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Executives

Richard Smith - President & CEO

John Marazza - EVP & CFO

Ed LaFramboise - VP of Finance

Jim Thomas - SVP of Product Management

Leslie Loyet - Financial Relations Board

Analysts

Keith Alexander - JPMorgan

Paul Newsome - Sandler O’Neill

Doug Mewhirter - RBC Capital Markets

Bob Farnam - Keefe, Bruyette & Woods

Morse Williams - Williams & Company

Caroline Steers - Macquarie

First Mercury Financial Corp. (FMR) Q1 2010 Earnings Call May 4, 2010 11:00 AM ET

Operator

Greetings and welcome to the First Mercury Financial Corporation first quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a remainder this conference is being recorded.

It is now my pleasure to introduce your host, Leslie Loyet of the Financial Relations Board. Thank you Ms. Loyet, you may begin.

Leslie Loyet

Thank you. I’d like to thank everyone for joining us today. Yesterday, we sent out a press release outlining the results for the first quarter 2010. 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 May 3, 2010 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, May 4, 2010 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, Executive Vice President and Chief Financial Officer; Ed LaFramboise, Vice President of Finance; and Jim Thomas, Senior Vice President, Product Management.

At this point, I’d like to turn the call over to Richard for his open remarks. Please go ahead.

Richard Smith

Thanks Leslie. Welcome to the First Mercury Financial Corp. first quarter earnings call. Probably the biggest headline for our first quarter is no surprises. Gross written premium was well within our expectation. We expected property production to be down as we continued refine our underwriting approach for that line.

We also expected growth in the excess and umbrella line of the professional I look building lines is our new those lines continued to get traction in the marketplace. The competitive position seems to see as bumping along at our market bottom as we continue to see rate decline in aggregate in the very low single digits. I’ve described in previous quarters’ completion continues to be much greater for our accounts and we continue to see pressure for admitted carrier as they offer significant competitions. Generally, terms, condition informed continued to hold.

We continue to see a good supply for our new opportunities, probably more than we see in a couple of years, and we’ll closely scrutinize these to evaluate the opportunity to add to shareholders value. As disclosed in the full-year earnings release and again in the first quarter earnings release, we completed a cost reduction action during the first quarter that reduced annual costs by approximately $4.5 million.

When we continue to look for opportunities to further reduce cost going forward, for example, we’re taking advantage of a very competitive commercial real estate market in Southeast Michigan by consolidating operations at one location that will say that immediately about $100,000 a year and as much as $1 million a year going forward.

AMC continues to grow their business and improve their contribution to profit and we continue to see their business as a good source of growth for the first mark going forward. We did see pressure on the loss ratio on the quarter, primarily because of a self deterioration within the loss results of a legal liability program we’ve been writing for five years. Because of the experience and the market condition, the Program Manager noticed that a combination of effective no later than early September, however we have been given noted that the program will move to another carrier effective July 1 of this year, continued to be very pleased with the performance of the investment portfolio is our conservative investment strategy we continued to reward as very well.

I will now turn it over to John Marazza, our Executive Vice President and Chief Financial Officer.

John Marazza

Thanks Richard. Since everyone has had the opportunity to review the press release that went out last night, I’ll focus my comments on the financial highlights for the quarter. You’ll note this quarter, that we changed our presentation of gross and net premium in the summary financial data table on the earnings release from an underwriting platform presentation to a product line presentation, for those you who have asked, we will post a supplemental schedule later today to the Investor Relations Page of our website that provide this to say historical information for 2008 and 2009 by product line for consistency.

On my first quarter 2010 calendar enacting a loss issue was 65.8% we had no net reserve development on prior accounting year reserves during the quarter, compared to $755 million of favorable development in the first quarter of last year.

Our first quarter actual year loss ratio reflects an increase of 6.4 percentage points over the first quarter of 2009 largely due to pricing trends, a higher loss ratio honest into reinsurance transactions in the quarter, and an increase in our loss ratio for our legal professional liability book of business as Richard mentioned. The gross our return premium for professional liability book of business was approximately $20 million to $1 million in 2009.

For the first quarter of 2010 expense ratio was 43.2% to 30.4% for the first quarter of 2009. The increase in the first quarter expense ratio is primarily attributable to the $5 million restructuring charge. Restructuring charge did impact the expense ratio in the quarter by approximately 9.7 percentage points and our expense ratio would have been 33.5% without the charge. We do anticipate realizing pre-tax annual operating savings of approximately $4.5 million as a result of these restructuring actions.

As Richard said, our investment portfolio continues to perform well. Our overall conservative investment philosophy and credit allocation through alternative investment in 2008 and 2009, such as convertibles, high yield securities and structured finance products contributed to a net tax equivalent total portfolio return of approximately 2.4% for the first quarter. The quality of fixed income portfolio remains high with an average credit quality of AA minus.

During the quarter, we allocated new money from cash flow and maturities primarily to agency and AAA rated non-agency CMOs and investment grade corporate bonds at a taxable equivalent weighted-average yield at 4.6% The effected duration of our investment portfolio was approximately 3.4 years and annualized taxable equivalent yield was 5.3%

As of today, we have not repurchased any shares of our common stock under our August, 2009 repurchased authorization. We have 1.0 million shares of capacity available under this repurchase plan through August 2010. I also want to point out, that there were 367,100 stock options, as advised during the first quarter. These options were highly dilutive and have the impact of reducing book value per share by $0.32 during the quarter. As of March 31, 2010 substantially all of the overhang relates to these highly diluted stock option has been eliminated as a result of these exercises.

On March 31, 2010, the company paid $35.7 million in dividend to our shareholders, which represented a special dividend of $2 per share on our fourth consecutive regular dividend of $0.025 per share. The special cash dividend [Audio Gap] from borrowings under our existing credit agreement and holding company cash, this special dividend was combined with our share repurchases during 2008 and 2009 and our regular dividends have resulted in approximately $56 million of capital being returned to our shareholders since August of 2008.

As of March 31, 2010, there was $30 million outstanding under our existing credit agreement, which represents the full amount of our lenders commitment to us. The current interest rate on this borrowing is 2.35%, which is 200 basis points over three months LIBOR. That’s an overview of our quarterly results.

I’ll now turn it back over to Richard for his concluding remarks.

Richard Smith

Thanks, John. As we discussed on the year-end 2009 earnings call, our focus is on delivering on 11.5% to 12.5% ROE in 2011. The result for the first quarter positioned us very well to deliver that result in 2011. We did not provide 2010 guidance. However, we continued think, we will deliver growth and gross rate in the premium for the year.

We will now take question.

Question-and-Answer Session

Operator

(Operator Instructions) Thank you. Our first question is from Keith Alexander with JPMorgan. Please proceed with your question.

Keith Alexander - JPMorgan

I’m wondering if you could start off just by talking about trends by the new line of business format, including where you expecting to see the most growth opportunities and which areas are in difficult decline?

Richard Smith

As I just mentioned Keith, what we would see for the rest of the year is probably about flat on the primary general liability, the primary casualty that we are about flat in the first quarter. As we mentioned, at year end and as mentioned this is where we see opportunistically, we see some accounts such as the one we wrote the large one below the fourth quarter, but that’s very opportunistic and we would only right those if we expect them to significantly enhance our financial performance, so primarily flat.

Excess and umbrella, we continue to see some good growth that’s primarily piece of that comes out CoverX, but primarily driven by First Mercury, Emerald and those guys continually get traction. We expect to see some growth by that. Professional liability, we’ve added several underwriters over the last couple of quarters have been pleased with what we’ve seen. So we look for the CoverX piece of that. We’ll continue to see some growth. However, offsetting that that’s where the program cancellation to legal liability will come. So the CoverX piece will grow and we’ll see some decline because of the cancellation on the program.

Commercial property, we’ve talked about refining our underwriting approach. We continue to look at that. You probably will see some growth there for the remainder of the year as we’re looking at several new underwriters and several new underwriting opportunity and the other again as opportunistic and that one will be what it will be the no way to get growth on that one, let’s answer to your question.

Keith Alexander - JPMorgan

Just moving to something probably different, you mentioned that your books competition from your immediate market, does that change it all the degree of competition?

John Marazza

No , I mean I think if its change has been a modest increasing presence of the admitted and so the admitted markets and so that is the comment just says that we still see admitted careers business moving up especially on the commercial general liability. We still see our business moving up and they show up this competition many times in the marketplace. We do have it admitted security develop program that’s being pretty aggressive in the marketplace right now, and so that would be consistent across the board it’s not unusual at this time in the marketplace to see it very consistent with what we’ve seen in past markets. So no significant change in the market, but the increased again just a gradual increasing partners from the admitted carrier.

Keith Alexander - JPMorgan

I just remember in the past, you mentioned that they turn the comment and then they leave one condition could better primary markets I mean when shall we start thinking about saying some of the competition goring away?

John Marazza

That’s a call that it would take somebody, with a much broader perspective and I mean if I’ll relate to our very narrow class experience, specifically we’ll talk about security guard, admitted markets coming to security guard, it’s a specialty class from our view. It has to be written on to be able to take advantage of the terms, conditions and so on.

So in the past when admitted markets have written that business that sort of the ultimate signal that very end of the soft market because that business tends to come back in the surplus lines as people see their experience in that class. So if you go back to ‘83, ‘84, if you go back to ‘98, ‘99 consistently what we’re seeing, but right now I don’t know what signals for market change.

Keith Alexander - JPMorgan

My last question is now at the special dividend is behind us. Can you talk about your capital management priorities going forward?

Richard Smith

We think we’ve got about the right amount of capital throughout these and you ask about holding company cash, we used our holding company cash with the dividend, where we look at capital right now is the capital that will generate the rest of this year would probably be the rate of think about what our excess capital will look like at year end.

Operator

Thank you. Our next question is from Paul Newsome with Sandler O’Neill. Please proceed with your question.

Paul Newsome - Sandler O’Neill

The $30 million of bank debt is that considered a permanent capital structure or are you contemplating a change?

Richard Smith

We do generate some cash as we talk about for remainder of the year. As John pointed out, we’ve done no stock buybacks until as long as we’re not buying stock back, we would be able to pay some of that down, Paul as we look over the next few quarters.

Paul Newsome - Sandler O’Neill

Were the goal be to pay that down, I mean should I think it that sort of really pay that down first and then start buying back stock?

Richard Smith

Yes, it’s a pretty a low cost capital for us, Paul we have to raise. So we’ll be opportunistic with our stock buybacks when we think our stocks at reasonably low price. So we sort of manage those things based upon what the market conditions are absolutely.

Paul Newsome - Sandler O’Neill

I had a situation where company had that two more situations that’s how being growing out for premium bond debt (Inaudible) like it?

Richard Smith

As I mentioned at the year end call, we’ve already reviewed this with our rating agencies and we’re well within our financial leverage requirements and they’re very comfortable with it.

Paul Newsome - Sandler O’Neill

Any change in your reinsurance position?

Richard Smith

Not, from year end.

Operator

Thank you. Our next question is from Doug Mewhirter with RBC Capital Markets; please proceed with your question.

Doug Mewhirter - RBC Capital Markets

Just to clarify with sort of circumstances surrounding the Program Manager that I guess you parted weight with, was that the one that was based in Boston?

Richard Smith

Yes, it is.

Doug Mewhirter - RBC Capital Markets

I just wanted to confirm, and John you had mentioned a number that were something like $29 million, so was that the premiums, gross premiums generated in 2009?

John Marazza

Yes, I think $21 million.

Doug Mewhirter - RBC Capital Markets

$21 million?

John Marazza

Yes.

Operator

(Operator Instructions) Our next question is from Bob Farnam with Keefe, Bruyette & Woods. Please proceed with your question.

Bob Farnam - Keefe, Bruyette & Woods

Just a couple more detailed questions here. I assume there’s no issue for the property book this quarter?

Richard Smith

Correct. We had minimal amount of storm loss, I think $0.5 million of storm loss, but whether it really didn’t take the performance of book outside of our expectation.

Bob Farnam - Keefe, Bruyette & Woods

You had a lower than expected the effective tax rate for the quarter, any driver for that?

Richard Smith

Yes, there was permitted difference related to amortization of some related purchase gap, so it was a one-time permit difference. The impact is with lower underwriting profit. The tax exempts are having a bigger impact on the overall tax rate as well, so those two items drove that.

Bob Farnam - Keefe, Bruyette & Woods

I think of the modeling when we have lower underwriting income, how much was that related to that primarily difference?

John Marazza

It was a pre-tax $1.3 million, so that’s about a 50,000 net tax and modeling going forward kind of below 30s, its typically a fairly good measure for us, but up and down depending on where realize gains or loss at the end of the quarter.

Bob Farnam - Keefe, Bruyette & Woods

Last one I have is can you give us anymore details on how the loss portfolio transfer has been working? Should be expect anything in terms of premium from that in the next three quarters?

Richard Smith

Well, with respect to the LPT were in fourth quarter our loss ratios on something try to change. So, we are actually getting investment income on the money for the small, we did small LPTs, we did in the first quarter were slightly increased to earning, they had impact of increasing the loss ratio by about 1.2 percentage points, but and review point of that, the expenses are a lot low with associated with those and to think about those going forward as Richard said, we are more opportunistic. So, we don’t model any annual plan for them that we something opportunistic will we look at it.

Operator

Our next question is from Morse Williams with Williams & Company; please proceed with your question.

Morse Williams - Williams & Company

Two questions, one since almost all study shows if companies get no credit for a special dividend as suppose to simply having a reasonable paying out on analyzing dividend on a regular basis. Why did you pay $2 special dividend as oppose establishing with just as 30% pay add raising dividend overtime?

Richard Smith

We wanted to make this with consider with the significant amount of time with the board. The board came to the conclusion in our business with critical for us to have capital to take advantage of a change in the market condition and that’s the use of a special dividend where we don’t established expectations going forward up continuing to paid dividend was important for us, but we want to make sure in this property amount of capital to the markets, but keep our options open going forward as we find uses for the capital. So given at significant amount of considerations of the Board and the Board was strongly and support in the use of the special dividend as opposed to a greater stock buyback or is opposed to a substantial increase in the recurring dividend.

Morse Williams - Williams & Company

I was disagree with that conclusion, but that’s really it’s been done. My second question is given that you’ve outlined the goal as 11.5% to 12.5% return on equity for 2010, once you’re saying that your goal for earnings per share is bucketed to $2?

John Marazza

For 2011 that goal had 11.5% to 12.5%.

Morse Williams - Williams & Company

Then can we think we translate that then to going for earnings, I guess that would be somewhere more in the area of $1.90 to $2.20, based on the book value of that will likely prevail at year end 2010?

John Marazza

You can do the math. I mean we also have that, I think we start the share purchase authorization. So you’ve got a few variables that you have to think about with respect to 2011 earnings per share.

Morse Williams - Williams & Company

Well, I guess that and leaves to the follow-on question, when do you actually expect to start spending money in terms of activating the share repurchase program?

John Marazza

There were opportunistic and it depends on all the stock prices.

Richard Smith

If you look at the history of our stock repurchase program, we bought the stock, when we think its historically significant on undervalue and so that’s what you should look for us to use to that have authorization, when we think there’s a significant undervalue in the marketplace.

Morse Williams - Williams & Company

You’ve done a very good job in contracts to most companies are in fact buying your stock at relatively cheap prices, the fact that you’re not buying anything referenced relative to the one million shares of authorization adjusted, you don’t yet think it’s cheap enough to buy, is that correct?

John Marazza

Again, we can look at our history, when we bought the stock, whatever it’s trading at a substantial discount of book, our stock price responded really well to the restructuring into the special dividend and we don’t do that more than one-time and as I mentioned, we got about the right amount of capital amount in that. We generated more capital, as we earn money into the rest of the year. So I think you want to take about stock buyback, I mean even though it does expire in August. I’m sure the Board really considered to extend that and where we think about that we wouldn’t really have all one-time and always something we’d be opportunistic that during as the year progresses.

Operator

(Operator Instructions) Our next question is from Caroline Steers with Macquarie. Please proceed with your questions.

Caroline Steers - Macquarie

Anyway many of my questions have been answered, but if we can go back to market conditions and if you could just comment on whether you’re seeing, I mean major discrepancies in any particular line of business, a new versus renewal business and then if you’re seeing any changes in terms and conditions in any particular line and not to be it? Thank you.

Richard Smith

We measure, I mean it’s obviously as far as the weight changes for these years measure on our renewal book of business and so when we talk about low single-digits, very low single-digits that’s our renewal book, but we also measure the overall rate levels compared to ISO rates and the overall rate levels for our new versus renewal are very, very consistent.

So there’s no reason for us to conclude to the extent that we can measure it that there’s a dramatic difference between the low single digits for the renewal book versus admitted, but we measure that in aggregate new and renewal compared to the ISO benchmark and that when I say bumping along as the bottom of the market, our aggregate rate levels compared to the ISO benchmark has been pretty consistent and cost us now for three or four quarters. Yes, pretty much I think if we go back to about mid years, so even though with a small rate decrease and aggregate our rate levels as compared to price have been constant now. I would say for just about a year. What was the second part, I’m sorry?

Caroline Steers - Macquarie

Just wondering on terms and conditions, is anything changing there?

Richard Smith

I mean the terms and conditions really come under pressure when there’s a dramatic change in the appetite of admitted carriers and we’ve said that admitted carriers have been sort of constant pressure, but nothing dramatic. So at this point in time, I would say if you can tract this to 1999 or 2000 terms and conditions to held up probably surprisingly well compared to the rate levels and so that’s something we monitor very closely and we’re still recently comfort with where we are with terms and condition.

Operator

There are no further questions at this time. I would like to turn the floor back over to Mr. Smith for any closing comments.

Richard Smith

Thanks for your support and we will look forward to talking to you for the second quarter conference call.

Operator

To access the replay of this call please dial 1-877-660-6853, pass code 3055, ID number is 349664. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: First Mercury Financial Corp. Q1 2010 Earnings Call Transcript
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