First Mercury Financial Corp. Q2 2009 Earnings Call.

Aug. 4.09 | About: First Mercury (FMR)

First Mercury Financial Corp. (FMR) Q2 2009 Earnings Call August 4, 2009 11:00 AM ET

Executives

Richard Smith - President & Chief Executive Officer

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

Ed LaFramboise - Vice President of Finance

Leslie Loyet - Financial Relations Board

Analysts

Amit Kumar - Fox-Pit Kelton

Ron Bobman - Capital Returns

Matthew Heimermann - JP Morgan

Paul Newsome - Sandler O’Neill & Partners

Mark Dwelle - RBC Capital Markets

Operator

Good afternoon ladies and gentlemen. Thank you for standing by. Welcome to the First Mercury Financial Corporation second 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. I would like to remind everyone that this conference is being recorded.

I would now like to turn conference over to Ms. Leslie Loyet of the Financial Relations Board. Please go ahead ma’am.

Leslie Loyet

Thank you. I would like to thank everyone for joining us today. Yesterday we send out a press release outlining the results for the second 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’ll open the call up to your questions.

Please be advised that this call may involve forward-looking statements, as discussed in the August 3rd, 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 day of this call, August 4th, 2009, and the Company assumes no obligation to update any statements, including forward-looking statements made during this call. Listeners trying to 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; Jim Thomas, SVP, Product Management and Ed LaFramboise, VP, Finance.

At this point, I would like to introduce Richard and open the call up to his remarks. Please go ahead.

Richard Smith

Thanks Leslie, and good morning. Welcome to the second quarter 2009 earnings conference call. Results for the second quarter were mostly solid with the property results being the one notable exception. Book value grew in the quarter by 6.8%, gross written to premium grew modestly in the second quarter brining the year to about flat compared to prior year.

The cash results for the 2009 accident year were very much in line with expectations and favorable prior year development led us to release some reserves. The investment portfolio continues to perform exceptionally as our conservative investment philosophy continues to serve us very well.

Obviously, the problem in the quarter, were the property results. Property production comes primarily from two sources, the contract underwriting program and the First Mercury MO property growth. The property results were carefully scrutinized at year-end ‘08 because of the cap losses we observed last year and the changing economic environment The underlying loss results were viewed to be very satisfactory through year-end ‘08.

In the first quarter of 2009 we saw an increase in large losses; many of them fire losses that continue to accelerate in the second quarter. In addition, we had weather related losses experienced by many of the property carriers. As described in the earnings release, we have decided to reduce our exposure to the property line until we are confident that we have an underwriting model that will work in our environment.

Cancellation notes were given to the MGA; while we are close to it, down to immediately improve the results, and the underwriting for the Emerald property line has been tight. We continue to view a presence in the ENS property as important to the future, but we don’t feel that the market conditions that we are experiencing now have appropriate time to grow property.

The casualty results across each of the underwriting platforms performed very well within our expectation. We continue to see pressure on the contractor book as policy size decreases, but the growth of First Mercury Emerald and Professional allowed the casualty book to be about flat for the six months.

We carefully evaluate our loss experience in pricing for each of the underwriting platforms and see the results within expectations across the board. We have continued to see a good flow of business in each of the underwriting platforms with submissions up almost 40% across all the underwriting platforms excluding contract underwriting.

The competitive environment remain very challenging with rate decrease activity stabilizing during the first six months of the year ranging for our different segments from low to high single digit decreases.

As an example of the uncertainty we are seeing in the market, during the last two months, June and July, we experienced both our best and worst month of the year from a rate standpoint. It appears from what we see in here that the competitive market is increasingly driven by a few companies, and our cases in most cases companies that are relatively new to our target markets.

I continue to be pleased with the progress with AMC, and look forward to improving contributions from that platform as we see some growth and their premiums for the year. We also continue to see more interesting opportunities, probably driven by the continued rate pressure and market deterioration.

The opportunities range from teams and programs available to MGAs and insurance operations that are being marketed. We are being increasingly selective of these opportunities, and have set an objective of immediate accretion to earnings as we look at the opportunities we find interesting.

I will now turn it over to CFO John Marazza for further detail on the financial results.

John Marazza

Thanks Richard. Since everyone has had the opportunity to review the press release which went out last night I’ll focus my comments on the financial highlights and trends for the second quarter and the full six months.

As Richard mentioned, the story for the second quarter is that our casualty businesses have performed well, and our investment results continue to be thought as reflected by our book value growth. These positive results were partially offset by significant losses in our property business.

In certain segments of these businesses, these property businesses are not achieving our profitability targets, we are scouring those businesses back as Richard mentioned. Our operating results combined with our concerted approach to investing in capital management permitted us to grow book value again in the second quarter.

As of June 30th, 2009 our book value per share was $16.34, an increase of 6.8% during the quarter and an increase of 12.1% over the last 12 months since June 30th of 2008. These are consistent with our long-term strategy of growing book value. Additionally, tangible book value per share increased to $13.45, an increase of 7.9% during the quarter and an increase of 14.6% over the last 12 months.

In spite of the property results, operating net income was $5.3 million or $0.30 per diluted share for the second quarter, and $12.8 million or $0.71 per diluted share for the six months. Gross written premiums were up 3.3% for the second quarter and flat for the six-month period.

Net earned premiums increased 10.5% in the quarter and were up 15.4% for the full six months reflective of our growth and net premiums last year. For the quarter it’s important to note that 73% of our net earned premiums were comprised of our more seasoned security, special and legal professional liability businesses.

Our second quarter 2009, calendar loss ratio of 69% included a current actua1 year loss ratio of 76%. The 76% includes 4.7 percentage points of higher than expected storm losses, and 10.1 percentage points of higher than expected fire and other para losses. Also included in the second quarter calendar year loss ratio was 7 percentage points of favorable development of prior year loss reserves.

For the six months ended June 30th, 2009, our calendar year loss ratio was 53.4% and we had 4.2 percentage points of favorable reserve development of prior loss and loss adjustment expense reserves.

For the second quarter of 2009, the expense ratio was 30.9% compared to 28.7% in the second quarter of 2008, and was 30.6% year to date 2009 compared to 25.1% for the first six months of 2008. The increase in the expense ratio is primarily due to increased cost associated with the development of our underwriting initiatives and due to purchasing last quarter share reinsurance in 2008.

For the second quarter of 2009, under writing agency and other expenses decreased by $2.1 million compared to the second quarter of 2008, the decrease is primarily due to lower corporate overhead expenses of $1.8.

Commissions and fees increased 35% to $9.6 million in the second quarter and we are up approximately 48%, the $16.5 million for the full six-month period. This increase is primarily attributable to our insurance service operations and included non-recurring contingent commission income of approximately $1.1 million from AMC.

Net realized gains on investments were $9.6 million for the second quarter. Included in those gains are positive mark to market adjustments of $6.2 million on a convertible securities portfolio and our high yield convertible fund combined. There were approximately $100,000 of other than separate impediment losses on investments recognized during the quarter.

Also, at the end of the quarter our available per sale fixed income investments reflected a net unrealized gain of $13.2 million, which is an increase of $9.7 million for the quarter. These gains help us achieve a net tax equivalent total portfolio return of 4.7% in the second quarter and 7.4% year-to-date. Net investment income increased to $7.1 million up approximately 37% in the second quarter and grew to $13.6 million up 35% for the full six months.

At June 30, 2009, the effective duration on our investment portfolio was approximately 3.4 years and a taxable equivalent yield was 5.3%. In the current yield environment, we are investing new money primarily in select corporates considerably structured asset backed securities and commercial mortgage backed securities at a taxable equivalent yield of 4.7%.

Our cash on investment assets increased to over $648 million at June 30th, 2009, short duration high quality municipal securities and agency CMOs and patch throughs still comprise the largest part of our portfolio at approximately 48% of our investments.

Given a current market, our financial and operating leverage remains modest. Year-to-date annualized net written premiums to surplus is just under one to one, and our debt to total capital was under 19% well within accessible levels for our present AFS rating.

In the second quarter, we repurchased approximately 390,000 shares of our promised stock at an average cost of $13.11 per share. The share repurchase plan terminates on August 18th of this year and we have 413,655 shares remaining available for repurchase under the plan. We also are pleased to report that our balance sheet remains strong, and for the first time our total assets exceeded $1 billion.

Finally, given the higher than expected 2009 property losses, and the scaling back of certain property segments, we are reducing our guidance of operating net income per diluted share between a $1.60 to a $1.75 to between a $1.30 to a $1.60 for all of 2009. The range has been expanded to provide for the variability embedded in the property business net [Inaudible] premium reserves.

That’s an overview of our quarterly results. I’ll now turn it over to Richard for some concluding remarks.

Richard Smith

Thanks John. In summary, I am pleased that our underwriting and balance sheet discipline allows us to continue to report results that should value for our shareholders.

During the last 12 months, faced with the tough economic environment, unprecedented volatility on investment markets and continued deterioration in the PMC market condition as we continue to search for a bottom in the market. We were able to grow our book value over the twelve months by over 12%, grow the top line of the business over the twelve months, and report a combined ratio of 94% for the first six months of ‘09.

John has already discussed the earnings guide. We’ve discontinued growth guidance, however, I expect that we will be able to report top line growth for the year as contributions from our both recent underwriting addition offset pressure in the contractor market and the expected loss of property premium.

While I’m not pleased at all with the second quarter results, I believe we are very well positioned for a market turn, and a great position to continue to grow value for the shareholders. With that we will take questions.

Question-and-Answer Session

Operator

(Operator Instruction) Your first question comes from Amit Kumar - Fox-Pit Kelton

Amit Kumar - Fox-Pit Kelton

I guess just going back to your perhaps closing remarks, you talked about companies that are new to your target markets, being more aggressive, can you just sort of expand on that a bit, are we talking about larger carriers here or Bermudians?

John Marazza

Well, Amit, I’m not going to mention specific companies, but it’s not new companies and it’s not necessarily of new interest. But it’s people that we haven’t seen in our market place before. So we see some pressure from some of the very large companies, but I would say that’s been pretty constant across, and I don’t think it’s necessarily the Bermudian company.

I would say it’s US; maybe specialty based companies that are doing something new. Maybe through an acquisition or maybe through teams or however they grow, but new to our markets and over the last month I tried to visit the number of our offices or visit number of the underwriters, and there is sort of a consistent theme coming forward of these specialty carriers new in the markets that seem to be the biggest competition we have faced.

Amit Kumar - Fox-Pit Kelton

So, it’s more a question of more capacity than the rate aggression.

John Marazza

Yes, I would say both. Not just rate aggression, terms and condition, we’ve seen pressure on from a couple of the carriers. So I would say a matter of capacity and aggressive bargaining.

Amit Kumar - Fox-Pit Kelton

Okay, that’s very helpful. I guess just going back to your discussion on contract underwriting and giving notice to line underwriter, I guess NGA in terms of non-renewing, can you maybe just expand on that a bit and remind us how much offshore topline or is it just one person responsible for?

John Marazza

Overall property I think was less than 10% of our program, right about that, and this one carrier, this one program is certainly less than 10%. So neither represent a significant impact, this is a MGA that we’ve been doing business with for over two years, certainly, and I have had good results.

We have had them under close scrutiny over the last year, and just feel like, as I mentioned, we have had a chance to talk to other carriers with larger positions in property and just feel like the market conditions right now with the specific lines that this carrier is in, are conducive at least in the short terms plus making a recent return in the market.

We continue to work with them to make sure that over as we go through the six months on track termination period that we minimize the losses but it won’t have an overall impact we think on the top line as we go into next year, and we think it’s the right thing to do for our business.

Amit Kumar - Fox-Pit Kelton

Have any new losses being reported in Q3 on these or is it over in terms of that spike in the fire losses?

Richard Smith

Obviously property is short tailed Amit. So, we have had a full month of claims notices subsequent to June 30, so we considered anything that came in subsequent to year and that provision we made in our IBNR reserves. So, I mean we know if that was reflected, as reported out earlier we really only have a small component of our premium reserves as reflected on the summary financial data on the last page of our release is about $12.8 million, so we think it’s fairly well contained.

Amit Kumar - Fox-Pit Kelton

In terms of these fires, can you just give some more color, if there was any fraud or any other activity involved?

Richard Smith

In bad economic times stuff burns, and you have to make sure and have protections in place to make sure that you have it under control. So, there is suspected arson in some of these cases, and we are doing full evaluations and investigations on those. But what we have seen as well as what we hear from other carriers wouldn’t be inconsistent with the expectations of the economic environment.

Operator

(Operator Instructions) Your next question comes from Paul Newsome - Sandler O’Neill & Partners.

Paul Newsome - Sandler O’Neill & Partners

Could you talk a little bit about the runoff schedule of the property book and how that work out? Is there actually a possibility that the MGA continues to write in the future the terms of the contract even if it is more restrictive?

Richard Smith

Yes, that’s a possibility, we are not precluding that possibility right now and I will let John to run off.

John Marazza

As part of the cancellation we did limit their authority to write any habitational classes, which was the class of business where we saw the frequency and severity of the fire related losses. So they will be writing with the away from where the issues were; the way we were thinking about the $12.8, about two-thirds of that are runoff this year and the other third by the middle of next year.

Paul Newsome - Sandler O’Neill & Partners

Could you talk a little bit about the possibility level, maybe you can give us a combined ratio or number for your business excluding the property business?

John Marazza

Yes, I have got that Paul. If you take out all the noise related to the storms and the caps and the higher than expected losses from the property business for the three months our exiting year combined ratio would have been 61.2 and for the six months it would have been, the loss ratio would have been 60.3.

Paul Newsome - Sandler O’Neill & Partners

That’s County or action at year?

John Marazza

Action at year, normalized action at year, and that’s sort of how we have been thinking about the year all along without end user property activity, which is just reflecting higher loss ratio picked because of the pricing environment.

Operator

Your next question comes from Matthew Heimermann - JP Morgan.

Matthew Heimermann – JP Morgan

A couple of questions; can you just give us a little bit of color, well, first things first. When you said property was 10% of the total and this was less than 10, this was approximately 10% of the total property, that imply on a net basis around $2 million of premium from this MGA is at ballpark?

John Marazza

No, that’s not right, it’s 10% of the total gross written is property for the first six months.

Matthew Heimermann – JP Morgan

Okay. Then 10% of that is, it’s more like [Inaudible]?

John Marazza

The contract underwrite is probably about 40% of that $16 million.

Richard Smith

Matt, what I have said is that both, the contract program is 10% or less of the total and property is 10% or less. Contract program are also casually for us.

Matthew Heimermann – JP Morgan

Okay. Then I guess, is this MGA I suspect is concentrated in this specific geographic area. Is that true and, if so, do you write any other business in that area and is this experience different than that other business?

Richard Smith

They don’t write in a specific geographic area. They write actually a pretty broadly distributive book, primarily east of Mississippi, and Emerald writes a true national book. So, as we looked at it and then we continue to look at, there is nothing really apparent but to the geography that they write, and we have heard from other carriers.

There are a couple of other carriers that we know, that on the ENS side they are reducing their positions in the Mid-West because of sort of similar issues. So as opposed to trying to tie to a geographic, we just decided to just overall our exposure in total.

Matthew Heimermann – JP Morgan

You said it was habitational, can you give us a little bit more detail on what type of habitational and whether it decides the property etcetera.

John Marazza

Matt, they are fairly sizeable apartment complex is the concentration, and more so I guess with the Emerald than it would be with the contract underwriting, maybe for smaller properties there. But in general, that’s where it is private complex.

Matthew Heimermann – JP Morgan

Okay, and then I’m sorry to beat the dead horse so much, but I mean do you feel like there is something you seem to be talking this up to the underwriting environment, but is there something you could have done differently with perspective relationship or risk control ahead of this that may have mitigated it, in terms of what we want?

Richard Smith

I guess we are obviously we are asking ourselves that now, and as I said the first time is to make sure we went back to year end ‘08, when we took a really good look at it, and year end ‘08 the performance was very good.

I mean this MGA has been around for a while. They have been with us for over two years. The results have been very good through the two year. So it wasn’t a change in the people, it wasn’t a change in the approach from the MGA, it obviously is a model, the underwriting model, and each of the platforms wasn’t stress tested for the economic environment that we have.

Now, there could be some bad luck associated in this, you do have a property tops. There could be some bad luck because we are still concentrated in the second quarter, we’ll see about that. But we do go back, and we are going back and looking at what we could have done differently to manage this, to make sure that we didn’t see this, and at this point in time we think at least we did right things and we are continuing to challenge ourselves on that.

Matthew Heimermann – JP Morgan

Okay. I guess changing gears on that. The insurance services revenue was at least better than we were looking for even adjusting for the $1.3 million commission, can you just talk about some of the underlying trends you are seeing in that business?

John Marazza

TMC is experiencing what I would call moderate growth, and then also as far as the trend from first quarter to second quarter, the second quarter is pretty much their best quarter, so you’ll see a little bit of a tight spike there.

Matthew Heimermann – JP Morgan

Well, I guess was there any, if we go back to close of it, was there any business that wasn’t captured a year ago that help, because I mean the underlying growth was X, the contingent was still like 20% which to me it’s more than moderate.

John Marazza

Yes, there was clearly, I think if you recall back in the second quarter of ‘08, we discussed the dislocation that they were occurring with the transition between the carriers as a result of the acquisition. So, of course, they picked up some of that business that kind of fell by the way side in the dislocation. So it’s better to have a supporting carrier and then what I would call modest expense improvement.

Richard Smith

Just one more thing, I mean we do think they are experiencing also some very modest rate increase activity in the book, sort of low single digit type rate activity, which obviously helps a lot, as opposed to negative rate a year ago. So, I think its right upfront with three trends and that looks, but their trend lines look really good right now.

Matthew Heimermann – JP Morgan

Okay, and then, with respect to kind of the recapture of some of the, with respect to the carrier dislocation, is that something that would continue through the balance of the year or is that something that you are contemplating at this point?

John Marazza

Matt, I would if you want to bake in something that’s moderated from the second, not exactly the increase you thought from the second quarter, but moderated and have a trend off towards the end of the year to have it being above flat at the end of the year, because they were up and running with their new carrier pretty much forward by the end of last year.

Matthew Heimermann - JPMorgan

Then, just one last question on this topic was, with that contingent commission, is it fair to assume that there was some, that led to tick up in the expense relative to what it would have been otherwise as well?

John Marazza

That is fair, probably about 20,000.

Operator

(Operator Instructions) Your next question comes from Mark Dwelle - RBC Capital Markets

Mark Dwelle - RBC Capital Markets

Matt, you stole most of my questions, but I have a couple left. You commented at the end of your remarks related to some kind of general growth guidance. So, that was referring to gross premium, full year growth track.

Richard Smith

Yes, I think it was. Yes, top line.

Mark Dwelle - RBC Capital Markets

With respect to, last quarter we talked a lot about the security business and that the pricing there was very weak. Obviously, the premiums were down in that segment once again. Is that continuing to be the primary driver for the reduction there, the rate turn adequate, so you are letting the business go?

Richard Smith

If you remember, we are specifically talking about the safe line, and that continues to be aligned, maybe the second quarter was a little bit improved over first quarter, but not much, but that’s the big loss of premium for the security line is in the safety line, and continues to be very competitive.

Operator

Your next question comes from Ron Bobman - Capital Returns.

Ron Bobman - Capital Returns

I just had one question. You mentioned in the press release about the mid-term cancellations on some of these effective policies that are inside the contract underwriter book. I was curious, is that an open right for all ENF policies or something unique to these circumstances that forge you the opportunity to cancel certain or all of these mid term.

Richard Smith

Not all of them, I mean that’s subject to state regulation, and all of the kind of things we have to adhere to, but there are opportunities where if we go back and what we are doing is going back and reviewing the underwriting submissions and all of the information we have. There are certain conditions that would allow us to get off mid term and certain states.

So, we have canceled mid term, a couple of large accounts where the condition that we found upon inspection were inconsistent with what we saw in the original submission and we’ll continue to look at that for opportunities in situations like that.

Ron Bobman - Capital Returns

Thanks for explaining it. Then, it sounds like this MGA also is a casualty, are you terminating both sides of your relationship, the property and the casualty or just the property?

Richard Smith

They are related. They offer a packaged policy. So it was both, and like we said, there is the opportunity that we’ll be in a continuing relationship and it will be when we are confident and they are confident that we have an underwriting model that meets our profitability targets.

Ron Bobman - Capital Returns

Got you, and there were a bunch of numbers around in percentage. So the property book for the company was $16 million in the first half of ‘09, and am I right that you are at approximately 40%. I want to know how much of your GWP or whatever denominator you want to say was from this MGA.

John Marazza

From this MGA, they were just under 10% of our total gross written premium, when you add up the property policies and the GL policies that they provide; in the $25 million to $30 million range.

Operator

Your next question comes from Amit Kumar - Fox-Pit Kelton

Amit Kumar – Fox-Pit Kelton

May be just, three or four quick follow ups here. In terms of just going back to these losses you have been talking about. Can you maybe just give us some more color, how many losses these were, was it one or two losses, and maybe what the policy limits were?

Jim Thomas

This is Jim Thomas. There were numerous losses involved, it wasn’t one or two large losses. There are six figure loss, there are losses over $100,000 generally, but I would say that you are talking about from the Emerald side probably there was 15 to 20 in that grouping, and maybe an equal number or a little less than that on the contract underwriter side. They were all in there, and then of course we had our provision on top of that.

John Marazza

We buy excess reinsurance on the property at $300,000. So, to get to that kind of a number it’s a frequency issue for us since we take the severity out with the excess reinsurance.

Amit Kumar – Fox-Pit Kelton

Okay. That’s very helpful. Sort of moving on, previously I think you mentioned that you had minimal dry wall exposure. I think you mentioned you had only two claims if I remember correctly, is there any update on that number?

Richard Smith

I think that number is the same, two claims at this point in time, and we are seeing nothing in that category that would be outside of our normal claim activity.

Amit Kumar – Fox-Pit Kelton

Okay. That’s helpful. Final question, in terms of the share repurchase remaining of roughly 400,000, what are your thoughts on that based on where the stock price is especially today?

Richard Smith

We went to the stock price, but we have been focused on the call. So, what we said, that’s the little book value, we have always felt that our stock was a pretty good buy. So, we’ll evaluate, actually we bought a fair amount of stock at a really good average cost as you know, and we will evaluate like we always do once we see where the stock price is at today.

Operator

Your next question comes from Matthew Heimermann – JP Morgan.

Matthew Heimermann – JP Morgan

I think I have one more on the contract underwriting. I just wanted to make sure that $25 to $30 million of GWP with this particular underwriter distributor; is that all in the contract underwriting segment or does any of it get reported anywhere else?

Richard Smith

All on contract underwriting.

Matthew Heimermann – JP Morgan

Okay, perfect. Then, just with respect to the reserve development being pretty positive, normally I would think about you guys having bigger releases and, in first and third quarter when you guys complete the semi-annual reserve review. Did you do that review earlier or just curious what drove that release?

John Marazza

Last summer we hired a fellow of the Casualty Actuarial Society to former owned internal loss reserving function and we do a full ground up study now every quarter, and we continue to use the outside actuary at the June 30, of course that June 30 was not done yet and a 12/31, and based upon the consistency we have seen between our actuaries and our outside actuaries we take a lot more serious look at our work each quarter now. So you might think about us making quarterly adjustments more than semi-annual now.

Matthew Heimermann – JP Morgan

Okay. Then I guess what accident years were primarily responsible for the release?

John Marazza

2006 and 2007, at both GL and security.

Operator

With no further questions in the queue, I would like to turn the conference back over to Mr. Smith for any additional or closing remarks.

Richard Smith

Thanks for your support. If you have any questions, please follow-up with us and we will look forward to talking to you next quarter. Thank you.

Operator

Once again this does conclude today’s conference. We thank you for your participation.

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