First Mercury Financial Corporation. Q1 2008 Earnings Call Transcript

May.16.08 | About: First Mercury (FMR)

First Mercury Financial Corporation (FMR) Q1 2008 Earnings Call May 1, 2008 11:00 AM ET

Executives

Leslie Loyet - Financial Relations Board - IR

Richard Smith - President and CEO

John Marazza - EVP and CFO

Jim Thomas - SVP Product Management

Ed LaFramboise - VP - Finance

Analysts

Mark Lane - William Blair

Amit Kumar - Fox-Pitt Kelton

Bob Farnam - KBW

Matthew Heimermann - JP Morgan

Doug Mewhirter - Ferris, Baker Watts

Operator

Ladies and gentlemen thank you for standing by. Welcome to the First Mercury Financial Corporation first quarter 2008 Earnings Call. (Operator Instructions). As a reminder, this conference is being recorded today, Thursday, May 1, 2008.

I would now like to turn the conference over to today's moderator, Leslie Loyet, of the Financial Relations Board. Ms. Loyet, please go ahead.

Leslie Loyet

Thank you. I would like to thank everyone for joining us today. Yesterday we sent out a press release outlining the results for the first quarter 2008. If anyone has not received the release, please visit the Investor Relations page on the company's website at 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 April 30, 2008 press release. Risks associated with these statements can be found in the company's latest SEC filings. Additionally, we wanted to remind participants that the information contained in this call is current only as the date of this call, May 1, 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 LaFramboise, Vice President of Finance.

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

Richard Smith

Thanks, Leslie. Good morning. I am very pleased to report solid first quarter results in the face of an increasingly challenging marketplace. Top line growth for premiums produced is 26.5%, and was consistent with our aggregate expectations, as well as the expectations for the sources of the growth. Our results are driven by the underwriting components of our business, and we are right on target in all areas of that business.

For the first time we are disclosing premiums produced by underwriting platform. And the results, again we are on our target. For the CoverX platform, made up of security and specialty lines, both were essentially flat for the quarter. Competition continues to increase in these lines. For the security lines the rate decreases are in the high single-digit range, with competition the greatest in our sprinkler class, and the least in our security guard class.

We continue to generally maintain terms and conditions in the security line. For the specialty line, the rate decreases continue in the 11% to 13% range, but vary greatly by geography and class. We are maintaining the production levels in the specialty line because of geographic expansion in 2007, as we have previously discussed.

As others have reported before us, California is very competitive. But although we are pleased with the new office we have there, for the first quarter California still represents less than 10% of our specialty writings, and we continue to write very modest account size in California.

The contract underwriting platform represented a substantial amount of first quarter growth, mainly because three programs added in 2007 were for a partial year in 2007, and did not have premium in the first quarter. Our new First Mercury Emerald platform is coming online as we expect and we will see growth accelerate as we move into the remainder of the year. The underwriting results were as expected. We saw no reason to change our estimates for prior year reserve levels.

I was very pleased that we were able to close the acquisition of AMC earlier this year. Prior to the closing, one of the two major markets that support AMC's core line of business informed us that they would not be supporting AMC going forward because of a policy of not supporting MGAs owned by insurance companies. The closing of the deal was delayed about a month, as we made sure that there was no permanent impairment to value. We did get comfortable and closed in February.

The exit of the market has created some dislocation of business in the first few months due to the supporting markets -- continuing supporting markets as they gear up to support the business.

We obtained a great experienced management team as part of the deal and they are committed to managing through this transaction and to aligning expenses with revenues. We fully expect them to make a positive contribution to our earnings, as we move into the second half of the year.

This is a good deal for First Mercury and will serve us very well as an underwriting platform going forward. I will now hand off to John Marazza, our CFO.

John Marazza

Thanks, Richard. As Richard said, we are pleased with another solid quarter. Operating net income for the first quarter was $10 million compared to $9.9 million for the same period in 2007. Diluted net income per common share was $0.53 for the first quarter. As we have said before, we report operating net income, which is a non-GAAP financial measure, and 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 these adjustments.

Our annualized return on average stockholders equity for the first quarter was 16.6%, which is consistent with our full year 2008 guidance of a range of 16.5% to 18%. As indicated in the narrative of our press release, premiums produced, which consists of all the premiums underwritten by the company's underwriting platforms, including coverage -- CoverX, for which we take risk, were $81.3 million for the first quarter, up $17 million or 26.5% over the same period in 2007.

As Richard said, the increase for the first quarter was primarily due to the production from our new contract underwriting programs and our new E&S underwriting platform, which we refer to as FM Emerald. These contract underwriters and FM Emerald both have established books of business and underwriters, who have experience across multiple market cycles.

Gross written premiums were $81.2 million for the first quarter of 2008, an increase of $20.6 million or 34% over the same period in 2007. The increase in gross written premiums for the quarter was primarily due to the increase in premiums produced I just mentioned, and also to an increase in assumed written premiums due to an increase in the assumed quota share from 30% to 100% on a portion -- on the admitted portion of our legal liability program, which is written through a front-end carrier.

Net earned premiums for the quarter were $43.6 million compared to $44.9 million for the first quarter of 2007. As previously reported, net earned premiums for the fourth quarter of last year included $17.6 million of net earned premium from the onetime year-end 2006 reinsurance cutoff transaction. So, if you remove the impact of the 2006 reinsurance cutoff transaction on the first quarter of 2007, net earned premiums for the first quarter of 2008 actually increased approximately 60% over last year.

And also as we mentioned in our last conference call, we did increase our net retention on our quota share reinsurance treaty covering our securities special and legal liability business at the beginning of this year from 65% to 90%.

Our underwriting results continue to be strong, with a loss ratio of 53.8% for the first quarter of 2008 compared to 53.3% for the comparable period in '07. As Richard said, for the three-month period there was no change in loss reserves for prior action at years.

Our expense ratio for the three-month period increased to 21.2% from 20.4% for the year ago period. The increase in the expense ratio for the first quarter was anticipated and is attributable to the impact of purchasing less quota share reinsurance in 2008, and to our investment in our new underwriting platforms.

Also, as Richard mentioned, we successfully completed the acquisition of AMC in February. The purchase price for AMC was $38.5 million, and was financed through holding company cash. AMC produced approximately $95 million of premium in 2007, with approximately 87% of this business on the admitted basis. In addition, AMC owns American Underwriters Insurance Company, or AUIC, which is a single state nonstandard auto insurance company.

In connection with this acquisition, commissions and fee income and underwriting agency and other expenses in the first quarter of 2008 include the commissions and fee income and the related expenses of AMC for two months of activity from the date of acquisition to the end of the quarter. Additionally, the estimated fair value of assets acquired and liabilities assumed are included in our balance sheet, and include goodwill of $25.1 million and intangible assets of $11.8 million.

Finally, except for the nonstandard auto business written through AUIC, we do not plan to take any underwriting risk on business produced by AMC in 2008. Net investment income in the first quarter increased 47.3% from the first quarter of 2007. At March 31, 2008 the effective duration on our investment portfolio was 3.1 years, and the taxable equivalent yield was 4.8%.

Our balance sheet remains strong. Cash and invested assets increased to $494.8 million compared to $477.7 million at December 31, 2007. As we have said before, our invested assets consist primarily of high-quality fixed-income investments. We use four outside investment managers that specialize in the insurance industry, and who have invested our assets consistent with our conservative investment guidelines.

Our municipal securities, which comprised 46% of our investment portfolio, are of extremely high credit quality, given our investment managers' constant focus on the underlying credit in these investments. These municipal securities are rated AA plus, with an average underlying credit quality of AA. Additionally, we have virtually no subprime exposure. We have no exposure to CDOs, and we have no exposure to auction rate securities, either directly or indirectly.

Our net loss and loss adjustment expense reserves total $198.2 million and 69.8% of the net loss and loss adjustment expense reserves relate to incurred but not reported claims.

We continue to maintain our moderate financial and operational leverage. Annualized net premiums written to surplus is approximately 1.16 to 1. Our debt to total capital is 21.9%, down slightly from 22.6% at December 31, 2007. Our debt consists entirely of trust-preferred securities, which receive partial equity treatment from our rating agencies.

At March 31, 2008 book value per outstanding share grew 2.7% to $13.10 per share compared to $12.76 per share at December 31, 2007. We were pleased to report that book value was not adversely affected by the fluctuations in the Capital Markets due to the high credit quality of our fixed-income investments and our minimal direct exposure to equity securities.

That is an overview of our solid first quarter. I will now turn it back to Richard for concluding remarks.

Richard Smith

Thanks, John. I think with the modest exception of the anticipated AMC transition issue, the first quarter results were exceptional. We are well-positioned to continue our track record of profitable growth for the remainder of this year and into 2009. We are confirming guidance of 20% plus growth and 16.5% to 18% ROE.

I will now open it up for questions. Thank you.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). And we start our first question from the line of Mark Lane of William Blair and company. Hello Mr. Lane.

Mark Lane - William Blair and company

First on the loss side, why given the pricing pressure and the rapid growth in new business, why aren’t we seeing a little bit more pressure on the accident year loss ratio?

John Marazza

Mark, this is John. We didn't hear the first part of that question. But I think you're wanting to know, looking at the accident year loss ratio in the first quarter versus last year --.

Mark Lane - William Blair and company

Yes, basically, from the pricing pressure and the fact that you are writing so much new business why aren't we seeing maybe a little bit more pressure there?

John Marazza

I think when you look at the first quarter versus last year, during '07 if you look at the accident year loss ratio in the fourth quarter it was what, Jim?

Jim Thomas

52.6.

John Marazza

52.6, because we saw good experience emerging during the year. We had done two actuarial studies last year. So, if you look at the fourth quarter accident year loss ratio and the first quarter, you do see that we're trending that for what we are seeing in pricing.

You're not going to -- since the pricing -- since a lot of the earned premium in the first quarter was written under last year's prices, you don't see -- you see that sort of grading quarter over quarter. And if you look at that sort of annualize that quarterly change that’s probably in line with what we're talking about our pricing.

Mark Lane - William Blair and company

Is the contract underwriting business a similar loss ratio type of business?

John Marazza

Yes, it is. And remember that have a smaller impact on our accident year loss ratio because we buy more reinsurance on that business.

Mark Lane - William Blair and company

Then the second question is on expenses. So, given you highlighted the investment in the new platforms and the impact from the reduction in the quarter share reinsurance, given your production targets, how would you expect the expense ratio to track for the rest of the year, particularly given the impact of the acquisition?

John Marazza

Again, we don't give loss and expense ratio guidance because the impact on those things, by the way, we decide it by reinsurance. But I think if you look at a lot of the numbers that are out there, you see that number is staying fairly flat through the year. As these new businesses ramp up, I think what you're going to see maybe a little improvement in the direct expense ratio that offset by the impact of buying less reinsurance. So, sort of flattish this year.

Mark Lane - William Blair and company

That’s helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Amit Kumar of Fox-Pitt Kelton. Please go ahead with your question.

Amit Kumar - Fox-Pitt Kelton

I guess just going back to the discussion, perhaps going back to the contract book, can you just refresh us what some of these programs were, the type of business, the limits, the losses? Just give some more color so that I think we can understand that when the E&S market is going down, even if you're growing at this stage and I understand a lot of these are new programs and obviously they're coming from somewhere else. Just trying to understand that a bit better.

Richard Smith

This is Richard Smith. I'm going to give a quick overview. I would note that if you go to our website, we just put a -- we put up about a month ago an investor presentation, and we actually have a fair amount of detail on --.

Amit Kumar - Fox-Pitt Kelton

Yes, I have that in front of me.

Richard Smith

Okay. So, it's perfect. So, again the lawyers’ professional liability, we have had that for over two years now. The first thing I should say for all of these programs, the profile of the limits is very consistent with what we see in our CoverX, typically $1 million of current limits for all these policies. So, there is nothing in these policies that have excess exposure. All of these are reinsured, so if you look in that presentation at the view of our net retention on any individual account, it’s very consistent. We buy excess and then we buy typically quota share, or have a risk partner.

The lawyers’ professional liability we have had for a couple of years now. We actually -- the reinsurance purchase on that program is made through what we call our mainframe program, so is added to the CoverX platform.

We have a hospitality habitation through a small account program. It tends to be nightclubs, restaurants, things like that. We have had that for a year now. We actually brought that up in April of last year. Again, $1 million policies, and they also the policies in this program also include a small amount of property exposure, which we use a similar reinsurance approach. In this case the contract underwriter takes half of the risk on all of this business.

We have a GL habitational program. This is written through an MGA on the East Coast, who has a big property book, and has been in business for a long time. So, it’s offering the GL for the property exposures. Again, $1 million policies heavily reinsured, that consistent with what we have done.

Texas non-subscriber work comp. In Texas you can opt out of work comp, and it basically converts the work comp coverage to a GL, $1 million policy and an outdoor recreation E&S. Again, this is guides, outdoor guides, fishing guides, a wide variety of things, again $1 million policies.

Amit Kumar - Fox-Pitt Kelton

That’s helpful. I guess you talked about these being heavily reinsured and I guess over time your retention will rise on this book. Typically what’s the profile? How long will you look at the numbers and then increase the retention going forward?

Richard Smith

On our recent -- you can see on -- since you have page 17 in front of you and everybody else doesn't, on our recent investor visits -- our retention for the aggregate on these programs is less than 50%. But for instance in the case of lawyers’ liability, we have had the program over two years, we have raised that retention. So, we would all of these come with long time experience before they come to us. We would put them on our platform, heavily reinsured, and over the first few years make a decision, whether it fits with our profile strategically, and decide exactly what amount of reinsurance that we will buy. We tend to buy less reinsurance over time as we get comfortable with the volatility in the results.

Amit Kumar - Fox-Pitt Kelton

Okay. That’s helpful. Just moving on to FM Emerald, I think you talked about the premiums previously, I think $40 million, $50 million, right, for '08? I guess that’s on track, right?

Richard Smith

Yes, we had a little over $5 million in the first quarter, and that will continue to ramp up as they just came online in late October. And so you can pretty much straight line with a ruler the ramp up we expect for that program to get to the $40 million to $50 million total for the year. We have the heavy reinsurance on that. Our aggregate retention on those programs is less than 30%.

Amit Kumar - Fox-Pitt Kelton

And in terms of just the competition in both these segments, whom do you typically run against, the mid-level E&S guys or I guess the smaller E&S guys?

Richard Smith

It depends on the individual. There's a big difference. There is a big difference in each of the individual programs. These are, again except in the case First Mercury Emerald has some larger account business, where we would typically run into maybe the larger players on the E&S side, but for these other programs it can be admitted carriers. It can be, for instance on the outdoor recreation E&S we write that through an MGA that was recently purchased by Philadelphia. So, we continue to write the E&S piece of that book. It’s a variety of carriers. It would tend to be the profile of the same people CoverX competes with, and that’s small to midsize E&S carriers or other MGAs.

Amit Kumar - Fox-Pitt Kelton

Got it. I guess my final question is that we have heard a lot of your peers talk about how standard lines carriers have been stepping into E&S and taking away a lot of market share. Could you just talk what sort of impact you might be seeing from the standard carriers?

Richard Smith

We do see an impact. Obviously, that’s part of the overall competitive profile and the only thing I will remind everyone that we say consistently, we write smaller account business. Our average account size on the security business is $7,000. The average account size on our specialty business is about $30,000. So, we're not in the mainstream of other admitted markets or other large E&S carriers attacking it. We are seeing that and we are seeing pressure in certain places on terms and conditions, but not across the entire book.

Amit Kumar - Fox-Pitt Kelton

Got it, okay. Thanks so much, very helpful.

Operator

Thank you, sir. Next question comes from the line of Bob Farnam of KBW. Please go ahead with your question.

Bob Farnam - KBW

Yes. Hi, good morning. I have a couple of questions. Going back to the contract underwriters, I think you -- I am just curious if you are still seeing more prospects for that business? I mean, is there any more out there in the pipeline that you might be thinking of picking up?

Richard Smith

I purposely, because Bob I talked about the pipeline every quarter, I just decided everybody was tired of it. But, yes, we still have a pipeline that’s actually very active right now. We have our hands full with the new platforms, but we are seeing some good opportunities out there. And at anytime we are probably looking at four or five or six things that either could fall under contract programming or small M&A type opportunities. We are still seeing a good pipeline and we continue to work it.

Bob Farnam - KBW

The next question I have was related to the AMC, the subsidiary, the insurance company, American Underwriting. Nonstandard auto in Arkansas doesn't sound like your typical -- it doesn't fit into the rest of your book of business. What are your plans for that business going forward?

Richard Smith

That’s a business that -- it is a one state very modest sized operation, $8 million. The AMC Group has a plan that they think they can execute to expand that business. But we all agreed, including with the AMC Group that now is probably not the time to attack the nonstandard auto segment of business.

So, we're sitting in place right now. The group thinks that there are some modest improvements that can come from a rating change on the company. So, we're talking about A.M. Best, about what that might look like. So, with the other transition issues we have, we're addressing those first for the mainframe business. We're trying to talk about an upgrade and then we will monitor the market and decide what our best strategy is concerning that small -- the total business Bob, is $8 million right now.

Bob Farnam - KBW

So, it would be in a holding period for now?

Richard Smith

We are in an absolute holding period, yes.

Bob Farnam - KBW

Okay. And the last question I have is -- I understand the insurance underwriting -- well, the insurance services commission fees went up due to AMC. The insurance underwriting fees were down year-over-year. I'm just curious what would be driving that?

Ed LaFramboise

Bob, its Ed. In the insurance underwriting quarter-over-quarter, first quarter of last year there was about $550,000 of profit sharing on fronted business that was recorded in the first quarter of '07, that’s not in the first quarter of '08. That is the reason for the decrease.

Bob Farnam - KBW

Okay. That’s it from me, thanks.

Operator

Thank you, sir. (Operator Instructions). Our next question comes from the line of Matthew Heimermann of JPMorgan. Please go ahead.

Matthew Heimermann - JPMorgan

Good morning. I was worried I was not in the queue. I guess one question I had with AMC was just, you talked about the insurance carrier that you had to replace. Can you just give us a more insight into, where that process is, and how much business perhaps was put in play or disrupted -- if disrupted is a better word?

Richard Smith

I don't have the exact numbers right in front of me, so I will qualify ahead that these are round numbers. But there were two carriers, both very large public companies -- unnamed public companies in great markets.

The carrier that told us they were not going forward represents about one-third of the business -- of the core business of AMC. The other carrier represented two-thirds. So, the other carrier, as I just mentioned, was very receptive to picking up the business, but I will remind you this is an admitted business, so the period of transition is that the larger existing carrier had to do some modification to rate filings and underwriting guides and things like that to be able to move in and support AMC to get that business.

So, it’s about one-third of the business is in what we will call a disruptive state. And we expect the disruption period to be three or four months, but not complete because some of the filings will come online and some of the things -- the going forward carrier has been very supportive and very interested in the business. So, we think it’s probably a three or four month period. And as know our guys told you, at the end of that three or four month period, we will take a look at what we think the new run rate is and make sure match the expenses to the run rate.

Matthew Heimermann - JPMorgan

Okay and then just following up on that, if I understand AMC correctly, it’s mostly admitted business, the customer relationships are really resided with AMC. So, I guess is this a situation, where for a time one-third of this business -- well, a quarter of one-third of the business, which is impacted by this three to four month period, might be retained by this departing carrier, or are there other markets that AMC maybe able to scramble to bridge the gap in the interim?

Richard Smith

We're doing both of those. The remaining market is being supportive, where they can to help us with retaining some of the business, and other supporting markets through relationships. We're doing all of that right now. But the concentration is making sure that the continuing carrier is up and operating with all the filings needed to support this.

Matthew Heimermann - JPMorgan

That's fair.

Richard Smith

As we said, we knew about this upfront, and we don't look at it as diminishing the value. This is just sort of a disruption that we knew we were going to have to go through.

Matthew Heimermann - JPMorgan

That's fair. And then just on the value, John, you ran through the goodwill and intangibles associated with AMC quicker than I could write. Could you just give those to me again?

John Marazza

Yeah, sure. The goodwill was $25.1 million.

Matthew Heimermann - JPMorgan

Okay.

John Marazza

Intangible assets of $11.8 million.

Matthew Heimermann - JPMorgan

Okay.

John Marazza

And the purchase price is in the release.

Matthew Heimermann - JPMorgan

Okay, that's fair. Then on the tax rate, I guess it was running a bit lower than I had anticipated, especially given that I suspected the fee business would have a slightly higher tax rate than your existing business mix. So, I guess, am I missing something with respect to just the contribution from net investment income going up and not be being heavily municipal, that’s impacting that? I just want to make sure I don't screw that up.

Ed LaFramboise

Matt, this is Ed. That is correct, where we do have a more substantial piece of our investment income coming from tax-exempt securities. So, in the first quarter of '07 tax-exempt interest was decreasing the effective tax rate by 2.6%, whereas in the fourth quarter of '08 it was decreasing the effective tax rate by 4.1%.

John Marazza

The first quarter of '08.

Ed LaFramboise

First quarter of '08. I'm sorry.

Matthew Heimermann - JPMorgan

Okay, all right. So, that’s there will probably be a little bit of upward drift from AMC being added on to the extent that remains -- the income, not underwriting income, but otherwise is looks pretty good, I guess, to read between the lines.

Ed LaFramboise

I would agree.

Matthew Heimermann - JPMorgan

Okay. The last thing was, are you going to -- any timing to posting in a supplement the other quarters for '07 on the produced gross written side?

John Marazza

Yes, Matt. Yeah, that’s a good concept thought. We had a couple of inquiries about that, so we are going to go ahead and put that supplemental in - yeah the production by underwriting platform for last year on the website. It will probably go up probably today or tomorrow?

Matthew Heimermann - JPMorgan

Okay, perfect. And then I don't have to bother you about general -- not to gross question. All right, thanks so much, guys.

John Marazza

Matt, thanks a lot.

Operator

Thank you. (Operator Instructions). Our next question comes from the line of Doug Mewhirter of Ferris, Baker Watts. Please go ahead.

Doug Mewhirter - Ferris, Baker Watts

Good morning. I just had a couple of different questions. First, could you just refresh my memory -- I apologize for my ignorance on, but the type of business that FM Emerald writes or intends to write?

Richard Smith

Sure, three classes of business. And I think on the material and on the website it breaks out about 40% is expected to be excess and umbrella business, about 20% expected primary -- large primary business about 20% property.

Doug Mewhirter - Ferris, Baker Watts

Okay, thanks that’s helpful. My next question is about your capital position. Is there a premium, a surplus or some leverage area where maybe you would start to think a little harder about where your capital is?

It seems like you are pretty comfortably capitalized right now. But you're also -- you're increasing retentions faster than you're growing your top line, so I was wondering where you might start bumping up into some constraints?

John Marazza

We obviously look at it very carefully, and we're very mindful of how A.M. Best looks at it. We do generate a fair amount of capital to support the top line, and we monitor it pretty carefully. But at this point, just looking through '08, we are projecting in fine shape, the way Best would be looking at us this year on all of our ratios.

Doug Mewhirter - Ferris, Baker Watts

Okay, great. And my last question is very quick. What was your operating cash flow this quarter and in the same quarter last year?

Richard Smith

It is in the supplemental material in the press release. It was the first quarter of '08, it was $26.2 million compared to $51.6 in the first quarter '07.

Doug Mewhirter - Ferris, Baker Watts

$51.6 million?

Richard Smith

Yes.

Doug Mewhirter - Ferris, Baker Watts

Okay, thanks. That’s all my question.

Operator

Okay. Thank you, sir. Mr. Smith, there are no further questions. If you would, please continue with any closing remarks you may have.

Richard Smith

Thank you for your continuing support. We look forward to either talking to you individually or next quarter. Thank you.

Operator

Ladies and gentlemen, this concludes the First Mercury Financial Corporation first quarter 2008 earnings conference call. We thank you for your participation. You may now disconnect.

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