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Executives

Leslie Loyet - Financial Relations Board

Richard H. Smith - President and Chief Executive Officer

John A. Marazza - Executive Vice President, Chief Financial Officer, Treasurer and Corporate Secretary

Ed LaFramboise - Vice President, Finance

Analysts

Mark Lane - William Blair & Company, L.L.C.

Matthew Heimermann - JPMorgan

Mark Dwelle - RBC Capital Markets

First Mercury Financial Corp. (FMR) Q1 2009 Earnings Call May 6, 2009 11:00 AM ET

Operator

Good day ladies and gentlemen. Thank you for standing by. Welcome to the First Mercury Financial Corporation's First Quarter 2009 Earnings Conference 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. Instructions will be provided at that time for you to queue up for questions.

And now, I'd like to turn conference over to Ms. Leslie Loyet of the Financial Relations Board. Please go ahead.

Leslie Loyet

Thank you. I would like to thank everyone for joining us today. Yesterday we filed a press release outlining the results for the first quarter 2009. If anyone has not received the release, please visit the Investor Relations page on the company's website 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 May 5th, 2009 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 of the date of this call, May 6th, 2009. 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.

Joining us today from management of First Mercury are Richard Smith, President and Chief Executive Officer; John Marazza, EVP and Chief Financial Officer; Brian Roney, EVP and treasurer, Jim Thomas, SVP, Product Management and Ed LaFramboise, Vice President, Finance.

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

Richard H. Smith

Thanks Leslie. And good morning. Welcome to the First Mercury Financial first quarter earnings call.

I'm very pleased with our reported results for the first quarter especially with both the results of investment and underwriting operations in the face of significant headwinds. The same conservative approach to balance sheet management in underwriting has allowed us to continue to report results comparing favorably to our peers in the industry. The $15.30 per share book value represents a growth of 4% for the quarter and 17% for the last twelve months. I believe this represents outstanding results in an obviously very turbulent environment.

John Marazza will talk in more detail about the balance sheet, but in my view the entire balance sheet, including the investments and reserves has never been in better shape for supporting the opportunities that we feel lie ahead of us.

On an issue, the issue of premium production, I was pleased with the results of our underwriting teams as they are walking a balancing act in a very difficult market. Two factors virtually drove all of the negative quarter-over-quarter premium growth. And both were conscious decisions.

In our security line the market rate for the safety business, and for those of you who haven't been with since long, safety or sprinkler accounts, the market rates don't support our margin objective and we reduced our position in that line significantly. The safety line decrease represents the entire premium reduction for security business, but we had small growth in the security guard and loan segment of that business.

For the specialty line, the overall decrease in the contractor's segment call for reduction in premium. The average contractor account size is down about 25% from the comparable '08 period and about 50% from the comparable '07 period. For the Specialty line, as for all of our underlying platforms we continue to see good submission flow causing our underwriters to work harder in selecting those submissions to work and those that will be most productive, as they continue to look at areas that have less competitive pressure.

I continue to be pleased with the rollout of the Emerald platform and our new professional liability team continues to make great progress. I expect the premium reduction to be somewhat back loaded for the year and continue to be optimistic that we can balance a good build in underwriting. We are taking advantage of market opportunities to grow the business for the year.

To better illustrate that point, for April, the gross written premiums for the entire company were up 14% over prior year, putting us slightly on the plus side for the year. And we continue to see opportunities as we move forward.

Rates remained under pressure, although at a continuing reduced level. Security rate decreases for the first quarter were in the mid single-digit area, with about 50% of our accounts now getting either no rate change or a positive rate change.

Specialty rates decreases were in the high single digit range with a little over 40% of those accounts getting no rate change or positive rate change. We obviously as we've discussed in the last quarterly call, we also continue to monitor very closely accounts requiring a rate decrease of 10% or more as that's the answer for us to seek continuing improvement in the way we perform. I mentioned earlier how pleased I am with the investment results and strength of the balance sheet, but I am also equally proud of the underlying results.

We reported an 88.4 combined ratio despite the expense pressure of significant investments in underwriting talent for both our existing and new platforms. I feel we are now positioned, better positioned to take advantage of the inevitable market opportunities than we've have been ever before. We continue to see a good flow of new opportunities, probably even some what improved from year end. We are carefully evaluating these new opportunities as well as expansion opportunities for the existing platforms to make sure our capital is allocated in the most effective and efficient manner.

John will now discuss the financial results in more detail.

John A. Marazza

Thanks Richard, I'm sure you have all read the press release. So I'll focus my comments on financial highlights and trends for the quarter and the quality of our balance sheet.

As Richard said, First Mercury remains committed to quality underwriting. This focus on underwriting, combined with our conservative approach to investing and capital management permitted us to achieve a combined ratio of 88.4% in the first quarter of 2009 and a 4.3% increased in book value per share to $15.30 at March 31st, consistent with our long-term strategy of growing book value.

Considering the impact of continued pricing pressure in today's markets, we're pleased to report net income for the first quarter of $0.48 per diluted share. Operating net income, which is a non-GAAP financial measure was $7.5 million or $0.41 per diluted share for the quarter.

Net earned premiums increased 21% in the quarter, reflective of our growth in net written premiums last year. For the quarter 75% of our net earned premiums were comprised of our more established security, capacity and legal professional liability businesses.

Our first quarter 2009 calendar year loss ratio of 58% included a current actual year loss ratio of 59.4%. Included in the first quarter loss ratio of 58% was $750,000 or 1.4 percentage points of favorable development of prior year's loss reserves. The first quarter 2009 actual year loss ratio of 59.4% increased 5.6 percentage points over the first quarter of 2008. The increase in the actual year loss ratio is attributable to our first quarter 2009 earned premium average rate levels being approximately 10%, lower than the first quarter of 2008.

In deriving our loss ratio fix for the current action a year, we incorporate projections of frequency, severity, and exposure trends. We are seeing moderating severity trends and a moderate increase in frequency. Overall our loss cost trends are stable.

For the first quarter of 2009 the expense ratio was 30.4%. This anticipated increase in the expense ratio is primarily due to a combination of the impact of us purchasing last quarter share reinsurance in 2008, less profit sharing commission and increased expenses due to the ramp-up of the underwriting initiatives as Richard mentioned.

Corporate overhead expenses decreased $800,000 from the first quarter of 2008. Our total commissions and fees increased 70% to $6.9 million in the quarter. This increase is primarily attributable to having three months of AMC results in the current quarter, compared to two months in the first quarter of 2008 due to our closing of the AMC transaction on February 1st, 2008.

Net realized gains on investments were $1.8 million for the first quarter. Included in those gains were positive mark-to-market adjustments at $2.6 million on a convertible securities portfolio and our high yield convertible fund. The total portfolio return was 2.53% in the first quarter.

Net investment income increased 32.7% in the quarter at $6.4 million. At March 31st 2009, the effective duration on our investment portfolio is approximately three years and it has equivalent yield at 5.2%. In the current yield environment, we are investing new money primarily in select high quality corporate conservatively structured ABS, royalties and CMBS and modestly to agency CMRs at a taxable equivalent yield of approximately 5.3%.

We remain committed to our conservative investment strategy and our total investment portfolio quality remains high. Our cash and invested assets increased to over $606 million at March 31st, 2009. Short duration, high quality municipal securities and agencies pass-throughs comprise the largest part of our portfolio at approximately 50% of our investment.

We do not adopt new FASB rules regarding other than temporary impairments at fair value measurements that were announced in April 9th of this year. Although these new accounting rules provide for greater discretion on the valuation of certain securities these new rules will have less impact on higher quality investments.

We do plan to adopt the new rules in the second quarter but we do not expect the adoption of these new rules to add material impact on the consolidated financial statement. Our financial operating leverage remains modest, year-to-date annualized net premiums written to surplus is 0.91. Our debt is comprised entirely of trust preferred securities and our debt to total capital was 19.6%, well within acceptable levels for our covenant rating.

On April, of 2009 AM Best affirmed A minus excellent rating of our insurance subsidiaries with a stable outlook. We did not repurchase any shares under our share repurchase plan during the quarter. The share repurchase plan terminates in August of this year and we have 801,423,000 shares available for repurchase under the plan.

Our balance sheet remains strong. At the holding company level we have cash and liquid investments of $18 million and debt capacity in the form of $13 million committed revolving credit agreement with JPMorgan in place through September of 2011.

We think that capital position combined with operating cash flows will continue to support our underwriting initiatives for this foreseeable future. That's an overview of our quarterly results. I will now turn it back to Richard for his concluding remarks.

Richard H. Smith

Thanks John. As we discussed on the year-end call, we are not providing guidance for premium growth this year. However as I mentioned in my earlier comments, we still have expectations that the top line will grow for the year. We are lowering guidance as you saw in the release for earnings per share to 1.60 to 1.75 reflecting lower than expected first quarter production.

Thanks for your support and we will now take any questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will begin Q&A with Mark Lane with William Blair & Company

Mark Lane - William Blair & Company, L.L.C.

Good morning.

Richard Smith

Morning.

Mark Lane - William Blair & Company, L.L.C.

Just have a couple of questions, first can you talk about the pricing movement in the quarter at AMC and if there's been any change in your view about risk appetite there over the next 6 to 18 months, something like that?

John Marazza

The actual movements, prices actually been increasing overall quarter-to-quarter, it's relatively flat versus our budget but what we really see is the opportunities to bring it on to our balance sheet and we continue to move in that direction, although in the first quarter we do not obviously reflect any premium within our overall growth.

Richard Smith

And Mark we don't anticipate taking any of that on our books the rest of this year. It's still going to be operating as an MGA this year. But for those of you who are sort of doing the math you'll see that AMC was slightly accretive in the first quarter earnings and it should be more accretive quarter-over-quarter as the year progresses.

Mark Lane - William Blair & Company, L.L.C.

But in pricing in their book was, you're saying it was better than kind of consistent with the overall trend versus last quarter and kind of flattish or up a little bit?

John Marazza

Yeah, it's flat to up a touch, Mark. That's right.

Mark Lane - William Blair & Company, L.L.C.

Okay. And then what about submission activity, broadly across your business, what has submission activity been like this quarter versus the last few quarters?

Richard Smith

Mark its Richard. It's up substantially for each one of our operating platforms. I don't have the exact report but I'm might give you numbers very close. We had about, in March about 10,500 submissions across all of our platforms. In March of last year, that was about 7000 submissions. And it's up for each of the platform and that's why I mentioned earlier it's making the underwriters work harder to find the most productive submissions to look at. Our submission activity has been fantastic, even in the contractor segment for this.

Mark Lane - William Blair & Company, L.L.C.

Okay, those are my two quick ones, thanks.

Operator

We'll now move to the next question and that will come from Matthew Heimermann with JPMorgan.

Matthew Heimermann - JPMorgan

Hi. Good morning everybody. Couple of questions, first was Richard, one of the -- almost I suspect that some of that price competition you are seeing in security and specialty is coming from mid-market in part and I was curious if we don't see kind of a classic house market parallel cycle where rates are going out, 10-15-20%, what's your expectation in terms of flow of business between the admitted market and surplus lines market?

Richard Smith

Matt, I mean you are right. Let's take the example value and our security guard business, for example most, almost virtually all of those security guards in the securities business, virtually all security guard is written off surplus buying (ph) spaces but especially for the safety line sprinklers, the admitted markets tend to be the competitors and that's where a fair amount of business, sort of admitted markets and one-off competitors.

And to use the example of that line, specifically the learning cure on that line and some of our other contractor business is pretty steep. The losses are reported pretty early and could be significant, especially when the underwriting or the pricing is wrong. So I guess what we've seen in the past when the admitted market is taking, in this case we would say taking business at prices that wouldn't be price threshold, it tends to come back to the surplus line market pretty quickly at better prices. If we use 2000-2001 for instance as an indication, because its got a severe curve, experience curve and you learn pretty quickly on that line, probably the admitted markets are somewhat the same on our contractor line although there by far it's just the reduction in the overall size of the contract, rather than the other markets taking that business line.

Matthew Heimermann - JPMorgan

That makes sense. The other thing that I wanted to ask that was just with respect to the retentions and the security and specialty line. It looks like they dipped year-on-year and I'm taking in terms of net growth. Does that have to -- I don't know that how to do with just percentage of excess of loss obviously the fixed expense rather than something that moves with premium. I didn't know if there's anything else running through those numbers?

Richard Smith

We got a little more product share of that line. As we every year to hedge out bets a little bit. We got what we regard as some very well priced quarter share for those lines and so, after our other -- after our major buy for the program, we bought an extra 10 points for quarterly share to those lines because we've thought we got attractive pricing on that.

Matthew Heimermann - JPMorgan

We got from a new reinsurer or is that...?

Richard Smith

Our two oldest supporting existing reinsurers.

Matthew Heimermann - JPMorgan

Okay. Thank you very much.

Richard Smith

Thanks Matt.

Operator

(Operator Instructions). Moving now to Mark Dwelle with RBC Capital Markets.

Mark Dwelle - RBC Capital Markets

Yeah, just kind of building on some other questions that were just asked. So if I understand correctly in the security lines the decline in premium is primarily related to pricing not been adequate and then effectively exiting contracts where that's the case. So I guess if I would surmise then it will be reasonable to expect sort of that to continue over the course of the year, unless something dramatic happens with rate?

Richard Smith

That's probably right although the size of our safety segment is reduced now. So you'll see that reduction, somewhat diminishing just because our overall size of that business has been reduced pretty substantially in last year.

Mark Dwelle - RBC Capital Markets

Okay. And then on the specialty business, if I understand the trend there, the absolute volume that people are purchasing is well over five, say 25 % just because they themselves are smaller and than there is an (inaudible) (ph) price decreases in the mid-high single-digits above and beyond that, that accounts for most of the overall decline there.

Richard Smith

That's a fair way of looking at it. As we said about two-thirds of our specialty business is a contract, but we write another line so what the underwriters are doing and what they are accomplished for instance in April is finding other pockets of business where the competition isn't quite so steep and you haven't seen the same market conditions causing the diminishing price.

Mark Dwelle - RBC Capital Markets

Okay. With respect to the Emerald business, now this is seen we've been watching that business ramp up for a while and now we've had a couple of consecutive quarters, kind around the 15, $16 million range. Is that sort of plausible run rate as we think about that business or is there really further ramping to go there?

Richard Smith

We think we have some further ramping to go there but obviously the pace of the ramp-up will be diminishing. So, as we look at our annual expectations for that line, we are not quite at the annualized run rate but we are much closer to the annualized run rate we expect than they were a couple of quarters ago.

Mark Dwelle - RBC Capital Markets

And the last question is just sort of a numbers question. You've commented that there within the realized gain for the quarter was 2.6 million of mark-to-market adjustments. From that I guess I would infer there were just regular ordinary realized losses and other things, that accounted for the difference?

Ed LaFramboise

Mark, this is Ed. That's correct, there is about $500,000 of sales on securities and then $37,000 of OTTI on security reserve cost to the quarter which was obviously very dependant. But that is correct.

Mark Dwelle - RBC Capital Markets

Okay. Thanks, that's all my questions. Thank you.

Richard Smith

Thanks a lot.

Operator

And now moving to our question from Bob Farnam from Capital Returns (ph).

Unidentified Analyst

Hi. Good morning. Thanks for taking the question. I want to know whether you had any claims related to this emerging Chinese drywall problem and sort of broader what are your starts off for the industry as it relates to specific exposure there? Thanks a lot.

Richard Smith

Specifically to answer the first question, we have no claims reported yet on Chinese drywall. We do have a very small segment of our contractor business or drywall contractors or supporting like that. So, obviously we're watching the litigation very, very closely at this point in time. When these kinds of claims come in as you guys have been with this for a while, no we don't write along of the general contractors on these projects. So we think our exposure is limited to the specific contractors who would have installed or purchased the drywall. But we're looking at U.S. for overall comment.

Unidentified Analyst

Yes please.

Richard Smith

It's a significant issue right now but that continues to emerge and it looks like a pretty isolated to a specific timeframe for the industry and we think there's some exposure there but we continue to watch to see how wide spread the use of the so called Chinese drywall is at this point in time.

Unidentified Analyst

Do you think the exposure ultimately will end up being sort of borne by the insurance that stood behind the -- like the U.S. distributors of the product or home installers, the K.B. Home Builder for they are major home builders or the sort of contractor population that actually did the work of installing, any thoughts of sort of our distribution?

Richard Smith

I think it's evenly spread among those things, among all those things. As these kinds of claims emerge and try to aggregate the limits, so typically our policy with drywall is $1 billion exposure limit for existing contractor. And so if they can find five people with a million or the one contractor with greater limits that's how these claims typically emerge. It's going to be there whole group of people that will be exposed as these claims develop further.

Unidentified Analyst

One more question, what about the home owners insured, the state farms et cetera.

Richard Smith

I think that the exposure there would be reasonably limited.

Unidentified Analyst

Kind of the excluded parallel or...

Richard Smith

Not covered, not necessarily excluded but not necessarily covered. I made the point. And you got your... it's evolving. It depends exactly what the claim is but if you typically thought about drywall itself that's not going to be a covered care or under a home owner policy.

Unidentified Analyst

Okay. Thanks for your help. Best of luck.

Operator

(Operator Instructions) Now moving on to Matthew Heimermann for a follow-up with JP Morgan.

Matthew Heimermann - JPMorgan

Hi. I thought of one more. The question was with respect to the growth in April where you noticed things have gotten better. Can you kind of talk about, if the composition of that growth I guess, what is the composition of that growth in other words, are you seeing a little bit of rebound due to price or other factors in security or especially is that just a new area is actually ramping up a bit more?

Richard Smith

The specialty are recovered and actually was on the plus side for the month, as they were able to redirect some of their efforts. The security was still a little bit negative because, as we continue to give up, as I mentioned earlier, the size of the safety book is diminishing. So the impact of giving up some of the accounts there was not as great.

So, security closed the gap, specialty actually ended up on the plus side and the other platforms performed about as expected.

Matthew Heimermann - JPMorgan

Okay. Perfect. Thank you.

Operator

At this time there no additional questions now. I will turn call back over to Mr. Smith for any closing remarks.

Richard Smith

Again, thanks for your support and if you have any follow-up question please let us know. Talk to you next quarter. Thank you.

Operator

And with that, that will conclude your conference for today. Thank you for your participation.

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