First Mercury Financial Corporation Q3 2008 Earnings Call Transcript

| About: First Mercury (FMR)

First Mercury Financial Corporation (FMR) Q3 2008 Earnings Call Transcript October 30, 2008 11:00 AM ET

Executives

Leslie Loyet – IR, Financial Relations Board

Richard Smith – President and CEO

John Marazza – EVP, CFO, Treasurer and Corporate Secretary

Jim Thomas – SVP, Product Management

Analysts

Matthew Heimermann – J.P. Morgan

Amit Kumar – Fox-Pitt Kelton

Doug Mewhirter – RBC Capital Markets

Bob Farnam – KBW

Operator

Good afternoon ladies and gentlemen thank you for standing by, and welcome to the First Mercury Financial Corporation Third Quarter 2008 Earnings Call. Today’s call is being recorded. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. (Operator instructions) I would like to remind everyone that this conference is being recorded.

And we would now like to turn the conference over to Ms. Leslie Loyet of the Financial Relations Board. Ms. Loyet, please go ahead ma’am.

Leslie Loyet

Thank you. I would like to thank everyone for joining us today. Yesterday we sent out a press release outlining the results for the third quarter 2008. If anyone has not received the release, please visit the Investor Relations page on the Company's Web site at www.firstmercury.com to retrieve a copy. Management will provide an overview of the quarter, and then we will open the call up to your questions.

Please be advised that this call may involve forward-looking statements, as discussed in the October 29, 2008 press release. Risks associated with these statements can be found in the Company's latest SEC filings. Additionally, we want to remind participants that the information contained in this call is current only as the date of this call, October 30, 2008. And the Company assumes no obligation to update any statements, including forward-looking statements made during this call. Listeners to any replay should understand that the passage of time by itself will diminish the quality of the statement.

With us today from management of First Mercury are Richard Smith, President and Chief Executive Officer; John Marazza, Executive Vice President and Chief Financial Officer; Jim Thomas, Senior Vice President Product Management; Brian Roney [ph], Executive Vice President and Treasurer; and Ed LaFramboise, Vice President of Finance.

At this point I would like to turn the call over to Richard for his opening remarks. Please go ahead.

Richard Smith

Thanks Leslie. Good morning. Welcome to the First Mercury Financial third quarter earnings call. I am very pleased with the continued progress of our organization in a very challenging operating environment. Growth in premiums produced of 16.2% and 14.1% for the year reflected the continued outstanding performance in our CoverX platform, as well as more recent contribution from our Program and First Mercury Emerald platform.

We still face headwinds from reduced rate, slowdown in construction, and extreme caution in our participation in an ultra-competitive California market. However, offsetting these hurdles is the significant submission flow that we have been seeing due to the results of our underwriters. For example, in September we received 5441 CoverX submission are broken down to 1388 security and 4053 specialty submission.

This compares to 4593 CoverX submissions received in September of ’07. The ’07 includes those submission from our closed Naples, Florida office. In addition, First Mercury Emerald received 2682 submissions in September for a total September submission account for our underlying operations of 8123 submissions, an increase of over 75% over September 2007.

The competitive environment continues to be challenging with the security rate down high single digit, specialty renewal rates down 12% to 13% for the quarter. However, starting in the second quarter, we saw the first moderation of the rate decreases and we saw that continued moderation, although very modest through the third quarter. As to our earnings, I was especially pleased with the contributions from AMC, the NGA we acquired early this year.

We expect that contribution to increase for the fourth quarter and continue increasing into 2009. First Mercury Emerald has also made substantial progress and we would expect that platform to contribute to our earnings in 2009. Each of these platforms is important to our efforts to diversify our products in premium base. These contributions are also demonstrate the ability of our people to integrate new businesses by our required critical confidence in our business strategy. I’m very pleased with the performance of our investment portfolio during the turbulent third quarter.

Our investment objective is to maintain a conservative portfolio that protects the capital base that’s so important to our underwriting operations. And I believe the portfolio met our objective, and with our cash position at the holding Company and well capitalized insurance operation, the capital position is in good shape going forward. I’m also comfortable that our pipeline of new opportunities is in the best position we’ve seen in a couple of years, both in terms of quantity and quality, the opportunities we have under review and discussion should continue to provide for our growth prospects and the future years consistent with the historical experience.

We will continue to be very cautious to use the holding Company cash because of the flexibility it provides. However, I’m very optimistic that we will land one or more of these opportunities in the near future. I’ll let others forecast the timing of the turn in the casualty pricing. However, it’s obvious that all of the turmoil for the industry will create opportunities for those in a position to take advantage of it, and we certainly intend to be one of those companies. When you consider the strength of our balance sheet, the performance of the existing underwriting assets and the prospects we see in the near term.

I’m most optimistic about First Mercury’s future prospects than at any time, certainly since the public offering. The Company is well positioned to take advantage of this turmoil and will continue to deliver our outstanding results over the next few years.

I’ll now turn it over to John Marazza to discuss the financial results.

John Marazza

Thanks, Richard. I’m sure you’ve all have read the press release. So, I’ll focus my comments this quarter on financial highlights and trends and on the quality of our balance sheet. We are pleased to report modest net income for the third quarter of $0.01 a share or $54,000 considering the significant impact of the previously announced realized investment losses and Hurricane Ike related losses.

Net income for the nine months was $38.5 million, inclusive of the ARPCO gain which closed during the second quarter. Operating net income was $7.4 million or $0.39 per diluted share for the third quarter and $23.5 million or $1.25 per diluted share for the nine months. As Richard mentioned, premiums produced increased 16.2%, $77 million in the quarter and increased 14.1% to $238 million for the nine-month period.

As anticipated, premiums produced for the quarter were down slightly in our security and specialty lines, and increased in FM Emerald due to continued ramp-up of this strategy. As we no longer rely on the funding model, gross written premiums growth were in lockstep with premiums produced growth in the quarter and for the nine months. Net earned premiums were up almost 20% in the quarter to just over $43 million, reflective of our growth in gross written premiums due to our contract underwriting in FM Emerald platforms, and to the purchase of less reinsurance in our sub-security and specialty business.

As we have previously mentioned, we rely more on reinsurance for our left [ph] fees in contract underwriting and First Mercury Emerald businesses, and purchase less reinsurance for our long-term security and specialty businesses. Also again this quarter, impacting our net earned premiums comparisons was the reinsurance cut off transaction from the year end of 2006. So, it’s removing the impact of 2006 reinsurance cut off transaction on last year’s net earned premium, the quarterly comparisons would have been up 45% rather than 20% for the quarter.

The continued soft market has impacted our actual [ph] year loss ratios slightly as pricing pressures remain. Our underwriting results has held up well with the loss ratio of 56.1% for the third quarter and 55.1% for the nine months. Included in the third quarter loss ratio was $4.8 million or 9.9 percentage points of favorable development with our prior year’s loss reserves due to largely to our specialty line.

Also during the third quarter, we increased the current loss and loss adjustment expenses by $1.3 million or 2.6 percentage points on our contract legal liability underwriting program. Also included in the third quarter loss ratio was $2.91 million or 5.9 percentage points related in net losses in Hurricane Ike. If you want to normalize our third quarter loss ratio for all of these items, our third quarter accident year loss ratio would have been 57.3%.

The expense ratio was up slightly in the quarter to 30.2%. This increase is primarily due to the impact of us purchasing less quota share reinsurance and increased expenses in the build out of the FM Emerald initiative. Additionally, during the third quarter, we recorded a negative profit-sharing commissions principally related to the aforementioned legal liability contract underwriting program, which added 2.2 percentage points to the third quarter expense ratio.

With decreases in commissions on credit premiums and a negative profit sharing commission reflected in the quarter, our insurance commission revenue in the summary financial schedule was a negative, but more than offsetting that was a significant increase in insurance services – in insurance services revenues due to our AMC acquisition which we completed in February of this year.

Our total commissions and fees were up over 114% for a total of $4.8 million in the quarter and up 159% to almost $16 million year to date. We are also pleased to report that AMC was slightly accretive to earnings in the third quarter. While we believe we employ a conservative approach to investing, we are not immune to the recent unprecedented turmoil in investments markets.

We reported both realized and unrealized investment losses in the quarter. Our realized losses were $10.6 million largely due to mark-to-market adjustments on our convertible securities investment and to OTTI [ph] impairments on certain names such as Lehman Brothers, AIG, and others. Our available-for-sale fixed-income investments reflected an unrealized loss net of tax of $6.6 million in the quarter.

These investment losses result in a total portfolio return of negative 2.3% in the quarter and negative 9.3% for the nine months. While short-term interest rates have declined, our net investment income grew to $5.6 million, up 28% in the quarter and increased to $15.6 million, up 36% year to date. At the end of third quarter, our effective duration on our investment portfolio was just over 3 years and our taxable equivalent yield was 4.8%.

Our total investment portfolio of quality remains high as our fixed income fixed income investments at an average credit quality of AA, and our cash and invested assets increased to just under $557 million. Municipal securities and agency pass-throughs still comprise the largest part of our portfolio at more than 50% of our investment, and non-agency residential exposure remains minimal.

We have no collateralized debt obligations, no option rate securities, and virtually no direct common stock equity holdings, and we do not engage in securities lending. And as you know, we utilize outside investment managers that specialize in the insurance industry who invest our assets consistent with our conservative guidelines. Since going public roughly two years, we have more than doubled our total invested assets.

We believe this speaks to our commitment to generating underwriting profits and solid cash flow. Our financial and operating leverage remains modest, and year to date annualized net risk [ph] to surplus is still approximately one to one allowing us room to grow. Our (inaudible) customer for securities has received partial equity treatment from our rating agencies, and our debt to capital is 20.6%, well within the acceptable levels for our present ratings.

During the quarter, we implemented a share repurchase program and bought approximately 225,000 shares of our stock for slightly over $3 million, leaving at just under1.3 million shares in capacity outstanding. Our stock repurchase plan has a one-year maturity and terminates on August of 2009. While the market is focusing on balance sheets at financial companies in particular, we are pleased to report that our balance sheet remains strong.

At the holding company level, we have cash and liquid investments that were over $30 million as well as debt capacity in the form of a $30 million committed revolving credit agreement in place through September of 2011. This excess capital position when combined with day-to-day cash flows will continue to support our underwriting initiatives for the foreseeable future.

As of September 30, 2008, our book value per outstanding share was $14.30, which represents 12% increase in December 31, 2007 and 43% increase in December 31, 2006. Finally, as indicated in the earnings release, we're maintaining our premium growth guidance for the full year of 10% to 20%. However, given the turbulent investments market and the impact of investments performance and the share repurchase program and ROE, we are not providing ROE guidance for the fourth quarter.

Since we are not giving this guidance for the fourth quarter, we can’t say, however, that we are comfortable with the revised fourth quarter operating earnings estimates published last night by two of the firms which cover our stock. With that overview of our quarter results, I’ll now turn it back over to Richard for his concluding remarks.

Richard Smith

Thanks John. And again, I will reiterate that I think we're well positioned to take advantage of those opportunities that will inevitably emerge from the industry turmoil. And those opportunities will both be new growth opportunities and improvement in market pricing. Thanks for your support, and we will now take questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question today will come from Matthew Heimermann with J.P. Morgan.

Matthew Heimermann – J.P. Morgan

Hi, good morning everybody. Couple of questions, maybe I will just go one at a time. First question I had was just on the development you saw coming out of the quarter. Was that part of the mid-year review process? And then also specifically with the legal liability book, where you increased the current accident year loss ratio, was that a byproduct to the analysis? And I would just be curious whether or not the – whether or not that was being driven by reported claims or just trends you are incorporating into IBNR?

John Marazza

Matthew, this is John. You are correct. The reserve adjustments that we do are primary reserve analysis, both our internal analysis and outside actuary's analysis is done on the June 30 number. So, that’s what gave rise to the prior period adjustments. With the –

Richard Smith

I’m sorry. I was just saying reinforced in that. John’s right. We did see continued favorable emergence in the third quarter, which drove part of the decision to release at this point.

Matthew Heimermann – J.P. Morgan

Right.

John Marazza

And then the question of legal liability was – yes, we saw those trends – yes, we have seeing those trends for the first six months of the year. When the actuaries did their June 30 work, they confirmed our suspicions that the frequency and severity were above what we would have anticipated. So we did increase prior accident years' reserves for legal liability and we increased our current year loss ratio selection for that line.

Matthew Heimermann – J.P. Morgan

Can you just opine on whether or not that’s more a function of frequent fears – I mean I'm guessing it is mostly just a frequency issue at this point?

Jim Thomas

Actually, Matt it’s really – this is Jim Thomas. It is really more severity related. This is a claims made line of business. So, the number of claims you have reported are known and don't change. So, there is really no IBNR on reported claims. So, it is really the continuing development of the existing phases that we have and they take a long time to develop because of the nature of the liability.

Matthew Heimermann – J.P. Morgan

Okay. And then just the question, is this primarily – I mean you changed the current accident year – so obviously you're trying to pull this forward. But is there any particular – is this primarily an issue for 2007, 2008? Was it – does it include – I would just be curious when the when you started to see the inflection point?

Jim Thomas

This really covers a range of years. We’ve been in the business since 2005 and we didn’t have a lot of history at the time. We heavily insured this line. And we have observed initially some favorable development in 2005. We got that, we stabilized and got more normal. And we saw the inverse in 2006, 2007. We had a few very large losses on single accounts that influenced the severity on that. And it has just taken a little time to emerge. But now, we're at what we think is a normalized level, and that's what we're booking, and we think we're booking at the right level at this point.

Matthew Heimermann – J.P. Morgan

Okay. That’s helpful. And then one question for Richard, if we go back and look at security and specialty, I mean AIG hasn’t been a direct competitor, but one other things you talked about increasing competition and rate pressure was the fact that you had companies like AIG that historically had more of a large premium focus, started to move downstream. You saw that cascade across a lot of different underwriters as they were just more interested in smaller accounts. With some of the issues there, are you seeing any change to that specific trend?

Richard Smith

We without specifically deal with AIG. You saw – you heard the submission numbers than we are seeing a lot of submission activity. We did see some resubmissions on large accounts both on security and specialty that had gone to AIG during the year, and we haven’t – there’s not enough to measure the performance of that. So, we are seeing some peripheral effect of AIG and others as well. So, we don’t have a specific number to add, yet. But we are seeing some peripherals.

Matthew Heimermann – J.P. Morgan

Okay. And then I’ll sneak one last question on – I think you’ve got – you have your casualty reinsurance renewal coming up, and I was curious whether or not you are anticipating any changes in retention on specialty and security or with respect to some of the other more recent line?

Richard Smith

We actually were in New York last week and met with most of our lead reinsures, the top five or six reinsures that set the tone for the year. At this point in time, I mentioned the new opportunities. So, we are still trying to understand what the results of those might be. My – at this point my instinct is we probably will attempt to overbuy reinsures a little bit early in the year to keep powder dry for continued opportunities that we see emerge during the year. And we don’t have specific pricing but we felt very good about the meetings with the reinsures as you can imagine we have a long history with most of our reinsures, and we think the performance of the reinsurance program has been good. So, I would say at least I’m cautiously optimistic about the renewal, and think that we probably tend to just overbuy a little bit to keep dry powder.

Matthew Heimermann – J.P. Morgan

Can I put some words in your mouth, may be is that is what you are saying is that – could – you won’t probably make any substantial changes to where you are then?

Richard Smith

That’s probably correct.

Matthew Heimermann – J.P. Morgan

Okay. Cool. Alright. Thank you.

Richard Smith

We probably would tend to buy a little bit more from where we are, more likely than little bit less.

Matthew Heimermann – J.P. Morgan

Okay. That’s best. Thank you very much.

Operator

Next we go to Amit Kumar from Fox-Pitt Kelton.

Amit Kumar – Fox-Pitt Kelton

Thanks. Good morning. I guess going back to those comments in terms of market opportunities going forward, I was just wondering, do you anticipate any change in your policy limit? We have seen some other insurance companies talking about taking their limits, so they can may be more effectively compete with business which would have previously gone to Lexington or its peer group?

Richard Smith

Amit, we are not a direct competitor with the big one that starts. We will – we offer some big limits but on a pretty limited basis. So, we don’t anticipate any changes specifically compete with AIG or others. We’ll make sure that our underwriters have plenty of limits to take advantage of the opportunities that they see in front of them.

Amit Kumar – Fox-Pitt Kelton

That’s helpful. I guess moving on to the capital management, and I missed some of your opening remarks. In terms of your buyback, and obviously you have bought back some stock here. The stock is very attractive at these levels. What are your thoughts because I know you mentioned about may be one or two specific I guess deals in your pipeline, should we expect more buyback or is that going to slowdown in this quarter?

Richard Smith

We will comment specifically, obviously on buyback plans. The price is very attractively priced in our view. However, we will wait. Any opportunities in buyback against specific opportunities that we have in front of us and as well as the opportunity to hold cash for opportunities that we don’t know about. So, I mean that’s non-answer, but that’s the process that we are involved with right now.

Amit Kumar – Fox-Pitt Kelton

Okay. That’s helpful and that’s all I have for now. I’ll re-queue. Thanks.

Operator

(Operator instructions) We’ll go next to Doug Mewhirter – RBC Capital Markets

Doug Mewhirter – RBC Capital Markets

Hi, good morning. I just had a question about AMC, I actually got two questions about AMC and your views toward it. The first is the numbers question. Do you have a figure for the premiums year to date that has passed through AMC?

Richard Smith

That is not a number that number we published. Ed's going to look that up and give you that number in a minute.

Doug Mewhirter – RBC Capital Markets

Okay. And just the non-number questions I guess. You are looking at the books that’s gone through AMC. You had I guess a little more time to look at it and see what the profitability is. Is your willingness to take on – take that on to your paper, changed it all either way for 2009?

Richard Smith

I would say our strategy Doug hasn’t changed at all. We will wait for the opportunity to take some of that on the paper versus the other opportunities we have. We hadn’t put out guidance for next year but certainly continue growth, and we’ll take a look at the growth opportunities that we are seeing elsewhere versus the opportunities that they can see. We bought that as an underwriting platform, but they have good support from the markets today, and we’ll be able to provide more guidance on that what we tend to do specifically. But as I said, we do have a number of good opportunities and we are seeing some good results of our existing business. So, all that will be weighed and we decide exactly what to do with AMC going forward.

Doug Mewhirter – RBC Capital Markets

Okay. Just the last (inaudible) related question. Has there been any progress replacing the one underwriter that you lost for –?

Richard Smith

Yes. Earlier on we said that we knew we are losing one underwriter, but they had two markets and the other market stepped in and has been very supportive replacing the underwriter we lost. At this point in time, we are back to full capacity on AMC, and that’s why you saw the results through in the third quarter and you will continue to see the results through in the fourth quarter. So, I’m very pleased. You asked initially, how I think about them. I’m very pleased with the acquisition. With the current pricing that’s what’s in front of us we will be – this will be a real opportunity for us going forward.

Doug Mewhirter – RBC Capital Markets

Okay. Thanks. That’s all my questions.

Richard Smith

Got it, Doug. Just to answer your last – the business with AMC truly as an agent the year to date, which includes G&A (inaudible) is about $53 million.

Doug Mewhirter – RBC Capital Markets

$53 million?

Richard Smith

Yes.

Doug Mewhirter – RBC Capital Markets

Okay. Thanks a lot.

Richard Smith

And then (inaudible) the amount shows up on our supplementary schedule, and that is going through our underwriting.

Doug Mewhirter – RBC Capital Markets

Okay. Thanks.

Operator

Our next question will come from Bob Farnam with KBW.

Bob Farnam – KBW

Thanks. All my questions have been answered. Thanks.

Richard Smith

Thanks Bob.

Operator

And at this time, there are no further questions. Mr. Smith, I’ll turn the conference back over to you.

Richard Smith

Okay. Thank you very much for your support and we will look forward to talking to you soon. Thanks.

Operator

And that does conclude today’s teleconference. We would like to thank everyone for their participation and wish everyone a great day.

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