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Executives

Richard H. Smith – Chairman, Chief Executive Officer, Director

John Marazza – Executive Vice President, Chief Financial Officer, Treasurer

Jim Thomas - Senior Vice President Product Management

Ed LaFrombroy - Vice President Finance

Leslie Loyett – Financial Relations Board

Analysts

Doug Moore – Ferris, Baker Watts, Inc.

Matthew Haberman – J. P. Morgan

Adam Franc – King Capital

First Mercury Financial Corp. (FMR) F4Q07 Earnings Call February 21, 2008 11:00 AM ET

Operator

Welcome Ladies and Gentlemen to the First Mercury Financial Corporation fourth quarter 2007 Earning Conference Call. Just a reminder, 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 given at that time. Now for opening remarks and introduction, I will turn the call over to Leslie Loyett of the Financial Relations Board. Please go ahead Leslie.

Leslie Loyett

Thank you. I would like to thank everyone for joining us today. Yesterday we sent out a press release outlining for the fourth quarter and full year 2007. If anyone has not received the release, please visit the Investor Relations page of the Company’s website at firstmercury.com to retrieve a copy.

Management will provide an overview of the quarter and year and then we’ll open the call up to your questions.

Please be advised that this call may involve forward looking statements as discussed on the ad free page of the press release. Words associated with these statements can be found on the Company’s latest SEC filings. Additionally, we wanted to remind participants that the information contained in this call is current only as of the day of this call, February 21, 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.

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, Jim Thomas - Senior Vice President Product Management and Ed LaFrombroy - Vice President 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 and good morning. I am very pleased with the solid performance for our organization during the fourth quarter and for the whole year as we continue to navigate an increasingly competitive environment.

Growth in premiums produced finished the year at 20% consistent with our guided growth rate, ROE 20.8%, our cap book value is $12.76 at year end representing a growth of almost 28% over year end 2006. It’s especially satisfying to achieve these results in our first year as a public company.

Our commentary on market conditions is probably consistent with others you’ve heard by now. Increased competition over the last two quarters, rate changes for our security lines were around 10% negative but vary significantly by lines within the security line, rate changes for the other specialty line moved to a little over 10%. We continue to see a good flow of business allowing us to be more cautious in picking those accounts that we work. There is some pressure on terms conditions especially in local markets or in specific products but generally they’re still holding up well.

I have discussed in the past pipeline of opportunities each quarter and am especially pleased with the productivity achieved from the flow of opportunities in 2007. We recently announced the acquisition of AMC in Conway, Arkansas, and look forward to significant contribution from that organization in the future.

We’ve added a new underwriting class force during the year that concentrates on excess umbrella on larger surplus buying accounts and I previously discussed a couple of new contract underwriting programs started during 2007.

We continue to see a good flow of opportunities although we obviously are very cautious of market conditions when evaluating these opportunities going forward. We think of ourselves and position ourselves as underwrite driven organization and as such, our underwriting assets, which are the people and the teams of people, and the acquisitions that we look at become our most valuable asset. Whether the market is hardening or softening, good underwriting will allow us to out perform over a long period of time. We continue to cautiously look to add some of these underwriting assets.

I am going to turn it over to John now for his comments on the financial.

John Marazza

Thanks Richard. As Richard said, we are pleased with another strong quarter, our fourth quarter results and our results for our first full year as a public company were in line with our expectations.

Operating at income for the fourth quarter was 229.4 % to $10.8 million compared to $3.3 million for the same period for 2006. Operating net income for the year was 93.9% to $41.7 million compared to $21.5 million for the same period in 2006. Diluted operating income per common share was $0.57 for the fourth quarter and $2.25 for the full year. As you know, we report operating net income which is a non-gap financial measure or which consists of net income adjusted to exclude the impact of net realized gains or losses on investments and changes in the fair value of derivative instruments and taxes related to those adjustments. You will note that we changed our definition of operating net income in the fourth quarter to also exclude the change in fair value of derivative instruments and taxes related to these adjustments to conform to the presentation of the analyst who maintains coverage on our Company.

Our annualized return on average stockholders equity for the fourth quarter was 18.3%. Annual return on average stockholders equity for the full year consistent with our 2007 guidance was 20.8%.

As we previously disclosed, the December 31, 2006 reinsurance cut off transaction had the effect of smoothing our net earned premium more evenly quarter by quarter throughout 2007. This more even distribution of our earned premium quarter over quarter in 2007 also resulted in our quarterly annualized return on average stock quotas equity being higher in the first half of 2007 compared to the second half of the year since our book value grew throughout the year.

As indicated in the narrative of our release, premiums produced which consists of all premiums underwritten by car wrecks were $67.3 million for the fourth quarter. Up $9.7 million or 16.8% over the same period in 2006. Premiums produced for $276 million for the year up $46 million or 20% over the same period in 2006. The increases for the fourth quarter and full year were primarily due to the production from our new specialty niche programs and net new business produced from our existing specialty underwriting offices including the opening of our California and Georgia offices.

Net earned premium for the fourth quarter increased 47.5% from a year ago to $39.5 million and increased 53% to $169.1 million from a year ago. The increase in net earned premiums during the fourth quarter is primarily due to our higher quota share retention in 2007 compared to the same period in 2006 and due to growth in premium fixed and due to growth in premiums produced. The anticipated higher net earned premium for the full year included $39.6 million of premiums earned on the unearned premiums returned by our quota share reinsurers as a result of the previously disclosed of our 2006 quota share treaties on December 31, 2006.

Commission and fee revenues for the fourth quarter decreased 72.3% to $1.2 million compared to the same period in 2006. Commission and fees revenue for the year decreased 0.9% to $16.5 million compared to the same period in 2006. The decrease in the fourth quarter is primarily attributable to our previously disclosed change in business model. For period when we were using front-end carriers, profit sharing commission adjustments are recorded in the commission and fee revenue line. For subsequent periods when we began issuing business on our paper, profit sharing commission adjustments are now recorded in the underwriting agency in other expenses line.

Underwriting agency and other expenses for the fourth quarter decreased 93.7% to $0.2 million compared to the same period in 2006. Underwriting agency and other expenses for the year increased 7.6% to $14.5 million compared to the same period in 2006. The decrease in this line item for the fourth quarter is likewise due to the change in business model as I just mentioned where profit sharing income in the quarter is recorded as a reduction in underwriting agency and other expenses.

Our expense ratio for the three month period increased to 16.6% from 13% for the year ago period. Our expense ratio for the year increased at 20.4% from 15.9% for the year ago period. This increase in the expense ratio for the fourth quarter and full year was anticipated and is primarily attributable to December 31, 2006 reinsurance cut up transaction and that we discussed and also the impact of purchasing less quota share reinsurance in 2007.

Our underwriting results continue to be strong with a loss ratio of 52.5% for the fourth quarter of 2007 compared to 48.7% for the comparable period of 2006. For the year, the loss ratio is 52.1% compared to 50.8% for the comparable period in 2006. For the three month period loss reserves for prior accident years were increased by approximately $1.4 million or 3.7 loss ratio points. For the year, our counted loss ratio approximately 2007 accident loss ratio and loss reserves for prior accident years were decreased by approximately $0.8 million or 0.5 loss ratio points.

Net investment income in the fourth quarter increased 59.3% from the fourth quarter of 2006. Net investment income for the year increased 67.8% from the year ago period. At December 31, 2007, the effective duration on our investment portfolio was three years and the tax equivalent yield was 4.8%.

Our balance sheet remains strong; cash and invested assets increased to $477.7 million compared to $312.2 million at December 31, 2006. All invested assets consist primarily of high quality fixed income investments. We use outside investment managers that specialize in the insurance industry and we have invested our assets consistent with our conservative investment guidelines. We have virtually no subprime exposure. Additionally, our municipal securities, which comprise 43% of our investment portfolio, are of extremely high credit quality given our investment mangers constant focus on the underlying credit in these investments. These municipal securities are rated an average double A plus with the added average underlying quality of double A.

Our net loss and loss adjustment expense reserves total $180.9 million and 70.9% of the net loss and loss adjustment expense reserves relate to incurred but not reported claims up 69.9% at December 31, 2006.

We continue to maintain our moderate financial operational leverage. Annual net premiums written to surplus are approximately 0.8 to 1.0. Our debts and total capital is 22.6% up slightly from 21.2% December 31, 2006. The debts and total capital ratio increased moderately due to the $20 million September Trust Preferred Security offering. Our debt consists entirely of trust-preferred securities, which receive partial equity treatment from our rating agencies.

As Richard said at December 31, 2007, book value per outstanding share grew 27.9% to $12.76 per share compared to $9.98 per share on December 31, 2006.

Operating cash flow for the three months was $17.5 million compared to $10.1 million for the fourth quarter of 2006. Operating cash flow for the year was $126.7 million compared to $52.9 million in the year ago period which is added to our investment leverage which has increased to 2.0 at December 31, 2007 compared to 1.72 at December 31, 2006.

That’s an overview of our solid fourth quarter and full year results. I will now turn it over to Richard for concluding remarks.

Richard Smith

Thanks John. A few comments on our newly published guidance, first the guidance of 20% plus growth in premiums produced. We think of the 20% like this. It’s flat to mid single digit growth in the security and other specialty lines. The first half growth over and above the flat to mid single digits but the first half driven by production from our contract underwriting classes added in mid year 2007. Second half growth driven by our new underwriting platform, which is now just coming up to speed and starting to produce business.

Significant to note though, there will be no 2008 premiums produced from our recent acquisition to be included in the 2008 plan as we will use this year for integration and ’09 to look for underwritten premium opportunities.

Another note, we are constantly evaluating the performance of each of the segments of our business and that both or all three the rate and the weight performance compared to our historical rates compared to industry guidelines the quality of the business and then ultimately the loss performance. We will be constantly doing this. We made some allocation changes during the last three or four months as we move some business from under performing areas to what we think are better performing areas. We will continue to monitor that in 2008.

The ROE guidance in the range of 16.5 to 18.0 we feel is prudent guidance given the uncertainty existing in the main through drivers were bottom line, the investment marketplace and the insurance marketplace. It is significant to note in our investment portfolio approximately half of our investment portfolio because of the new cash generation and because of the short duration of our portfolio approximately half of that money, half of the portfolio will be invested in the current interest rate environment.

We are being very conservative with our operating leverage, our debt earned premium to our equity is very little change from last year being very conservative offering leverages we are very conscious of the rating agencies and leaving some dry powder for changes in our allocation. We have about a point of expenses that we are investing in these new platforms to bring them up to speed before they’re completely covering their cost. The combination primarily from those three things along with just the general deterioration in the marketplace cause us to, what we think, be prudent and bring our ROE Guidance down for the year as we continue to produce the business.

I want to address two potential questions up front. The first is quarterly performance of the growth the premiums produced. I am very confident the 20% guidance for the full year but can absolutely assure you it will not be exactly 20% each quarter. As we have talked about, we have new underwriters and new offices, the changing marketplace we have good months and months that aren’t as good. We have large accounts that renew or at times when we write new larger accounts and every other variable, you can imagine as we manage that and the results in each quarter will show some variability and we expect it to. If we see something that causes us to change our thinking for the year, we will disclose it as quickly as we can to the marketplace.

The second issue is quarterly reserves. Each month we carefully review Act year loss experience for each of our key segments. It is not unusual for John or myself to actually go back to the Actuaries with questions and observations about our actual year loss experience. Our Actuaries do complete quarterly review. We have an outside Actuarial Firm do picks twice a year. Each of these reviews causes us to realign our thinking on the reserves and to evaluate our best estimate. At quarter end if the realignment creates insignificant emergence either positive or negative, we don’t try to go back and balance the total for optics purposes. That’s what you’ve seen this year, we have a couple quarters of little bit of positive and the fourth quarter a little bit of negative. On the whole year, we are about a push on reserves.

We will be glad to answer any questions related to that but we won’t be able to provide much meaningful commentary on the small quarterly changes that we’ve had.

With that, I will ask that we be ready to take questions.

Question-and-Answer Session

Operator

Thank you, sir. Ladies and Gentlemen the question and answer session is conducted electronically. (Operator Instructions). We will pause just a moment to assemble the roster.

Our first question today is from Doug Moore with Ferris, Baker, Watts.

Doug Moore – Ferris, Baker Watts, Inc.

Hi good morning, I just had a question regarding your recently closed acquisition of AMC. I think in an earlier release you said it had about 100 million of premiums that pass through that underwriting facility. How much commission did they earn and how much fees did they earn off that $100 million of premium?

John Marazza

This is John you know we don’t disclose margins from our service businesses and when we talk about acquisition we indicated that we wouldn’t be writing any of that business on our paper. In ’08 that would be inherent growth for ’09 and we’ve indicated that you should be thinking about that acquisition as earnings neutral in ’08 and that’s still our thinking on that.

Doug Moore – Ferris, Baker Watts, Inc.

Okay, I was just trying to get an idea for how much the commission line might improve over the next year on that.

John Marazza

I think you will see that emerge when we report on service our fees for the first quarter.

Doug Moore – Ferris, Baker Watts, Inc.

Okay, that’s all my questions.

John Marazza

Thanks Doug.

Operator

Again, ladies and gentlemen, it is star one if you would like to ask a question and please remember to disengage your mute function on your speakerphone so that your signal can reach our equipment.

We will go next to Matthew Haberman with J.P. Morgan.

Matthew Haberman – J. P. Morgan

Good morning a couple of questions, first is with respect, I know you said you didn’t have much substantive today on the reserve change but can you just remind us what years maybe drove that change – a. And b. – and whether it was in frequency or severity?

Richard Smith

Matt, Richard. It spreads back through probably three of the underlying years and it’s specifically related to a few large case reserves that we decide to put up, be prudent and put up, on cases related to 2002, 2003, 2004 and specific large cases that we decided to put up case reserves and not change our overall IBNR pick.

Matthew Haberman – J. P. Morgan

Okay and are those the same cases that prior to the IPO had seen a little bit of development?

Richard Smith

Not at all.

Matthew Haberman – J. P. Morgan

Okay, the other question I had was with respect to the ROE Guidance, can you just talk about how you are thinking about capital and I guess you are not expecting with AMC for that to use capital this year but in thinking about capital with potentially taking business in ’09 is that one thing, is that a factor that constrains your capital flexibility in ’08?

Richard Smith

You know having been with us, we are very cautious about capital management and we have guided the 20% growth at least over the mid term. The fact that AMC is sitting there with a significant amount of business and what we hope are some new business opportunities causes us to be very thoughtful and not taking our operating leverage up this year. We also as you know carefully balance our reinsurance programs. We are taking more risks this year on what we call our mainframe program, the other specialties and securities. Our quota share is down to 10%; we are heavily reinsuring the other program as we wait to see what the emergence of that is. We wanted to make sure that we had adequate capital to balance those needs too as we saw the growth. It’s trying to be prudent in our management of the capital base as we look at the opportunities on the balance sheet making sure that we are meeting our margins on each of our business segments.

Matthew Haberman – J. P. Morgan

That’s fair and just following up on that comment Richard, could you remind us maybe as we look at ’08 what the quota share intentions are going to look like by maybe security, other specialty and then let’s just call it other new business?

Richard Smith

Yes, that’s a good way to categorize it. The security and other specialty where currently we have 10% of quota share effective January 1 and we have an option, a preset option, in that contract to buy additional quota share on a quarterly basis on the same terms as year end. We have the flexibility built in that program. On the rest of the business, our net retention rate on the rest of the business is if you aggregate all of this, it’s somewhat less than 50%.

Matthew Haberman – J. P. Morgan

Then the last question I had, just with respect to the premiums produced guidance, could you just give us the sense of between, because it seems to me that you’ve got the programs that we go back to first quarter a year ago, the premiums produced were very low because some of the programs that you had talked about didn’t really kick in until middle, late second quarter. How much of the growth is purely just a function of that 20% just effectively having a full year versus a partial year and then also just with the new underwriting team maybe put into context how much business you’re targeting from that team relative to or as a percentage of business they wrote in their prior life.

Richard

I will try to answer that in a couple of ways. Of the 20% guided growth about 10% of that comes from just the existing infrastructure things that we were doing last year full year and about 10% of the 20% comes from the new underwriting team. The new underwriting team, our premium that we have in the plan for new underwriting team would be a dramatically smaller than they would have collectively written in their prior life.

Matthew Haberman – J. P. Morgan

Okay, thank you very much.

Operator

Having no other questions in Q at this time, I would like to offer everyone a final opportunity. It is star one just ask your question.

We will go to Adam Franc with King Capital

Adam Franc – King Capital

Good morning, thank you for taking my call, could you repeat what you said, you had mentioned earlier in your comments 10% negative in security lines. I am assuming you are referring to the price there and was it greater than 10% decline in non-security lines?

Richard Smith

Yes, you’re exactly right. About 10% in the security line negative rate and it moved to slightly over 10% in our other security lines late in the year. We had advised mid year was approaching 10% and moved to slightly over 10% in the second half of the year.

Adam Franc – King Capital

Okay, thank you.

Operator

Mr. Smith, having no other questions, I will turn it back to you for closing remarks.

Richard Smith

I first want to thank all of our employees, a tremendous year as the first year as a public company and we look forward to meeting with everyone going forward and thank each of you for your support.

Operator

Ladies and gentlemen, thank you so much for your participation. This does conclude the conference and you may now disconnect your phone line.

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Source: First Mercury Financial Corp. F4Q07 (Qtr End 12/31/07) Earnings Call Transcript
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