Balance Sheets in accordance with FASB accounting guidance for investments in debt and equity securities. The change in the fair value of these investments is recorded as a component of Other comprehensive income (loss).

We adopted the FASB guidance for the fair value option related to financial instruments effective January 1, 2008. Under this standard, we are permitted to elect to measure financial instruments and certain other items at fair value, with the change in fair value recorded in earnings. On January 1, 2008, we elected not to measure any eligible items using the fair value option in accordance with the FASB guidance. We believe the current accounting is appropriate for our available-for-sale investments as we have the intent and ability to hold our investments, therefore, this standard did not have any impact on our consolidated financial condition or results of operations on the adoption date.

We also adopted the FASB guidance on fair value measurements and disclosures effective January 1, 2008. This standard defines fair value as the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable. In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets, or “market approach” as defined by the FASB guidance. The implementation of this standard did not have any impact on our consolidated financial condition or results of operations; however, it resulted in expanded disclosures about securities measured at fair value, as discussed below.

The FASB guidance established a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”). The estimated fair values of the Company’s fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. Approximately 95.0% of the

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

11. FAIR VALUE MEASUREMENTS (Continued)

Company’s fixed income security prices are obtained from the independent pricing service. The prices provided by this service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices, except as otherwise disclosed. The Company obtains an understanding of the methods, models and inputs used by the independent pricing service, and has controls in place to validate that amounts provided represent fair values, consistent with this standard. The Company’s controls include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service, a review of specific securities and an assessment for proper classification within the fair value hierarchy. The hierarchy level assigned to each security in our available-for-sale, hybrid securities, and alternative investments portfolios is based on our assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The three hierarchy levels are defined as follows:

• Level 1 — Valuations based on unadjusted quoted market prices in active markets for identical securities. The fair values of fixed maturity and equity securities and short-term investments included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The Level 1 category includes publicly traded equity securities; highly liquid U.S. Government notes, treasury bills and mortgage-backed securities issued by the Government National Mortgage Association; highly liquid cash management funds; and short-term certificates of deposit.

• Level 2 — Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of fixed maturity and equity securities and short-term investments included in the Level 2 category were based on the market values obtained from an independent pricing service that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other market information and price quotes from well established independent broker-dealers. The independent pricing service monitors market indicators, industry and economic events, and for broker-quoted only securities, obtains quotes from market makers or broker-dealers that it recognizes to be market participants. The Level 2 category includes corporate bonds, municipal bonds, redeemable preferred stocks and certain publicly traded common stocks with no trades on the measurement date.

• Level 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement, and involve management judgment.

If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement. A number of our investment grade corporate bonds are frequently traded in active markets and traded market prices for these securities existed at September 30, 2009. These securities were classified as Level 2 at September 30, 2009 because our third party pricing service uses valuation models which use observable market inputs in addition to traded prices.

The following table presents our investments measured at fair value on a recurring basis as of September 30, 2009 classified by the fair value measurements standard valuation hierarchy (as discussed above):


			Fair Value Measurements Using
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Available for sale investments:
Fixed maturity securities	$	573,011	$	3,922	$	569,089	$	—
Short-term investments		10,754		10,754		—		—
Hybrid securities		66,131		—		66,131		—
Alternative investments		24,115		—		11,814		12,301

Total	$	674,011	$	14,676	$	647,034	$	12,301

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

11. FAIR VALUE MEASUREMENTS (Concluded)

Level 3 assets above include a $12.3 million investment in a limited partnership. At times, this limited partnership will invest in highly illiquid high yield convertible securities for which observable inputs are not available. The manager of this limited partnership valued this investment through an internally developed pricing model as follows. If a security is listed on a recognized exchange, it shall be valued at the last sale price or the average of the highest current independent bid and lowest current independent offer for the security if there is not a reported transaction in the security on that day. If a security is traded over the counter, it shall be valued at the average of the highest current independent bid and lowest current independent offer reported upon the closing of trading on that day. If the market for a security exists predominantly through a limited number of market makers, the General Partner shall attain the bid and offer for the security made by at least two market makers in the security. The security shall then be valued at the mid-point of the quote that, under the circumstances and in the good faith judgment of the General Partner, represents the fair value of the security. Notwithstanding the foregoing, upon a good faith determination by the General Partner that the application of such rules does not properly reflect a security’s fair market value, then such security shall be valued at fair value as determined in good faith by the General Partner on the basis of all relevant facts and circumstances. All records with regard to valuation shall be retained by the Partnership. All determinations of values by the General Partner shall be final and conclusive as to all Partners. With respect to securities denominated in currencies other than the U.S. dollar, the value of such securities shall be converted to U.S. dollars upon the close of each month by utilizing the spot currency exchange rate as set forth by Bloomberg Financial Services (or such other source deemed appropriate by the General Partner). As of September 30, 2009, 9.2% of the reported market value of this limited partnership was valued by a good faith judgment of the General Partner and the balance by observable market inputs.


	Three Months Ended			Nine Months Ended
	September 30, 2009			September 30, 2009

Level 3 investments, beginning of period	$	10,633		$	6,282
Purchases		—			2,000
Transfer to Level 2		(660	)		(660	)
Increase in market value		2,328			4,679

Level 3 investments as of September 30, 2009	$	12,301		$	12,301

The Company uses derivatives to hedge its exposure to interest rate fluctuations. For these derivatives, the Company uses quoted market prices to estimate fair value and includes the estimate as a Level 2 measurement.

The Company’s financial instruments include investments, cash and cash equivalents, premiums and reinsurance balances receivable, reinsurance recoverable on paid losses and long-term debt. At September 30, 2009, the carrying amounts of the Company’s financial instruments, including its derivative financial instruments, approximated fair value, except for the $67.0 million of the Company’s junior subordinated debentures. The fair value of these junior subordinated debentures is estimated to be $29.3 million at September 30, 2009. The estimate of fair value for the Company’s junior subordinated debentures is a Level 3 measurement. We use a discounted cash flow model based on the contractual terms of the junior subordinated debentures and a discount rate of 10.5%, which was based on yields of comparable securities. The fair values of the Company’s investments, as determined by quoted market prices, are disclosed in Note 5.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

12. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The Company’s accumulated other comprehensive income (loss) included the following:


	September 30,
	2009			2008
	(Dollars in thousands)
Unrealized holding losses on securities having credit losses recognized in the condensed consolidated statements of income, net of tax	$	(1,782	)	$	—
Unrealized holding gains (losses) on securities having no credit losses recognized in the condensed consolidated statements of income, net of tax		20,163			(6,559	)
Fair value of interest rate swaps, net of tax		(2,075	)		(684	)

Total accumulated other comprehensive income (loss)	$	16,306		$	(7,243	)

13. INSURANCE REGULATION

In September 2009, First Mercury Insurance Company (“FMIC”) and CoverX Corporation (“CoverX”) received from the California Department of Insurance (the “California Department”) an Accusation and an Order to Cease and Desist (collectively the “Pleadings”). The Pleadings (i) allege that FMIC and CoverX transacted business in California without the proper licenses, (ii) order FMIC and CoverX to stop transacting any business in California for which they do not have a license and (iii) seek the revocation of CoverX’s existing California fire and casualty producer license. In October 2009, the Pleadings were expanded to include First Mercury Emerald Insurance Services, Inc. (“Emerald”). Although the Pleadings seek to revoke CoverX’s and Emerald’s existing California fire and casualty producer licenses, the California Department has agreed that CoverX and Emerald may continue to produce California business, and that FMIC may continue to insure California risks as long as those risks are produced by CoverX and Emerald personnel located outside the State of California. The Pleadings also assert a right to seek monetary penalties, but no demand for payment has been made. FMIC, CoverX and Emerald have denied the allegations in the Pleadings, and CoverX and Emerald have requested a hearing on the action to revoke their respective fire and casualty producer licenses. FMIC, CoverX and Emerald have also been conferring with the California Department to obtain surplus lines broker licenses and resolve these issues. While it is not possible to predict with certainty the outcome of any legal proceeding, we believe the outcome of these proceedings will not result in a material adverse effect on our consolidated financial condition or results of operations.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements that relate to future periods and includes statements regarding our anticipated performance. Generally, the words “anticipates,” “believes,” “expects,” “intends,” “estimates,” “projects,” “plans” and similar expressions identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements or industry results to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. These risks, uncertainties and other important factors include, among others: recent and future events and circumstances impacting financial, stock, and capital markets, and the responses to such events by governments and financial communities; the impact of catastrophic events and the occurrence of significant severe weather conditions on our operating results; our ability to maintain or the lowering or loss of one of our financial or claims-paying ratings; our actual incurred losses exceeding our loss and loss adjustment expense reserves; the failure of reinsurers to meet their obligations; our estimates for accrued profit sharing commissions are based on loss ratio performance and could be reduced if the underlying loss ratios deteriorate; our inability to obtain reinsurance coverage at reasonable prices; the failure of any loss limitations or exclusions or changes in claims or coverage; our ability to successfully integrate acquisitions that we make such as our acquisition of AMC; our lack of long-term operating history in certain specialty classes of insurance; our ability to acquire and retain additional underwriting expertise and capacity; the concentration of our insurance business in relatively few specialty classes; the increasingly competitive property and casualty marketplace; fluctuations and uncertainty within the excess and surplus lines insurance industry; the extensive regulations to which our business is subject and our failure to comply with those regulations; our ability to maintain our risk-based capital at levels required by regulatory authorities; our inability to realize our investment objectives; and the risks identified in our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K. Given these uncertainties, you are cautioned not to place undue reliance on these forward-looking statements. We assume no obligation to update or revise them or provide reasons why actual results may differ.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and the related notes included elsewhere in this Form 10-Q.

Overview

We are a provider of insurance products and services to the specialty commercial insurance markets, primarily focusing on niche and underserved segments where we believe that we have underwriting expertise and other competitive advantages. During our 36 years of underwriting security risks, we have established CoverX^{^®} as a recognized brand among insurance agents and brokers and developed significant underwriting expertise and a cost-efficient infrastructure. Over the last nine years, we have leveraged our brand, expertise and infrastructure to expand into other specialty classes of business, particularly focusing on smaller accounts that receive less attention from competitors.

First Mercury Financial Corporation (“FMFC”) is a holding company for our operating subsidiaries. Our operations are conducted with the goal of producing overall profits by strategically balancing underwriting profits from our insurance subsidiaries with the commissions and fee income generated by our non-insurance subsidiaries. FMFC’s principal operating subsidiaries are CoverX Corporation (“CoverX”), First Mercury Insurance Company (“FMIC”), First Mercury Casualty Company (“FMCC”), First Mercury Emerald Insurance Services, Inc. (“FM Emerald”), and American Management Corporation (“AMC”).

CoverX produces and underwrites insurance policies for which we retain risk and receive premiums. As a wholesale insurance broker, CoverX markets our insurance policies through a nationwide network of wholesale and retail insurance brokers who then distribute these policies through retail insurance brokers. CoverX also provides underwriting services with respect to the insurance policies it markets in that it reviews the applications submitted for insurance coverage, decides whether to accept all or part of the coverage requested and determines applicable premiums, all in a manner consistent with and within parameters defined by underwriting or binding authority guidelines established by FMIC or other non-affiliated insurers on whose behalf CoverX is producing business. CoverX receives commissions from affiliated insurance companies, reinsurers, and non-affiliated insurers as well as policy fees from wholesale and retail insurance brokers.

FM Emerald produces commercial lines business on primarily an excess and surplus lines basis for CoverX via a producer agreement. FM Emerald markets insurance products for CoverX through a nationwide network of wholesale and retail insurance brokers who then distribute these products through retail insurance brokers.

FMIC and FMCC are two of our insurance subsidiaries. FMIC writes substantially all the policies produced by CoverX. FMCC provides reinsurance to FMIC. FMIC and FMCC have entered into an intercompany pooling reinsurance agreement wherein all premiums, losses and expenses of FMIC and FMCC, including all past liabilities, are combined and apportioned between FMIC and

FMCC in accordance with fixed percentages. FMIC also provides claims handling and adjustment services for policies produced by CoverX and directly written by third parties.

On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Condensed Consolidated Statements of Income. ARPCO provided third party administrative services for risk sharing pools of governmental entity risks, including underwriting, claims, loss control and reinsurance services. ARPCO was solely a fee-based business and received fees for these services and commissions on excess per occurrence insurance placed in the commercial market with third party companies on behalf of the pools.

On February 1, 2008, we acquired 100% of the issued and outstanding common stock of American Management Corporation. AMC is a managing general agency writing primarily commercial lines package policies focused primarily on the niche fuel-related marketplace. AMC distributes these insurance policies through a nationwide distribution system of independent general agencies. AMC underwrites these policies for third party insurance carriers and receives commission income for its services. AMC also provides claims handling and adjustment services for policies produced by AMC and directly written for third parties. In addition, AMC owns and operates American Underwriters Insurance Company (“AUIC”), a single state, non-standard auto insurance company domiciled in the state of Arkansas, and AMC Re, Inc. (“AMC Re”), a captive reinsurer incorporated under the provisions of the laws of Arkansas. Effective July 1, 2008, FMIC and AUIC entered into an intercompany reinsurance agreement wherein all premiums and losses of AUIC, including all past liabilities, are 100% assumed by FMIC.

GAAP and Non-GAAP Financial Performance Metrics

Throughout this report, we present our operations in the way we believe will be most meaningful, useful, and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP (generally accepted accounting principles in the United States of America) presentation of net income and certain statutory reporting information, we show certain non-GAAP financial and other performance measures that we believe are valuable in managing our business and drawing comparisons to our peers. These measures are gross written premiums, net written premiums, and combined ratio.

Following is a list of performance measures found throughout this report with their definitions, relationships to GAAP measures, and explanations of their importance to our operations:

Gross written premiums. While net premiums earned is the related GAAP measure used in the statements of earnings, gross written premiums is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses, and loss costs.

Net written premiums. While net premiums earned is the related GAAP measure used in the statements of earnings, net written premiums is the component of net premiums earned that measures the difference between gross written premiums and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in our insurance underwriting operations. It is an indicator of future earnings potential subject to our expenses and loss costs.

Combined ratio. This ratio is a common industry measure of profitability for any underwriting operation, and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses, net of insurance underwriting commissions and fees, divided by net premiums earned. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of pre-tax underwriting income.

Critical Accounting Policies

The critical accounting policies discussed below are important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgments concerning future results and developments in making these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of material contingent assets and liabilities. We evaluate our estimates on a continual basis using information that we believe to be relevant. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements.

Readers are also urged to review “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” and Note 1 to the audited consolidated financial statements thereto included in the Annual Report on Form 10-K for the year ended December 31, 2008 on file with the Securities and Exchange Commission for a more complete description of our critical accounting policies and estimates.

Use of Estimates

In preparing our consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements, and revenues and expenses reported for the periods then ended. Actual results may differ from those estimates. Material estimates that are susceptible to significant change in the near term relate primarily to the determination of the reserves for losses and loss adjustment expenses and valuation of intangible assets and goodwill.

Loss and Loss Adjustment Expense Reserves

The reserves for losses and loss adjustment expenses represent our estimated ultimate costs of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. Our reserves reflect our estimates at a given time of amounts that we expect to pay for losses that have been reported, which are referred to as Case reserves, and losses that have been incurred but not reported and the expected development of losses and allocated loss adjustment expenses on reported cases, which are referred to as IBNR reserves. We do not discount the reserves for losses and loss adjustment expenses.

We allocate the applicable portion of our estimated loss and loss adjustment expense reserves to amounts recoverable from reinsurers under ceded reinsurance contracts and report those amounts separately from our loss and loss adjustment expense reserves as an asset on our balance sheet.

The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process, requiring the use of informed estimates and judgments. Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are our estimates based upon various factors, including:

	•		actuarial projections of what we, at a given time, expect to be the cost of the ultimate settlement and administration of claims reflecting facts and circumstances then known;

	•		estimates of future trends in claims severity and frequency;

	•		assessment of asserted theories of liability; and

	•		analysis of other factors, such as variables in claims handling procedures, economic factors, and judicial and legislative trends and actions.

Most or all of these factors are not directly or precisely quantifiable, particularly on a prospective basis, and are subject to a significant degree of variability over time. In addition, the establishment of loss and loss adjustment expense reserves makes no provision for the broadening of coverage by legislative action or judicial interpretation or for the extraordinary future emergence of new types of losses not sufficiently represented in our historical experience or which cannot yet be quantified. Accordingly, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimated reserves are included in the results of operations in the period in which the estimate is revised.

Our reserves consist of reserves for property and liability losses, consistent with the coverages provided for in the insurance policies directly written or assumed by the Company under reinsurance contracts. In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions and may, in fact, vary significantly from our assumptions. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We continually review our estimates and adjust them as we believe appropriate as our experience develops or new information becomes known to us.

Our reserves for losses and loss adjustment expenses at September 30, 2009 and December 31, 2008, gross and net of ceded reinsurance were as follows:


	September 30,		December 31,
	2009		2008
	(Dollars in thousands)
Gross
Case reserves	$	107,137	$	91,057
IBNR and ULAE reserves		341,128		281,664

Total reserves	$	448,265	$	372,721


Net of reinsurance
Case reserves	$	73,651	$	62,497
IBNR and ULAE reserves		217,718		181,672

Total	$	291,369	$	244,169

Revenue Recognition

Premiums. Premiums are recognized as earned using the daily pro rata method over the terms of the policies. When premium rates change, the effect of those changes will not immediately affect earned premium. Rather, those changes will be recognized ratably over the period of coverage. Unearned premiums represent the portion of premiums written that relate to the unexpired terms of policies-in-force. As policies expire, we audit those policies comparing the estimated premium rating units that were used to set the initial premium to the actual premiums rating units for the period and adjust the premiums accordingly. Premium adjustments identified as a result of these audits are recognized as earned when identified.

Commissions and Fees. Wholesale agency commissions and fee income from unaffiliated companies are earned at the effective date of the related insurance policies produced or as services are provided under the terms of the administrative and service provider contracts. Related commissions to retail agencies are concurrently expensed at the effective date of the related insurance policies produced. Profit sharing commissions due from certain insurance and reinsurance companies, based on losses and loss adjustment expense experience, are earned when determined in accordance with the applicable contract.

Investments

Our marketable investment securities, including money market accounts held in our investment portfolio, are classified as available-for-sale and, as a result, are reported at market value. Effective January 1, 2008, we adopted the accounting guidance for fair value measurements and disclosures which resulted in no material changes in valuation techniques we previously used to measure fair values. See Note 11 to the Condensed Consolidated Financial Statements for a more complete description. Convertible securities were accounted for under the accounting guidance for hybrid securities for the three and nine months ended September 30, 2009 and 2008. Alternative investments consist of our investments in limited partnerships, which invest in high yield convertible securities and distressed structured finance products. These alternative investments are accounted for in accordance with FASB guidance for the fair value option of financial instruments for the three and nine months ended September 30, 2009 and 2008.

Premiums and discounts are amortized or accreted over the life of the related debt security as an adjustment to yield using the effective-interest method. Dividend and interest income are recognized when earned. Realized gains and losses are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

Impairment of Investment Securities

Impairment of investment securities results when a market decline below cost is other-than-temporary. The other-than-temporary write down is separated into an amount representing the credit loss which is recognized in earnings and the amount related to all other factors which is recorded in other comprehensive income. Management regularly reviews our fixed maturity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost or amortized cost of the security, as appropriate, the length of time the investment has been below cost or amortized cost and by how much, our intent to sell a security and whether it is more-likely-than-not we will be required to sell the security before the recovery of our amortized cost basis, and specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a reduction of the cost basis of the underlying investment. Significant changes in these factors we consider

when evaluating investments for impairment losses could result in a change in impairment losses reported in the consolidated financial statements.

As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other-than-temporary decline. The Company’s ability to hold such securities is supported by sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment and other disbursement obligations arising from its underwriting operations without selling such investments. With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information and market conditions. Management of the Company’s investment portfolio is outsourced to third party investment managers which is directed and monitored by our investment committee. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available-for-sale.

Deferred Policy Acquisition Costs

Policy acquisition costs related to direct and assumed premiums consist of commissions, underwriting, policy issuance, and other costs that vary with and are primarily related to the production of new and renewal business, and are deferred, subject to ultimate recoverability, and expensed over the period in which the related premiums are earned. Investment income is included in the calculation of ultimate recoverability.

Goodwill and Intangible Assets

In accordance with the accounting guidance for goodwill and intangible assets that are not subject to amortization, these intangible assets shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test for goodwill shall consist of a comparison of the fair value of the goodwill with the carrying amount of the reporting unit to which it is assigned. The impairment test for intangible assets shall consist of a comparison of the fair value of the intangible assets with their carrying amounts. If the carrying amount of the goodwill or intangible assets exceeds their fair value, an impairment loss shall be recognized in an amount equal to that excess.

In accordance with the accounting guidance for the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including amortizable intangibles and property and equipment, are evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred relative to a given asset or assets. Impairment is deemed to have occurred if projected undiscounted cash flows associated with an asset are less than the carrying value of the asset. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. The amount of the impairment loss recognized is equal to the excess of the carrying value of the asset over its then estimated fair value.

Results of Operations

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

The following table summarizes our results for the three months ended September 30, 2009 and 2008:


	Three Months Ended
	September 30,
	2009			2008			Change
	(Dollars in thousands)
Operating Revenue
Net earned premiums	$	51,512		$	49,092			5	%
Commissions and fees		7,445			4,757			57
Net investment income		7,540			5,571			35
Net realized gains (losses) on investments		13,766			(7,128	)		293
Other-than-temporary impairment losses on investments		(292	)		(3,476	)		92

Total Operating Revenues		79,971			48,816			64

Operating Expenses
Losses and loss adjustment expenses, net		30,345			27,537			10
Amortization of intangible assets		559			553			1
Other operating expenses		24,129			19,797			22

Total Operating Expenses		55,033			47,887			15

Operating Income		24,938			929			2,584
Interest Expense		1,275			1,376			(7	)

Income (Loss) From Continuing Operations Before Income Taxes		23,663			(447	)		5,394
Income Taxes		8,018			(948	)		946

Income From Continuing Operations		15,645			501			3,023
Income (Loss) From Discontinued Operations, Net of Income Taxes		—			(447	)		n/m

Net Income	$	15,645		$	54			28,872	%

Loss Ratio		58.9	%		56.1	%	2.8 points
Underwriting Expense Ratio		33.6	%		30.2	%	3.4 points

Combined Ratio		92.5	%		86.3	%	6.2 points

Operating Revenue

Net Earned Premiums


	Three Months Ended
	September 30,
	2009			2008			Change
	(Dollars in thousands)
Written premiums
Direct	$	77,607		$	72,746			7	%
Assumed		4,201			4,253			(1	)
Ceded		(35,483	)		(27,453	)		29

Net written premiums	$	46,325		$	49,546			(7	)%


Earned premiums
Direct	$	77,907		$	70,985			10	%
Assumed		4,529			4,422			2
Ceded		(29,907	)		(26,566	)		13
Earned but unbilled premiums		(1,017	)		251			(505	)

Net earned premiums	$	51,512		$	49,092			5	%

Direct written premiums increased $4.9 million, or 7%, primarily due to increases in premium production from the Company’s Professional Liability and FM Emerald platforms partially offset by decreases in production from the Company’s Security and Specialty underwriting platforms during the three months ended September 30, 2009. Direct earned premiums increased $6.9 million in the three months ended September 30, 2009, or 10%, compared to the three months ended September 30, 2008.

Assumed written and assumed earned premiums were approximately flat.

Ceded written premiums increased $8.0 million, or 29%, and ceded earned premiums increased $3.3 million, or 13%, for the three months ended September 30, 2009 compared to the three months ended September 30, 2008. Ceded written premiums increased to 43.4% of direct and assumed written premiums during the third quarter of 2009 compared to 35.7% of direct and assumed written premiums during the third quarter of 2008 principally due to purchasing more quota share reinsurance during the third quarter of 2009 for the Company’s primary casualty business compared to the third quarter of 2008. The increase in quota share cessions was partially offset by lower cessions under our excess of loss treaties during the third quarter of 2009 and the elimination of a 50% quota share on a contract underwriting class of business during the fourth quarter of 2008, which impacted the third quarter of 2009.

Earned but unbilled premiums decreased $1.3 million, or 505%, primarily due to the net earned premiums subject to audit during the three months ended September 30, 2009 decreasing compared to the net premiums earned subject to audit during the three months ended September 30, 2008.

Commissions and Fees


	Three Months Ended
	September 30,
	2009		2008			Change
	(Dollars in thousands)
Insurance underwriting commissions and fees	$	1,272	$	(619	)		305	%
Insurance services commissions and fees		6,173		5,376			15

Total commissions and fees	$	7,445	$	4,757			57	%

Insurance underwriting commissions and fees increased 305% from the three months ended September 30, 2008 to the three months ended September 30, 2009, principally due to a non-recurring $1.8 million negative profit sharing commission on a fronted program recorded during the three months ended September 30, 2008. Insurance services commissions and fees, which were principally AMC commission and fee income and not related to premiums, increased $0.8 million, as the result of increased AMC commission and fee income of $0.5 million during the third quarter of 2009 compared to the third quarter of 2008. In addition, commission income related to our workers’ compensation service program increased $0.3 million.

Net Investment Income and Realized Gains (Losses) on Investments. During the three months ended September 30, 2009, net investment income was $7.5 million, a $2.0 million, or 35%, increase from $5.6 million reported for the three months ended September 30, 2008 primarily due to the increase in invested assets over the period and an increase in the book yield of the portfolio. At September 30, 2009, invested assets were $674.0 million, a $139.8 million, or 26%, increase over $534.2 million of invested assets at September 30, 2008. This increase was due to cash flows from net written premiums, and from the cash retained on our quota share reinsurance contracts on a “funds withheld” basis. The annualized investment yield on total investments (net of investment expenses) was 5.0% and 4.0% at September 30, 2009 and 2008, respectively. The annualized taxable equivalent yield on total investments (net of investment expenses) was 5.5% and 4.8% at September 30, 2009 and 2008, respectively.

During the three months ended September 30, 2009, net realized gains were $13.8 million compared to net realized losses of $7.1 million during the three months ended September 30, 2008. The third quarter 2009 net realized gains were due to the mark to market increase in securities carried at market of approximately $12.4 million and gains on the sale of certain securities of $2.3 million, partially offset by the losses on the sale of certain securities. Those securities that are marked to market include convertible securities held both as individually-owned securities and an investment in a limited partnership, and an investment in a structured finance limited partnership. Convertible bond prices are a function of the underlying equity and the fixed income component whose values change with the stock market and changes in spread of corporate bonds, respectively. The structured finance limited partnership is valued based on a portfolio of non-agency mortgage securities, and the hedges that may accompany these positions. The value of these components in the limited partnership change in value for a variety of reasons including, but not limited to, changes in spread for mortgage product, changes in prepayment rates, default rates, severity rates, changes in the overall level of rates and the corresponding value of the underlying loans, and changes in the value of the properties by which these loans are collateralized.

Other-than-temporary Impairment Losses on Investments. During the three months ended September 30, 2009 other-than-temporary impairment losses on investments were $0.3 million compared to other-than-temporary impairment losses on investments of $3.5 million during the three months ended September 30, 2008. The decrease in other-than-temporary impairment losses on investments is primarily attributable to the stabilization of the capital markets.

Operating Expenses

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred increased $2.8 million, or 10%, in the three months ended September 30, 2009 compared to the three months ended September 30, 2008. This increase was primarily due to the increase in net earned exposures reflected in the 5% increase in net earned premiums and an increase in the accident year loss and loss adjustment expense ratio from decreased premium rates, partially offset by favorable claims trends for the current and prior accident years. Losses and loss adjustment expenses for the three months ended September 30, 2009 included approximately $1.3 million of favorable development of December 31, 2008 prior years’ loss and loss adjustment expense reserves in our Specialty general liability classes in the 2007 accident year due to lower than expected claim frequency along with lower than expected severity. Losses and loss adjustment expenses for the three months ended September 30, 2008 included approximately $4.8 million in favorable development of December 31, 2007 prior years’ loss and loss adjustment expense reserves and $2.9 million from the impact of Hurricane Ike. The $4.8 million in net favorable development included $6.0 million in our Specialty general liability classes in the 2007 accident year due to favorable claims trends, unfavorable development of $1.4 million in our Contract Underwriting liability classes in accident years 2005 through 2007 due to higher than expected severity in the 2006 and 2007 accident years reduced by lower than expected severity in the 2005 accident year and net favorable development of $0.2 million in unallocated loss and loss adjustment expenses for the 2005 through 2007 accident years.

Other Operating Expenses


	Three Months Ended
	September 30
	2009			2008			Change
	(Dollars in thousands)
Amortization of deferred acquisition expenses	$	13,960		$	10,798			29	%
Ceded reinsurance commissions		(8,340	)		(7,164	)		16
Other underwriting and operating expenses		18,509			16,163			15

Other operating expenses	$	24,129		$	19,797			22	%

During the three months ended September 30, 2009, other operating expenses increased $4.3 million, or 22%, from the three months ended September 30, 2008. Amortization of deferred acquisition expenses increased by $3.2 million, or 29% due to increased acquisition expenses on new underwriting initiatives and the impact of purchasing less quota share reinsurance in 2008, partially offset by purchasing more quota share reinsurance in 2009. Ceded reinsurance commissions increased $1.2 million, or 16%, principally due to the effect of purchasing more quota share reinsurance during the third quarter of 2009 compared to the third quarter of 2008. Other underwriting and operating expenses, which consist of commissions, other acquisition costs, and general and underwriting expenses, net of acquisition cost deferrals increased by $2.3 million, or 15%. The increase was principally due to higher commissions and other acquisition costs of $1.1 million, higher corporate expenses of $1.0 million, and an increase of $0.2 million in general and underwriting expenses related to our insurance services operations, which are unrelated to premiums.

Interest Expense. Interest expense decreased 7% from the three months ended September 30, 2008 compared to the three months ended September 30, 2009. This decrease was primarily due to a $0.1 million decrease in the change in fair value of the interest rate swaps on junior subordinated debentures as discussed in “Liquidity and Capital Resources” below.

Income Taxes. Our effective tax rates were approximately 33.9% for the three months ended September 30, 2009 and -212.1% for the three months ended September 30, 2008 and differed from the federal statutory rate primarily due to state income taxes, non-deductible expenses, and the nontaxable portion of dividends received and tax-exempt interest. The increase in the effective tax rate is primarily due to the nontaxable portion of dividends received and tax-exempt interest constituting a lower portion of overall pretax income for the three months ended September 30, 2009 compared to the same period of 2008.

Discontinued Operations. On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Condensed Consolidated Statements of Income. For the three months ended September 30, 2008, income from discontinued operations consisted of state income tax expense of $0.4 million, net of federal taxes, on the sale of ARPCO.

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

The following table summarizes our results for the nine months ended September 30, 2009 and 2008:


	Nine Months Ended
	September 30,
	2009			2008			Change
	(Dollars in thousands)
Operating Revenue
Net earned premiums	$	155,539		$	139,222			12	%
Commissions and fees		23,916			15,896			50
Net investment income		21,105			15,635			35
Net realized gains (losses) on investments		25,204			(8,714	)		389
Other-than-temporary impairment losses on investments		(426	)		(3,701	)		88

Total Operating Revenues		225,338			158,338			42

Operating Expenses
Losses and loss adjustment expenses, net		96,301			76,713			26
Amortization of intangible assets		1,709			1,466			17
Other operating expenses		69,808			54,706			28

Total Operating Expenses		167,818			132,885			26

Operating Income		57,520			25,453			126
Interest Expense		3,877			4,490			(14	)

Income From Continuing Operations Before Income Taxes		53,643			20,963			156
Income Taxes		17,707			5,592			217

Income From Continuing Operations		35,936			15,371			134
Income From Discontinued Operations, Net of Income Taxes		—			23,106			n/m

Net Income	$	35,936		$	38,477			(7	)%

Loss Ratio		61.9	%		55.1	%	6.8 points
Underwriting Expense Ratio		31.6	%		26.9	%	4.7 points

Combined Ratio		93.5	%		82.0	%	11.5 points

Operating Revenue

Net Earned Premiums


	Nine Months Ended
	September 30,
	2009			2008			Change
	(Dollars in thousands)
Written premiums
Direct	$	228,619		$	224,720			2	%
Assumed		13,588			13,399			1
Ceded		(92,615	)		(77,828	)		19

Net written premiums	$	149,592		$	160,291			(7	)%


Earned premiums
Direct	$	226,125		$	209,208			8	%
Assumed		13,276			12,405			7
Ceded		(81,752	)		(82,063	)		(0	)
Earned but unbilled premiums		(2,110	)		(328	)		543

Net earned premiums	$	155,539		$	139,222			12	%

Direct written premiums increased $3.9 million, or 2%, primarily due to increases in production from the Company’s FM Emerald, Professional Liability and Contract Underwriting platforms offset by decreases in premium production from the Company’s Security and Specialty underwriting platforms during the nine months ended September 30, 2009. Direct earned premiums increased $16.9 million in the nine months ended September 30, 2009, or 8%, compared to the nine months ended September 30, 2008.

Assumed written premiums were approximately flat and assumed earned premiums increased $0.9 million, or 7%.

Ceded written premiums increased $14.8 million, or 19%, and ceded earned premiums decreased $0.3 million, or less than 1%, for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. Ceded written premiums increased to 38.2% of direct and assumed written premiums during the nine months ended September 30, 2009 compared to 32.7% of direct and assumed written premiums during the nine months ended September 30, 2008 principally due to purchasing more quota share reinsurance during the nine months ended September 30, 2009 for the Company’s primary casualty business compared to the same period of 2008. The increase in quota share cessions was partially offset by lower cessions under our excess of loss treaties during the nine months ended September 30, 2009 and the elimination of a 50% quota share on a contract underwriting class of business during the fourth quarter of 2008, which impacted the nine months ended September 30, 2009.

Earned but unbilled premiums decreased $1.8 million, or 543%, primarily due to the net earned premiums subject to audit during the nine months ended September 30, 2009 decreasing compared to the net premiums earned subject to audit during the nine months ended September 30, 2008.

Commissions and Fees


	Nine Months Ended
	September 30,
	2009		2008		Change
	(Dollars in thousands)
Insurance underwriting commissions and fees	$	3,989	$	2,136		87	%
Insurance services commissions and fees		19,927		13,760		45

Total commissions and fees	$	23,916	$	15,896		50	%

Insurance underwriting commissions and fees increased $1.9 million, or 87%, in the nine months ended September 30, 2008 compared to the nine months ended September 30, 2009. This increase was primarily due to a non-recurring $1.8 million negative profit sharing commission on a fronted program recorded during the nine months ended September 30, 2008. Insurance services commissions and fees, which were principally AMC commission and fee income and not related to premiums, increased $6.2 million, as the result of nine months of commission and fee income during the period ended September 30, 2009 compared to eight months during the period ended September 30, 2008, the favorable settlement of a contingent adjustment due to an unaffiliated carrier for $1.3 million, and $1.3 million increase in commission income related to our workers’ compensation service program.

Net Investment Income and Realized Gains (Losses) on Investments. During the nine months ended September 30, 2009, net investment income was $21.1 million, a $5.5 million, or 35%, increase from $15.6 million reported for the nine months ended September 30, 2008 primarily due to the increase in invested assets over the period and an increase in the book yield of the portfolio. At September 30, 2009, invested assets were $674.0 million, a $139.8 million, or 26%, increase over $534.2 million of invested assets at September 30, 2008. This increase was due to cash flows from net written premiums and from the cash retained on our quota share reinsurance contracts on a “funds withheld” basis. The annualized investment yield on total investments (net of investment expenses) was 5.0% and 4.0% at September 30, 2009 and 2008, respectively. The annualized taxable equivalent yield on total investments (net of investment expenses) was 5.5% and 4.8% at September 30, 2009 and 2008, respectively.

During the nine months ended September 30, 2009, net realized gains were $25.2 million compared to net realized losses of $8.7 million during the nine months ended September 30, 2008. The nine months ended September 30, 2009 net realized gains were principally due to the mark to market increase in securities carried at market of approximately $21.1 million and gains on the sale of certain securities of $5.9 million, partially offset by the losses on the sale of certain securities. Those securities that are marked to market include convertible securities held both as individually-owned securities and an investment in a limited partnership, and an investment in a structured finance limited partnership. Convertible bond prices are a function of the underlying equity and the fixed income component whose values change with the stock market and changes in spread of corporate bonds, respectively. The structured finance limited partnership is valued based on a portfolio of non-agency mortgage securities, and the hedges that may accompany positions. The value of these components in the limited partnership change in value for a variety of reasons including, but not limited to, changes in spread for mortgage product, changes in prepayment rates, default rates, severity rates, changes in the overall level of rates and the corresponding value of the underlying loans, and changes in the value of the properties by which these loans are collateralized.

Other-than-temporary Impairment Losses on Investments. During the nine months ended September 30, 2009, other-than-temporary impairment losses on investments were $0.4 million compared to other-than-temporary impairment losses on investments of $3.7 million during the nine months ended September 30, 2008. The decrease in other-than-temporary impairment losses on investments is primarily attributable to the stabilization of the capital markets.

Operating Expenses

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred increased $19.6 million, or 26%, in the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. This increase was primarily due to the increase in net earned exposures reflected in the 12% increase in net earned premiums, an increase in the accident year loss and loss adjustment expense ratio from decreased premium rates, $2.4 million of storm-related losses experienced during the second quarter of 2009, and $5.2 million of higher than anticipated 2009 commercial property fire and other losses and loss adjustment expenses during the second quarter of 2009, partially offset by favorable claims trends in the current and prior accident years. Losses and loss adjustment expenses for the nine months ended September 30, 2009 included approximately $5.7 million of favorable development of December 31, 2008 prior years’ loss and loss adjustment expense reserves. Favorable development of $1.9 million in our Security general liability classes in 2006 through 2007 accident years and $3.6 million in our Specialty general liability classes in the 2006 through 2007 accident years was due to lower than expected claim frequency and lower than expected severity. Net favorable

development of $0.2 million in unallocated loss and loss adjustment expenses was recorded for the 2006 through 2007 accident years. Losses and loss adjustment expenses for the nine months ended September 30, 2008 included approximately $4.8 million in favorable development of December 31, 2007 prior years’ loss and loss adjustment expense reserves and $2.9 million from the impact of Hurricane Ike. The $4.8 million in net favorable development included $6.0 million in our Specialty general liability classes in the 2007 accident year due to favorable claims trends, unfavorable development of $1.4 million in our Contract Underwriting liability classes in accident years 2005 through 2007 due to higher than expected severity in the 2006 and 2007 accident years reduced by lower than expected severity in the 2005 accident year and net favorable development of $0.2 million in unallocated loss and loss adjustment expenses for the 2005 through 2007 accident years.

Other Operating Expenses


	Nine Months Ended
	September 30
	2009			2008			Change
	(Dollars in thousands)
Amortization of deferred acquisition expenses	$	40,889		$	28,107			45	%
Ceded reinsurance commissions		(24,767	)		(23,959	)		3
Other underwriting and operating expenses		53,686			50,558			6

Other operating expenses	$	69,808		$	54,706			28	%

During the nine months ended September 30, 2009, other operating expenses increased $15.1 million, or 28%, from the nine months ended September 30, 2008. Amortization of deferred acquisition expenses increased by $12.8 million, or 45% due to increased acquisition expenses on new underwriting initiatives and the impact of purchasing less quota share reinsurance in 2008, partially offset by purchasing more quota share reinsurance in 2009. Ceded reinsurance commissions decreased $0.8 million, or 3%, principally due to the effect of purchasing more quota share reinsurance during the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008 and lower ceding commissions related to profit sharing on ceded written premiums. Other underwriting and operating expenses, which consist of commissions, other acquisition costs, and general and underwriting expenses, net of acquisition cost deferrals, increased by $3.1 million, or 6%. The increase was principally due to higher commissions and other acquisition costs of $2.4 million, lower corporate expenses of $1.0 million and an increase of $1.7 million in general and underwriting expenses related to our insurance services operations, which are unrelated to premiums, principally due to having nine months of AMC results compared to eight months during the period ended September 30, 2008 due to the closing of the AMC acquisition on February 1, 2008 and increased premium production for unaffiliated carriers by our services operations.

Interest Expense. Interest expense decreased 14% from the nine months ended September 30, 2008 compared to the nine months ended September 30, 2009. This decrease was primarily due to a $0.5 million decrease in the change in fair value of the interest rate swaps on junior subordinated debentures as discussed in “Liquidity and Capital Resources” below.

Income Taxes. Our effective tax rates were approximately 33.0% for the nine months ended September 30, 2009 and 26.7% for the nine months ended September 30, 2008 and differed from the federal statutory rate primarily due to state income taxes, non-deductible expenses, and the nontaxable portion of dividends received and tax-exempt interest. The increase in the effective tax rate is primarily due to the nontaxable portion of dividends received and tax-exempt interest constituting a lower portion of overall pretax income for the nine months ended September 30, 2009 compared to the same period of 2008.

Discontinued Operations. On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Condensed Consolidated Statements of Income. For the nine months ended September 30, 2008, income from discontinued operations consisted principally of ARPCO’s operating income, net of taxes, and the gain on the sale of ARPCO of $20.9 million.

Liquidity and Capital Resources

Sources and Uses of Funds

FMFC. FMFC is a holding company with all of its operations being conducted by its subsidiaries. Accordingly, FMFC has continuing cash needs primarily for administrative expenses, debt service and taxes. Funds to meet these obligations come primarily from management and administrative fees from all of our subsidiaries, and dividends from our non-insurance subsidiaries.

Insurance Subsidiaries. The primary sources of our insurance subsidiaries’ cash are net written premiums, claims handling fees, amounts earned from investments and the sale or maturity of invested assets. Additionally, FMFC has in the past and may in the future contribute capital to its insurance subsidiaries.

The primary uses of our insurance subsidiaries’ cash include the payment of claims and related adjustment expenses, underwriting fees and commissions and taxes and making investments. Because the payment of individual claims cannot be predicted with certainty, our insurance subsidiaries rely on our paid claims history and industry data in determining the expected payout of claims and estimated loss reserves. To the extent that FMIC, FMCC, and AUIC have an unanticipated shortfall in cash, they may either liquidate securities held in their investment portfolios or obtain capital from FMFC. However, given the cash generated by our insurance subsidiaries’ operations and the relatively short duration of their investment portfolios, we do not currently foresee any such shortfall.

Non-insurance Subsidiaries. The primary sources of our non-insurance subsidiaries’ cash are commissions and fees, policy fees, administrative fees and claims handling and loss control fees. The primary uses of our non-insurance subsidiaries’ cash are commissions paid to brokers, operating expenses, taxes and dividends paid to FMFC. There are generally no restrictions on the payment of dividends by our non-insurance subsidiaries, except as may be set forth in our borrowing arrangements.

Cash Flows

Our sources of funds have consisted primarily of net written premiums, commissions and fees, investment income and proceeds from the issuance of equity securities and debt. We use operating cash primarily to pay operating expenses and losses and loss adjustment expenses and for purchasing investments. A summary of our cash flows is as follows:


	Nine Months Ended
	September 30,
	2009			2008
	(Dollars in thousands)
Cash and cash equivalents provided by (used in):
Operating activities — continuing operations	$	66,606		$	91,712
Operating activities — discontinued operations		—			1,928
Investing activities — continuing operations		(72,513	)		(128,185	)
Investing activities — discontinued operations		—			41,830
Financing activities		(9,721	)		(3,122	)

Change in cash and cash equivalents	$	(15,628	)	$	4,163

Net cash provided by operating activities from continuing operations for the nine months ended September 30, 2009 and 2008 was primarily from cash received on net written premiums and less cash disbursed for operating expenses and losses and loss adjustment expenses. Cash received from net written premiums for the nine months ended September 30, 2009 and 2008 was retained on a “funds withheld” basis in accordance with the quota share reinsurance contracts.

Net cash provided by operating activities from discontinued operations for the nine months ended September 30, 2008 was primarily from cash received on commissions and service fees less cash disbursed for operating expenses.

Net cash used in investing activities from continuing operations for the nine months ended September 30, 2009 primarily resulted from our net investment in short-term, debt and equity securities. Net cash used in investing activities from continuing operations for the nine months ended September 30, 2008 primarily resulted from our net investment in short-term, debt and equity securities, and for the acquisition of AMC.

Net cash provided by investing activities from discontinued operations for the nine months ended September 30, 2008 was from cash received on the sale of ARPCO less cash disbursed for transaction costs.

Net cash used in financing activities for the nine months ended September 30, 2009 was primarily from the purchase of common stock under the Company’s Share Repurchase Plan (Note 9), the payment of shareholders’ dividends, and the purchase of common stock by the Company to be held in a rabbi trust for the benefit of the Company’s Supplemental Executive Retirement Plan, partially offset by net short-term borrowings of $3.0 million on the Company’s $30.0 million revolving credit facility.

Net cash used in financing activities for the nine months ended September 30, 2008 resulted from the issuance of common stock as a result of the exercise of stock options offset by the purchase of common stock under the Company’s Share Repurchase Plan and the purchase of common stock by the Company to be held in a rabbi trust for the benefit of the Company’s Supplemental Executive Retirement Plan.

Based on historical trends, market conditions, and our business plans, we believe that our existing resources and sources of funds will be sufficient to meet our liquidity needs in the next twelve months. Because economic, market and regulatory conditions may change, however, there can be no assurances that our funds will be sufficient to meet our liquidity needs. In addition, competition, pricing, the frequency and severity of losses, and interest rates could significantly affect our short-term and long-term liquidity needs.

Stockholders’ Equity

Our total stockholders’ equity was $307.5 million, or $17.90 per outstanding share, as of September 30, 2009 compared to $261.6 million, or $14.67 per outstanding share, as of December 31, 2008. Our tangible stockholders’ equity attributable to common shareholders was $257.1 million, or $14.97 per outstanding share, as of September 30, 2009 compared to $210.2 million, or $11.79 per outstanding share as of December 31, 2008. Below is a reconciliation of our total stockholders’ equity to our tangible stockholders’ equity attributable to common shareholders:


	September 30,			December 31,
	2009			2008
	(Dollars in thousands, except share and per share data)
Total stockholders’ equity	$	307,472		$	261,637
Intangible assets, net		(37,642	)		(39,351	)
Deferred tax liability — intangible assets, net		12,801			13,399
Goodwill		(25,483	)		(25,483	)

Tangible stockholders’ equity attributable to common shareholders	$	257,148		$	210,202


Common shares outstanding		17,174,906			17,836,337


Book value per share	$	17.90		$	14.67

Tangible book value per share	$	14.97		$	11.79

Book value per share is total common stockholders’ equity divided by the number of common shares outstanding. Tangible book value per share is book value per share excluding the value of intangible assets, goodwill, and the deferred tax liability related to intangible assets divided by the number of common shares outstanding.

Long-term debt

Junior Subordinated Debentures. We have $67.0 million cumulative principal amount of floating rate junior subordinated debentures outstanding. The debentures were issued in connection with the issuance of trust preferred stock by our wholly-owned, non-consolidated trusts. Cumulative interest on $46.4 million cumulative principal amount of the debentures is payable quarterly in arrears at a variable annual rate, reset quarterly, equal to the three month LIBOR plus 3.75% for $8.2 million, the three month LIBOR plus 4.00% for $12.4 million, and the three month LIBOR plus 3.0% for $25.8 million principal amount of the debentures. Cumulative interest on $20.6 million of the cumulative principal amount of the debentures is payable quarterly in arrears at a fixed annual rate of 8.25% through December 15, 2012, and a variable annual rate, reset quarterly, equal to the three month LIBOR plus 3.30% thereafter. For our floating rate junior subordinated debentures, we have entered into interest rate swap agreements to pay a fixed rate of interest. See “Derivative Financial Instruments” for further discussion. At September 30, 2009, the three month LIBOR rate was 0.29%. We may defer the payment of interest for up to 20 consecutive quarterly periods; however, no such deferral has been made.

Credit Facility. In October 2006, we entered into a credit facility which provided for borrowings of up to $30.0 million. Borrowings under the credit facility bear interest at our election as follows: (i) at a rate per annum equal to the greater of the lender’s prime rate and the federal funds rate less 0.5%, each minus 0.75%; or, (ii) a rate per annum equal to LIBOR plus an applicable margin

based on our leverage ratio, which is currently 0.75%. The obligations under the credit facility are guaranteed by our material non-insurance subsidiaries. The maturity date of borrowings made under the credit facility is September 2011. The credit facility contains covenants which, among other things, restrict our ability to incur indebtedness, grant liens, make investments and sell assets. The credit facility also has certain financial covenants. At September 30, 2009, there were $3.0 million of borrowings under the facility. At September 30, 2009, the Company was in compliance with all of the covenants related to the credit facility.

Derivative Financial Instruments. Financial derivatives are used as part of the overall asset and liability risk management process. We use interest rate swap agreements with a combined notional amount of $45.0 million in order to reduce our exposure to interest rate fluctuations with respect to our junior subordinated debentures. In June 2009, the Company entered into two interest rate swap agreements which expire in August 2014. Under one of the swap agreements we pay interest at a fixed rate of 3.695% and under the other swap agreement we pay interest at a fixed rate of 3.710%. Under our other swap agreement, which expires in December 2011, we pay interest at a fixed rate of 5.013%. Under all three swap agreements, we receive interest at the three month LIBOR, which is equal to the contractual rate under the junior subordinated debentures. At September 30, 2009, we had no exposure to credit loss on the interest rate swap agreements.

Cash and Invested Assets

Our cash and invested assets consist of fixed maturity securities, convertible securities, equity securities, and cash and cash equivalents. At September 30, 2009, our investments had a market value of $674.0 million and consisted of the following investments:


	Market Value		% of Portfolio
	(Dollars in thousands)
Short Term Investments	$	10,754		1.6	%
U.S. Treasuries		3,922		0.6	%
U.S. Agencies		1,028		0.2	%
Municipal Bonds		197,257		29.2	%
Taxable Municipal Bonds		3,445		0.5	%
Corporate Bonds		129,254		19.2	%
High Yield Bonds		19,275		2.9	%
MBS Passthroughs		61,532		9.1	%
CMOs		74,226		11.0	%
Asset Backed Securities		22,875		3.4	%
Commercial MBS		58,924		8.7	%
Convertible Securities		66,131		9.8	%
High Yield Convertible Fund		12,301		1.8	%
Structured Finance Fund		11,814		1.8	%
Preferred Stocks		1,273		0.2	%
Common Stocks		—		0.0	%

Total	$	674,011		100.0	%

The following table shows the composition of the investment portfolio by remaining time to maturity at September 30, 2009. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the expected maturities of our investments in putable bonds fluctuate inversely with interest rates and therefore may also differ from contractual maturities.


	% of Total
Average Life	Investment
Less than one year		15.2	%
One to two years		13.5	%
Two to three years		15.6	%
Three to four years		15.5	%
Four to five years		13.6	%
Five to seven years		11.1	%
More than seven years		15.5	%

Total		100.0	%

The effective duration of the portfolio as of September 30, 2009 is approximately 3.4 years and the taxable equivalent duration is 3.1 years. Excluding cash and cash equivalents, equity and convertible securities, the portfolio duration and taxable equivalent duration are 3.6 years and 3.3 years, respectively. The shorter taxable equivalent duration reflects the significant portion of the portfolio in municipal securities. The annualized investment yield on total investments (net of investment expenses) was 5.0% at September 30, 2009 and 4.0% at September 30, 2008. The annualized taxable equivalent yield on total investments (net of investment expenses) was 5.5% at September 30, 2009 and 4.8% at September 30, 2008.

The majority of our portfolio consists of AAA or AA rated securities with a Standard and Poor’s weighted average credit quality of AA- at September 30, 2009. The fixed income portfolio had a weighted average credit quality of AA at September 30, 2009. The majority of the investments rated BBB and below are convertible securities and opportunistic investments in high yield credit and non-agency mortgage securities. Consistent with our investment policy, we review any security if it falls below BBB- and assess whether it should be held or sold. The following table shows the ratings distribution of our investment portfolio as of September 30, 2009 as a percentage of total market value.


	% of Total
S&P Rating	Investments
AAA		47.6	%
AA		14.6	%
A		14.8	%
BBB		12.9	%
BB		5.7	%
B		1.7	%
CCC		2.7	%
C		0.0	%
NR		0.0	%

Total		100.0	%

Within Mortgages, the Company invests in residential collateralized mortgage obligations (“CMO”) that typically have high credit quality and are expected to provide an advantage in yield compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO tranches which offer the most favorable return given the risks involved. One significant risk evaluated is prepayment sensitivity. While prepayment risk (either shortening or lengthening of duration) and its effect on total return cannot be fully controlled, particularly when interest rates move dramatically, the investment process generally favors securities that control this risk within expected interest rate ranges. The Company does not purchase residual interests in CMO’s.

At September 30, 2009, the Company held CMO’s classified as available-for-sale with a fair value of $74.2 million. Approximately 60.4% of those CMO holdings were guaranteed by or fully collateralized by securities issued by a full faith and credit agency such as GNMA, or government sponsored enterprises (“GSE”) such as FNMA or FHLMC. In addition, at September 30, 2009, the Company held $60.8 million of mortgage-backed pass-through securities issued by one of the GSE’s and classified as available-for-sale.

The Company held commercial mortgage-backed securities (“CMBS”) of $58.9 million, of which 83.5% are pre-2006 vintage, at September 30, 2009. The weighted average credit support (adjusted for defeasance) of our CMBS portfolio was 40.6% and comprised mainly of super senior structures. The weighted average loan to value at origination was 67.3%. The average credit rating of these

securities was AAA. The CMBS portfolio was supported by loans that were diversified across economic sectors and geographical areas. It is not believed that this portfolio exposes the Company to a material adverse impact on its results of operations, financial position or liquidity, due to the underlying credit strength of these securities.

The Company’s fixed maturity investment portfolio included asset-backed securities and collateralized mortgage obligations collateralized by sub-prime mortgages and alternative documentation mortgages (“Alt-A”) with market values of $9.2 million and $3.5 million at September 30, 2009, respectively. Included in these securities is a recent allocation made during the quarter to a manager who specializes in opportunities in the non-agency mortgage sector. The Company defines sub-prime mortgage-backed securities as investments with weighted average FICO scores below 650. Alt-A securities are defined by above-prime interest rates, high loan-to-value ratios, high debt-to-income ratios, low loan documentation (e.g., limited or no verification of income and assets), or other characteristics that are inconsistent with conventional underwriting standards employed by government-sponsored mortgage entities. The average credit rating on these securities and obligations held by the Company at September 30, 2009 was BB-.

The Company’s fixed maturity investment portfolio at September 30, 2009 included securities issued by numerous municipalities with a total carrying value of $200.7 million. Approximately $21.5 million, or 10.7%, were pre-refunded (escrowed with Treasuries). Approximately $95.9 million, or 47.8%, of the securities were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. Such insurance, prior to the downgrades of many of the third party insurers, results in a rating of AAA being assigned by independent rating agencies to those securities. The downgrade of credit ratings of insurers of these securities could result in a corresponding downgrade in the ratings of the securities from AA+ to the underlying rating of the respective security without giving effect to the benefit of insurance. Of the total $95.9 million of insured municipal securities in the Company’s investment portfolio at September 30, 2009, 98.9% were rated at A- or above, and approximately 73.5% were rated AA- or above, without the benefit of insurance. The average underlying credit rating of the entire municipal bond portfolio was AA at September 30, 2009. The Company believes that a loss of the benefit of insurance would not result in a material adverse impact on the Company’s results of operations, financial position or liquidity, due to the underlying credit strength of the issuers of the securities, as well as the Company’s ability and intent to hold the securities.

The Company’s investment portfolio does not contain any exposure to Collateralized Debt Obligations (“CDO”) or investments collateralized by CDOs. In addition, the Company’s investment portfolio does not contain any exposure to auction-rate securities.

Cash and cash equivalents consisted of cash on hand of $16.2 million at September 30, 2009.


			Gross Unrealized
	Amortized Cost		Gains		Losses			Market Value
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	3,776	$	146	$	—		$	3,922
Government agency mortgage-backed securities		101,160		4,491		(8	)		105,643
Government agency obligations		989		39		—			1,028
Collateralized mortgage obligations and other asset-backed securities		109,734		5,176		(2,996	)		111,914
Obligations of states and political subdivisions		189,101		11,661		(60	)		200,702
Corporate bonds		137,912		11,317		(700	)		148,529

Total Debt Securities		542,672		32,830		(3,764	)		571,738
Preferred stocks		1,416		50		(193	)		1,273
Short-term investments		10,754		—		—			10,754

Total	$	554,842	$	32,880	$	(3,957	)	$	583,765

At September 30, 2009, there were 108 unrealized loss positions with a total unrealized loss of $4.0 million. This represents approximately 0.7% of quarter end available-for-sale assets of $583.8 million. This unrealized loss position is a function of the purchase of specific securities in a lower interest rate or spread environment than what prevails as of September 30, 2009. Some of these losses are due to the increase in spreads of select corporate bonds or structured securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of the core fixed income portfolio excluding cash, convertible securities, and equity is approximately 3.6 years. We do not intend to sell and it is not expected we will need to sell these temporarily impaired securities. In light of our growth over the past 24 months, liquidity needs from the portfolio are minimal. As a result, we would not expect to have to liquidate temporarily impaired securities to pay claims or for any other purposes. There

have been certain instances over the past year where due to market based opportunities we have elected to sell a small portion of the portfolio. These situations were unique and infrequent occurrences and in our opinion, do not reflect an indication that we intend to sell or will be required to sell these securities before they mature or recover in value.

The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at September 30, 2009:


	Less than 12 Months					Greater than 12 Months
	Fair Value					Fair Value
	of					of
	Investments					Investments
	With		Gross			With		Gross
	Unrealized		Unrealized			Unrealized		Unrealized
	Losses		Losses			Losses		Losses
			(Dollars in thousands)
Debt Securities
U.S. government securities	$	—	$	—		$	—	$	—
Government agency mortgage-backed securities		1,680		(1	)		194		(7	)
Government agency obligations		—		—			—		—
Collateralized mortgage obligations and other asset-backed securities		6,351		(262	)		14,157		(2,734	)
Obligations of states and political subdivisions		—		—			3,645		(60	)
Corporate bonds		1,252		(1	)		8,542		(699	)

Total Debt Securities		9,283		(264	)		26,538		(3,500	)
Preferred Stocks		—		—			313		(193	)

Total	$	9,283	$	(264	)	$	26,851	$	(3,693	)

The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at December 31, 2008:


	Less than 12 Months					Greater than 12 Months
	Fair Value					Fair Value
	of					of
	Investments					Investments
	With		Gross			With		Gross
	Unrealized		Unrealized			Unrealized		Unrealized
	Losses		Losses			Losses		Losses
	(Dollars in thousands)
Debt Securities
U.S. government securities	$	—	$	—		$	—	$	—
Government agency mortgage-backed securities		3,902		(37	)		326		(2	)
Government agency obligations		—		—			—		—
Collateralized mortgage obligations and other asset-backed securities		48,125		(5,143	)		5,963		(1,944	)
Obligations of states and political subdivisions		14,063		(427	)		8,809		(267	)
Corporate bonds		42,402		(2,549	)		12,824		(1,325	)

Total Debt Securities		108,492		(8,156	)		27,922		(3,538	)
Preferred Stocks		832		(78	)		216		(289	)

Total	$	109,324	$	(8,234	)	$	28,138	$	(3,827	)

Below is a table that illustrates the unrecognized impairment loss by sector. The increase in spread relative to U.S. Treasury Bonds was the primary factor leading to impairment for the nine months ended September 30, 2009. All asset sectors were affected by the overall increase in spreads as can be seen from the table below. In addition to the general level of rates, we also look at a variety of other factors such as direction of credit spreads for an individual issue as well as the magnitude of specific securities that have declined below amortized cost.


	Amount of
	Unrealized Loss at
Sector	September 30, 2009
	(Dollars in thousands)
Short Term Investments	$	—
U.S. Treasuries		—
U.S. Agencies		—
Municipal Bonds		(60	)
Taxable Municipal Bonds		—
Corporate Bonds		(700	)
High Yield Bonds		—
MBS Passthroughs		(23	)
CMOs		(1,339	)
Asset Backed Securities		(631	)
Commercial MBS		(1,011	)
Convertible Securities		—
High Yield Convertible Fund		—
Structured Finance Fund		—
Preferred Stocks		(193	)
Common Stocks		—

	$	(3,957	)

The most significant risk or uncertainty inherent in our assessment methodology is that the current credit rating of a particular issue changes over time. If the rating agencies should change their rating on a particular security in our portfolio, it could lead to a reclassification of that specific issue. The vast majority of our unrealized impairment losses are rated investment grade, with the majority rated AA or better. Should the credit quality of individual issues decline for whatever reason then it would lead us to reconsider the classification of that particular security. Within the non-investment grade sector, we continue to monitor the particular status of each issue. Should prospects for any one issue deteriorate, we would potentially alter our classification of that particular issue.

The table below illustrates the breakdown of impaired securities by investment grade and non investment grade as well as the duration that these sectors have been trading below amortized cost. The average duration of the impairment has been greater than 12 months. The unrealized loss of impaired securities as a percent of the amortized cost of those securities is 9.9% as of September 30, 2009.


	% of Total			Total		Total		Average Unrealized Loss			% of Loss
	Amortized Cost			Amortized Cost		Unrealized Losses		as % of Amortized Cost			> 12 Months
				(Dollars in thousands)
Non Investment Grade		19.0	%	$	7,615	$	1,859		24.4	%		98.7	%
Investment Grade		81.0			32,477		2,098		6.5			88.5


Total		100.0	%	$	40,092	$	3,957		9.9	%		93.3	%

The highest concentration of temporarily impaired securities is CMOs at 33.8% of the total loss. Within CMOs 72.4% are rated AAA including the 60.4% of the CMO exposure that is agency issued, and have primarily been affected by the general level of interest rates as well. The next largest concentration of temporarily impaired securities is Commercial MBS at approximately 25.5% of the total loss. These securities are all AAA rated and have been affected primarily by the widening of spreads within this sector and/or the general level of interest rates. The next largest concentration of temporarily impaired securities is Corporate Bonds at

approximately 17.7% of the total loss. Within Corporate Bonds 98.6% are rated investment grade or better, and their temporary impairment results primarily from the widening of credit spreads.

Deferred Policy Acquisition Costs

We defer a portion of the costs of acquiring insurance business, primarily commissions and certain policy underwriting and issuance costs, which vary with and are primarily related to the production of insurance business. For the nine months ended September 30, 2009, $41.4 million of the costs were deferred. Deferred policy acquisition costs totaled $26.3 million, or 29.0% of unearned premiums (net of reinsurance), at September 30, 2009.

Reinsurance

The following table illustrates our direct written premiums and premiums ceded for the nine months ended September 30, 2009 and 2008:


	Nine Months Ended
	September 30,
	2009			2008
	(Dollars in thousands)
Direct written premiums	$	228,619		$	224,720
Ceded written premiums		92,615			77,828

Net written premiums	$	136,004		$	146,892

Ceded written premiums as percentage of direct written premiums		40.5	%		34.6	%

The following table illustrates the effect of our reinsurance ceded strategies on our results of operations:


	Nine Months Ended
	September 30,
	2009		2008
	(Dollars in thousands)
Ceded written premiums	$	92,615	$	77,828
Ceded premiums earned		81,752		82,063
Losses and loss adjustment expenses ceded		59,604		46,536
Ceding commissions		21,897		27,470

Our net cash flows relating to ceded reinsurance activities (premiums paid less losses recovered and ceding commissions received) were approximately $24.9 million net cash paid for the nine months ended September 30, 2009 compared to net cash paid of $35.9 million for the nine months ended September 30, 2008.

The assuming reinsurer is obligated to indemnify the ceding company to the extent of the coverage ceded. The inability to recover amounts due from reinsurers could result in significant losses to us. To protect us from reinsurance recoverable losses, FMIC seeks to enter into reinsurance agreements with financially strong reinsurers. Our senior executives evaluate the credit risk of each reinsurer before entering into a contract and monitor the financial strength of the reinsurer. On September 30, 2009, substantially all reinsurance contracts to which we were a party were with companies with A.M. Best ratings of “A” or better. One reinsurance contract to which we were a party was with a reinsurer that does not carry an A.M. Best rating. For this contract, we required full collateralization of our recoverable via a grantor trust and an irrevocable letter of credit. In addition, ceded reinsurance contracts contain trigger clauses through which FMIC can initiate cancellation including immediate return of all ceded unearned premiums at its option, or which result in immediate collateralization of ceded reserves by the assuming company in the event of a financial strength rating downgrade, thus limiting credit exposure. On September 30, 2009, there was no allowance for uncollectible reinsurance, as all reinsurance balances were current and there were no disputes with reinsurers.

On September 30, 2009 and December 31, 2008, FMFC had a net amount of recoverables from reinsurers of $223.7 million and $181.2 million, respectively, on a consolidated basis.

Recent Accounting Pronouncements

On July 1, 2009, the FASB issued Topic 105, “Generally Accepted Accounting Principles” which establishes the “Accounting Standards Codification” (ASC) as the single official source of authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to guidance issued by the Securities and Exchange Commission (SEC). All other nongrandfathered, non-SEC accounting literature not included in the ASC is deemed nonauthoritative. The ASC supersedes all existing, non-SEC accounting and reporting standards applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles (GAAP). The ASC is effective for interim and annual reporting periods ending after September 15, 2009. As the ASC reorganizes GAAP literature but does not change GAAP, the implementation of the ASC did not have a material impact on the Company’s financial statements.

In April 2009, the FASB issued new accounting guidance for the recognition and presentation of other-than-temporary-impairments on investments. The new guidance modifies the existing other-than-temporary impairment guidance to require the recognition of an other-than-temporary impairment when an entity has the intent to sell a debt security or when it is more likely than not an entity will be required to sell the debt security before its anticipated recovery. Additionally, the new guidance changes the presentation and amount of other-than-temporary losses recognized in the income statement for instances when the Company determines that there is a credit loss on a debt security but it is more likely than not that the entity will not be required to sell the security prior to the anticipated recovery of its remaining cost basis. For these debt securities, the amount representing the credit loss will be reported as an impairment loss in the Condensed Consolidated Statements of Income and the amount related to all other factors will be reported in accumulated other comprehensive income. It also requires the presentation of other-than-temporary impairments separately from realized gains and losses on the face of the income statement. In addition to the changes in measurement and presentation, the new guidance is intended to enhance the existing disclosure requirements for other-than-temporary impairment and requires all disclosures related to other-than-temporary impairments in both interim and annual periods. The adoption of the new guidance in the second quarter of 2009 resulted in a $1.0 million increase in retained earnings, which was offset by a corresponding decrease in accumulated other comprehensive income (loss) of the same amount.

entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly; the entity shall place little, if any weight on that transaction price as an indicator of fair value. The adoption of this guidance in the second quarter of 2009 did not have a material effect on the Company’s results of operations, financial position, or liquidity.

In April 2009, the FASB issued new accounting guidance that requires disclosures about the fair value of financial instruments in interim and annual financial statements. The adoption of this guidance in the second quarter of 2009 is included in Note 11, “Fair Value Measurements” to the condensed consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 for a complete discussion of the Company’s market risk. There have been no material changes to the market risk information included in the Company’s Annual Report on Form 10-K.

Item 4. Controls and Procedures

The Company’s chief executive officer and chief financial officer have concluded, based on their evaluation as of the end of the period covered by this report, that the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding financial disclosures. There was no change in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2009 that has materially affected or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. — OTHER INFORMATION

Item 1. Legal Proceedings

In September 2009, First Mercury Insurance Company (“FMIC”) and CoverX Corporation (“CoverX”) received from the California Department of Insurance (the “California Department”) an Accusation and an Order to Cease and Desist (collectively the “Pleadings”). The Pleadings (i) allege that FMIC and CoverX transacted business in California without the proper licenses, (ii) order FMIC and CoverX to stop transacting any business in California for which they do not have a license and (iii) seek the revocation of CoverX’s existing California fire and casualty producer license. In October 2009, the Pleadings were expanded to include First Mercury Emerald Insurance Services, Inc. (“Emerald”). Although the Pleadings seek to revoke CoverX’s and Emerald’s existing California fire and casualty producer licenses, the California Department has agreed that CoverX and Emerald may continue to produce California business, and that FMIC may continue to insure California risks as long as these risks are produced by CoverX and Emerald personnel located outside the State of California. The Pleadings also assert a right to seek monetary penalties, but no demand for payment has been made. FMIC, CoverX and Emerald have denied the allegations in the Pleadings, and CoverX and Emerald have requested a hearing on the action to revoke their respective fire and casualty producer licenses. FMIC, CoverX and Emerald have also been conferring with the California Department to obtain surplus lines broker licenses and resolve these issues. While it is not possible to predict with certainty the outcome of any legal proceeding, we believe the outcome of these proceedings will not result in a material adverse effect on our consolidated financial condition or results of operations.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On August 20, 2009, the Board of Directors of the Company authorized a share repurchase plan to purchase up to 1.0 million shares of common stock through open market or privately negotiated transactions. The repurchase program expires on August 20, 2010. During the three months ended September 30, 2009, the Company did not repurchase any shares of common stock under this new share repurchase program. Shares purchased under the program are retired and returned to the status of authorized but unissued shares.

The Company’s prior share repurchase program, announced in August 2008, originally authorized the repurchase of up to 1.5 million shares of the Company’s outstanding common stock. As of August 7, 2009, the Company had repurchased 100 percent, or 1.5 million, of the total shares authorized for repurchase for approximately $19.0 million.


							Maximum Number (or
					Total Number of		Approximate Dollar
					Shares (or Units)		Value) of Shares
					Purchased as Part		(or Units) that May
	Total Number of		Average Price as		of Publicly		Yet Be Purchased
	Shares (or Units)		Paid per Share (or		Announced Plans or		Under the Plan or
Month	Purchased		Unit)		Programs		Programs

July		118,740	$	13.86		118,740		294,925
August		294,925		12.74		294,925		—
September		—		—		—		—

Total		413,665	$	13.06		413,665		—
	=

Item 6. Exhibits

See Index of Exhibits following the signature page, which is incorporated herein by reference.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	FIRST MERCURY FINANCIAL CORPORATION
	By:	/s/ RICHARD H. SMITH
		Richard H. Smith
		Chairman, President and Chief Executive Officer

	By:	/s/ JOHN A. MARAZZA
		John A. Marazza
		Executive Vice President and Chief Financial Officer

Date: November 9, 2009

INDEX OF EXHIBITS


Exhibit
Number	Note			Description
10.34*		(1	)	Employment Letter from First Mercury Financial Corporation to Terrance A. Fleckenstein dated June 27, 2008

31 (a)		(1	)	Certification of Chief Executive Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934

31 (b)		(1	)	Certification of Chief Financial Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934

32 (a)		(1	)	Certification of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act of 1934

32 (b)		(1	)	Certification of Chief Financial Officer, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act of 1934


(1)		— Filed herewith

*		— Management contract or compensation plan or arrangement.

FIRST MERCURY FINANCIAL CORP - FORM 10-Q - November 9, 2009

Attached files

FIRST MERCURY FINANCIAL CORP Reports