UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FIRST MERCURY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Delaware		38-3164336
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
29110 Inkster Road
Suite 100
Southfield, Michigan		48034
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (800) 762-6837

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes   þ     No   o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes   o     No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes   o     No   þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of shares of Common Stock, par value $0.01, outstanding on November 5, 2010 was 17,752,360

 

 

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS

Item				Page
		PART I — FINANCIAL INFORMATION
1.		Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets			3
		Condensed Consolidated Statements of Income			4
		Condensed Consolidated Statements of Stockholders’ Equity			5
		Condensed Consolidated Statements of Cash Flows			6
		Notes to Condensed Consolidated Financial Statements (Unaudited)			7
2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
3.		Quantitative and Qualitative Disclosures about Market Risk			45
4.		Controls and Procedures			45
		PART II — OTHER INFORMATION
1.		Legal Proceedings			46
1A.		Risk Factors			46
6.		Exhibits			47
EX-31.A
EX-31.B
EX-32.A
EX-32.B

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

PART I. — FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets

		September 30,				December 31,
		2010				2009
		(Unaudited)
		(Dollars in thousands,
		except share and per share data)
ASSETS
Investments
Debt securities		$	688,556			$	648,522
Equity securities and other			42,328				38,752
Short-term			40,710				12,216
Total Investments			771,594				699,490
Cash and cash equivalents			13,771				14,275
Premiums and reinsurance balances receivable			48,576				78,544
Accrued investment income			6,220				6,248
Accrued profit sharing commissions			8,903				14,661
Reinsurance recoverable on paid and unpaid losses			216,003				172,711
Prepaid reinsurance premiums			63,072				57,374
Deferred acquisition costs			24,197				25,654
Intangible assets, net of accumulated amortization			35,590				37,104
Goodwill			25,483				25,483
Other assets			44,421				26,049
Total Assets		$	1,257,830			$	1,157,593
LIABILITIES AND STOCKHOLDERS’ EQUITY
Loss and loss adjustment expense reserves		$	566,886			$	488,444
Unearned premium reserves			149,491				146,773
Long-term debt			67,013				67,013
Line of credit			30,000				4,000
Funds held under reinsurance treaties			80,409				71,661
Premiums payable to insurance companies			29,767				31,167
Reinsurance payable on paid losses			1,221				958
Deferred federal income taxes			17,821				13,844
Accounts payable, accrued expenses, and other liabilities			13,523				17,649
Total Liabilities			956,131				841,509
Stockholders’ Equity
Common stock, $0.01 par value; authorized 100,000,000 shares; issued and outstanding 17,752,360 and 17,181,106 shares			178				172
Paid-in-capital			157,535				154,417
Accumulated other comprehensive income			28,020				16,256
Retained earnings			117,814				147,087
Treasury stock; 134,500 shares			(1,848	)			(1,848	)
Total Stockholders’ Equity			301,699				316,084
Total Liabilities and Stockholders’ Equity		$	1,257,830			$	1,157,593

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Income
(Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
		(Dollars in thousands, except share and per share data)
Operating Revenue
Net earned premiums		$	49,236			$	51,512			$	152,413			$	155,539
Commissions and fees			40				7,445				15,699				23,916
Net investment income			8,349				7,540				25,434				21,105
Net realized gains on investments			7,671				13,766				10,354				25,204
Other-than-temporary impairment losses on investments:
Total losses			(214	)			(761	)			(1,339	)			(1,631	)
Portion of losses recognized in accumulated other comprehensive income			103				469				684				1,205
Net impairment losses recognized in earnings			(111	)			(292	)			(655	)			(426	)
Total Operating Revenues			65,185				79,971				203,245				225,338
Operating Expenses
Losses and loss adjustment expenses, net			42,531				30,345				108,114				96,301
Amortization of deferred acquisition expenses			13,269				13,960				40,024				40,889
Underwriting, agency and other expenses			11,215				10,169				35,071				28,919
Amortization of intangible assets			482				559				1,515				1,709
Restructuring			—				—				5,018				—
Total Operating Expenses			67,497				55,033				189,742				167,818
Operating Income (Loss)			(2,312	)			24,938				13,503				57,520
Interest Expense			1,554				1,446				4,483				4,278
Change in Fair Value of Derivative Instruments			—				(171	)			—				(401	)
Income (Loss) Before Income Taxes			(3,866	)			23,663				9,020				53,643
Provision for (Benefit from) Income Taxes			(1,835	)			8,018				1,694				17,707
Net Income (Loss)		$	(2,031	)		$	15,645			$	7,326			$	35,936
Net Income (Loss) Per Share:
Basic		$	(0.11	)		$	0.90			$	0.42			$	2.03
Diluted		$	(0.11	)		$	0.89			$	0.41			$	1.99
Weighted Average Shares Outstanding:
Basic			17,469,803				17,144,077				17,343,255				17,537,754
Diluted			17,469,803				17,486,020				17,435,544				17,877,126

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity
(Unaudited)

										Accumulated
										Other
		Common				Paid-in				Comprehensive				Retained				Treasury
		Stock				Capital				Income (Loss)				Earnings				Stock				Total
		(Dollars in thousands)
Balance, January 1, 2009		$	178			$	161,957			$	(3,027	)		$	103,028			$	(499	)		$	261,637
Issuance of restricted stock			1				(1	)			—				—				—				—
Exercise of stock options			1				8				—				—				—				9
Stock-based compensation expense			—				2,288				—				—				—				2,288
Stock-based compensation excess tax benefits			—				(21	)			—				—				—				(21	)
Common stock repurchased and held in treasury			—				—				—				—				(1,349	)			(1,349	)
Common stock repurchased and retired			(8	)			(10,479	)			—				—				—				(10,487	)
Payment of shareholder dividend			—				—				—				(873	)			—				(873	)
Comprehensive income:
Net income			—				—				—				35,936				—				35,936
Cumulative effect of adoption of FASB ASC 320-10 at April 1, 2009			—				—				(999	)			999								—
Other comprehensive income, net of tax
Unrealized holding losses on securities arising during the period having credit losses recognized in the condensed consolidated statements of income, net of tax of $422			—				—				(783	)			—				—				(783	)
Unrealized holding gains on securities arising during the period having no credit losses recognized in the condensed consolidated statements of income, net of tax of ($12,377)			—				—				22,986				—				—				22,986
Change in fair value of interest rate swaps, net of tax of $268			—				—				(498	)			—				—				(498	)
Less reclassification adjustment for gains included in net income, net of tax of $739			—				—				(1,373	)			—				—				(1,373	)
Total other comprehensive income			—				—				20,332				—				—				20,332
Total comprehensive income			—				—				20,332				35,936				—				56,268
Balance, September 30, 2009		$	172			$	153,752			$	16,306			$	139,090			$	(1,848	)		$	307,472
Balance, January 1, 2010		$	172			$	154,417			$	16,256			$	147,087			$	(1,848	)		$	316,084
Issuance of restricted stock			2				(2	)			—				—				—				—
Exercise of stock options			4				1,089				—				—				—				1,093
Stock-based compensation expense			—				2,053				—				—				—				2,053
Stock-based compensation excess tax benefits			—				(22	)			—				—				—				(22	)
Payment of shareholder dividends			—				—				—				(36,599	)			—				(36,599	)
Comprehensive income:							—
Net income			—				—				—				7,326				—				7,326
Other comprehensive income, net of tax
Unrealized holding gains on securities arising during the period having credit losses recognized in the condensed consolidated statements of income, net of tax ($378)			—				—				702				—				—				702
Unrealized holding gains on securities arising during the period having no credit losses recognized in the condensed consolidated statements of income, net of tax ($8,325)			—				—				15,460				—				—				15,460
Change in fair value of interest rate swaps, net of tax of $272			—				—				(506	)			—				—				(506	)
Less reclassification adjustment for gains included in net income, net of tax of $2,095			—				—				(3,892	)			—				—				(3,892	)
Total other comprehensive income			—				—				11,764				—				—				11,764
Total comprehensive income			—				—				11,764				7,326				—				19,090
Balance, September 30, 2010		$	178			$	157,535			$	28,020			$	117,814			$	(1,848	)		$	301,699

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
(Unaudited)

		Nine Months Ended
		September 30,
		2010				2009
		(Dollars in thousands)
Cash Flows from Operating Activities
Net Income		$	7,326			$	35,936
Adjustments to reconcile income to net cash provided by operating activities
Depreciation and amortization			3,006				3,051
Net investment income on alternative investments			(1,880	)			(1,338	)
Realized gains on investments			(10,354	)			(25,204	)
Other-than-temporary impairment losses on investments			655				426
Deferrals of acquisition costs, net			1,457				1,060
Deferred income taxes			(2,358	)			5,716
Stock-based compensation expense			2,053				2,288
Increase (decrease) in cash resulting from changes in assets and liabilities
Premiums and reinsurance balances receivable			29,968				3,930
Accrued investment income			28				(540	)
Accrued profit sharing commissions			5,757				(2,526	)
Reinsurance recoverable on paid and unpaid losses			(43,292	)			(32,185	)
Prepaid reinsurance premiums			(5,698	)			(10,863	)
Loss and loss adjustment expense reserves			78,442				75,544
Unearned premium reserves			2,718				2,806
Funds held under reinsurance treaties			8,749				17,674
Reinsurance payable on paid losses			263				12
Premiums payable to insurance companies			(1,401	)			3,532
Other			(9,195	)			(14,051	)
Net Cash Provided By Operating Activities			66,244				65,268
Cash Flows From Investing Activities
Cost of short-term investments acquired			(209,916	)			(238,579	)
Proceeds from disposals of short-term investments			165,849				259,966
Cost of debt and equity securities acquired			(179,557	)			(213,818	)
Proceeds from disposals of debt and equity securities			166,404				121,256
Net Cash Used In Investing Activities			(57,220	)			(71,175	)
Cash Flows From Financing Activities
Stock issued on stock options exercised			1,093				9
Purchase of common stock			—				(10,487	)
Payment of shareholder dividends			(36,599	)			(873	)
Cash retained on excess tax benefits			(22	)			(21	)
Purchase of treasury stock			—				(1,349	)
Net borrowings under credit facility			26,000				3,000
Net Cash Used In Financing Activities			(9,528	)			(9,721	)
Net Decrease In Cash and Cash Equivalents			(504	)			(15,628	)
Cash and Cash Equivalents, beginning of period			14,275				31,833
Cash and Cash Equivalents, end of period		$	13,771			$	16,205
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest		$	4,379			$	4,137
Income taxes		$	10,150			$	8,100

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Basis of Presentation

     The accompanying condensed consolidated financial statements and notes of First Mercury Financial Corporation and subsidiaries (“FMFC” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Readers are urged to review the Company’s 2009 audited consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2009 for a more complete description of the Company’s business and accounting policies. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. Such adjustments consist only of normal recurring items. Interim results are not necessarily indicative of results of operations for the full year. The consolidated balance sheet as of December 31, 2009 was derived from the Company’s audited annual consolidated financial statements.

     Significant intercompany transactions and balances have been eliminated.

     Use of Estimates

     In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements, and revenues and expenses reported for the periods then ended. Actual results may differ from those estimates. Material estimates that are susceptible to significant change in the near term relate primarily to the determination of the reserves for losses and loss adjustment expenses and valuation of investments, intangible assets and goodwill.

     Reclassifications

     Certain prior period amounts have been reclassified to conform to the current year presentation.

     Recently Issued Accounting Standards

     In January 2010, the FASB issued an update to the Accounting Standards Codification (ASC) related to fair value measurements and disclosures. This ASC update provides for additional disclosure requirements to improve the transparency and comparability of fair value information in financial reporting. Specifically, the new guidance requires separate disclosure of the amounts of significant transfers in and out of Levels 1 and 2, as well as the reasons for the transfers, and separate disclosure for the purchases, sales, issuances and settlement activity in Level 3. In addition, this ASC update requires fair value measurement disclosure for each class of assets and liabilities, and disclosures about the input and valuation techniques used to measure fair value for both recurring and nonrecurring fair value measurements in Levels 2 and 3. The new disclosures and clarifications of existing disclosures are effective for annual or interim reporting periods beginning after December 15, 2009, except for the requirement to provide Level 3 activity detail which will become effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. Early adoption is permitted. These amendments do not require disclosures for earlier periods presented for comparative purposes at initial adoption. The adoption of this guidance during 2010 is included in Note 5, “Fair Value Measurements” to the condensed consolidated financial statements.

     In September 2009, the FASB issued updated guidance on the accounting for variable interest entities that eliminates the concept of a qualifying special-purpose entity and the quantitative-based risks and rewards calculation of the previous guidance for determining which company, if any, has a controlling financial interest in a variable interest entity. The guidance requires an analysis of whether a company has: (1) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (2) the obligation to absorb the losses that could potentially be significant to the entity or the right to receive benefits from the entity that could potentially be significant to the entity. An entity is required to be re-evaluated as a variable interest entity when the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights to direct the activities that most significantly impact the entity’s economic performance. Additional disclosures are required about a company’s involvement in variable interest entities and an ongoing assessment of whether a company is the primary beneficiary. The guidance is effective for all variable interest entities owned on or formed after January 1, 2010. The adoption of this guidance during 2010 did not have a material effect on the Company’s results of operations, financial position or liquidity.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – (Concluded)

     Prospective Accounting Standards

     In October 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-26, Financial Services – Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. The ASU amends FASB Accounting Standards Codification Topic 944, Financial Services – Insurance to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. ASU 2010-26 reflects the consensus reached in Emerging Issues Task Force (EITF) Issue No. 09-G, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts.”

     The guidance provides that the deferral of acquisition costs will be limited to incremental direct costs of contract acquisition that are incurred in transactions with independent third parties. In addition, future cash flows attributable to advertising costs should be accounted for using the direct-response advertising guidance in Subtopic 340-20 for capitalization purposes. The capitalized costs would then be treated as deferred acquisition costs pursuant to Subtopic 944-30 for classification, subsequent measurement and premium deficiency purposes. The guidance in the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011, and should be applied prospectively upon adoption. Retrospective application to all prior periods presented upon the date of adoption also is permitted, but not required.

     The adoption of this guidance will likely have a material effect on the Company’s results of operations and financial position. In the period of adoption and thereafter, the Company expects to capitalize less acquisition costs than those that would have been capitalized if the previous guidance had been applied, due to the narrowed definition of what constitutes an acquisition cost eligible for capitalization. The result will be a decrease in the Deferred acquisition costs asset balance in the Consolidated Balance Sheet, compared to the balance if the previous guidance had been applied. This lower asset balance will also result in lower amortization expense, presented as Amortization of deferred acquisition expenses in the Consolidated Statement of Income, in the period of adoption and thereafter compared to amortization recorded under the previous guidance. Lastly, by deferring less expense in the period of adoption and future periods, the result is an increase in expenses classified as Underwriting, agency and other in the Consolidated Statement of Income compared to those recorded if the previous guidance had been applied.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

2. NET INCOME (LOSS) PER SHARE

     Basic net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding for the period. Diluted net income (loss) per share reflects the potential dilution that could occur if common stock equivalents were issued and exercised.

     The following is a reconciliation of basic number of common shares outstanding to diluted common and common equivalent shares outstanding:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
		(Dollars in thousands, except share and per share data)
Net income (loss) as reported		$	(2,031	)		$	15,645			$	7,326			$	35,936
Net income (loss) allocated to unvested restricted stock shares			32				(141	)			(116	)			(316	)
Net income (loss) available to common		$	(1,999	)		$	15,504			$	7,210			$	35,620
Weighted-average number of common and common equivalent shares outstanding:
Basic number of common shares outstanding			17,469,803				17,144,077				17,343,255				17,537,754
Dilutive effect of stock options			—				341,943				92,289				339,372
Dilutive number of common and common equivalent shares outstanding			17,469,803				17,486,020				17,435,544				17,877,126
Net Income (Loss) Per Common Share:
Basic		$	(0.11	)		$	0.90			$	0.42			$	2.03
Diluted		$	(0.11	)		$	0.89			$	0.41			$	1.99
Anti-dilutive shares excluded from diluted net income (loss) per common share			1,072,705				1,112,688				1,053,022				1,112,688

     On January 1, 2009, we adopted new FASB accounting guidance which requires that unvested restricted stock with a nonforfeitable right to receive dividends be included in the two-class method of computing earnings per share. The adoption of this guidance did not have a material impact on our reported earnings per share amounts.

3. INVESTMENTS

     The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at September 30, 2010 by major security type were as follows:

						Gross Unrealized
		Amortized Cost				Gains				Losses				Market Value
		(Dollars in thousands)
Debt Securities
U.S. government securities		$	3,675			$	170			$	—			$	3,845
Government agency mortgage-backed securities			106,919				6,223				(9	)			113,133
Government agency obligations			1,009				33				—				1,042
Collateralized mortgage obligations and other asset-backed securities			117,441				12,476				(549	)			129,368
Obligations of states and political subdivisions			192,332				13,299				(62	)			205,569
Corporate bonds			152,653				15,839				(32	)			168,460
Total Debt Securities			574,029				48,040				(652	)			621,417
Preferred stocks			1,416				162				(129	)			1,449
Short-term investments			40,710				—				—				40,710
Total		$	616,155			$	48,202			$	(781	)		$	663,576

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

3. INVESTMENTS — (Continued)

     The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at December 31, 2009 by major security type were as follows:

						Gross Unrealized
		Amortized Cost				Gains				Losses				Market Value
		(Dollars in thousands)
Debt Securities
U.S. government securities		$	4,014			$	110			$	(3	)		$	4,121
Government agency mortgage-backed securities			98,278				3,820				(16	)			102,082
Government agency obligations			986				30				—				1,016
Collateralized mortgage obligations and other asset-backed securities			120,505				8,142				(3,033	)			125,614
Obligations of states and political subdivisions			198,252				9,310				(293	)			207,269
Corporate bonds			135,549				10,596				(505	)			145,640
Total Debt Securities			557,584				32,008				(3,850	)			585,742
Preferred stocks			1,416				121				(131	)			1,406
Short-term investments			12,216				—				—				12,216
Total		$	571,216			$	32,129			$	(3,981	)		$	599,364

     The amortized cost and market value of debt securities classified as available-for-sale, by contractual maturity, as of September 30, 2010 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the expected maturities of the Company’s investments in putable bonds fluctuate inversely with interest rates and therefore may also differ from contractual maturities.

		Amortized Cost				Market Value
		(Dollars in thousands)
Due in one year or less		$	73,841			$	74,750
Due after one year through five years			151,333				163,448
Due after five years through ten years			139,243				153,282
Due after ten years			27,378				29,595
			391,795				421,075
Government agency mortgage-backed securities			106,919				113,133
Collateralized mortgage obligations and other asset-backed securities			117,441				129,368
Total		$	616,155			$	663,576

     As of September 30, 2010 and December 31, 2009, the market value of convertible securities accounted for as hybrid instruments was $73.4 million and $69.5 million, respectively. Convertible bonds and bond units had a market value of $66.2 million and $61.4 million and were included in Debt securities in the Condensed Consolidated Balance Sheets at September 30, 2010 and December 31, 2009, respectively. Convertible preferred stocks had a market value of $7.2 million and $8.2 million and were included in Equity securities and other in the Condensed Consolidated Balance Sheets at September 30, 2010 and December 31, 2009, respectively. The Company recorded an increase in the fair value of the hybrid instruments of $3.0 million and a decrease of $2.9 million in Net realized gains on investments for the three months and nine months, respectively, ended September 30, 2010. As of September 30, 2010 and December 31, 2009, all convertible securities were accounted for as hybrid instruments in accordance with FASB accounting guidance.

Alternative Investments

     The Company has $17.0 million invested in a limited partnership, which invests in high yield convertible securities. The market value of this investment was $20.5 million at September 30, 2010. In addition, the Company has $10.0 million invested in another limited partnership, which invests in distressed structured finance products. The market value of this investment was $14.2 million at September 30, 2010. The Company elected the fair value option for these investments in accordance with FASB accounting guidance. The change in fair value of these investments is recorded in Net investment income and Net realized gains on investments in the Condensed Consolidated Statements of Income.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

3. INVESTMENTS — (Concluded)

The Company recorded an increase in the fair value of these alternative investments of $0.6 million and $1.9 million as Net investment income for the three and nine months ended September 30, 2010, respectively. Also, the Company recorded an increase in the fair value of these alternative investments of $1.1 million and $2.2 million recognized as Net realized gains on investments for the three and nine months ended September 30, 2010, respectively. These investments are recorded in Equity securities and other in the Condensed Consolidated Balance Sheets.

4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES

Impairment of Investment Securities

     Impairment of investment securities results when a market value decline below amortized cost is other-than-temporary. The other-than-temporary write down is separated into an amount representing the credit loss which is recognized in earnings and the amount related to all other factors which is recorded in other comprehensive income. Management regularly reviews our fixed maturity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost or amortized cost of the security, as appropriate, the length of time the investment has been below cost or amortized cost and by how much, our intent to sell a security and whether it is more-likely-than-not we will be required to sell the security before the recovery of our amortized cost basis, and specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment (OTTI) losses result in a reduction of the cost basis of the underlying investment. Significant changes in these factors we consider when evaluating investments for impairment losses could result in a change in impairment losses reported in the consolidated financial statements.

     With respect to securities where the decline in value is determined to be temporary and the security’s cost basis is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information and market conditions. Management of the Company’s investment portfolio is outsourced to third party investment managers which is directed and monitored by our investment committee. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available-for-sale.

     Investment managers are required to notify management of rating agency downgrades of securities in their portfolios as well as any potential investment valuation issues no later than the end of each quarter. Investment managers are also required to notify management, and receive prior approval, prior to the execution of a transaction or series of related transactions that may result in a realized loss above a certain threshold. Additionally, investment managers are required to notify management, and receive approval, prior to the execution of a transaction or series of related transactions that may result in any realized loss up until a certain period beyond the close of a quarterly accounting period.

     Under current accounting standards, an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered in circumstances where (1) an entity has the intent to sell a security, (2) it is more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more-likely-than-not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more-likely-than-not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES — (Continued)

     The following table presents a roll-forward of the credit component of OTTI on debt securities recognized in the Condensed Consolidated Statements of Income for which a portion of the OTTI was recognized in other comprehensive income for the period January 1, 2010 through September 30, 2010:

										Additions for
		January 1, 2010				Additions for OTTI				OTTI Securities				Reductions Due to				Adjustments to				September 30,
		Cumulative OTTI				Securities Where				Where Credit				Sales or				Book Value of				2010 Cumulative
		Credit Losses				No Credit Losses				Losses Have Been				Intend/Required to				Credit-Impaired				OTTI Credit Losses
		Recognized for				Were Recognized				Recognized Prior				Sell of Credit-				Securities due to				Recognized for
		Securities Still				Prior to				to				Impaired				Changes in Cash				Securities Still
		Held				Janaury 1, 2010				January 1, 2010				Securities				Flows				Held
		(Dollars in thousands)
Debt securities:
Mortgage-backed securities, collateralized mortgage obligations and passthrough securities		$	796			$	—			$	545			$	—			$	—			$	1,341
All other corporate bonds			569				110				—				(110	)			—				569
Total debt securities		$	1,365			$	110			$	545			$	(110	)		$	—			$	1,910

     The Company determines the credit loss component of fixed maturity investments by utilizing discounted cash flow modeling to determine the present value of the security and comparing the present value with the amortized cost of the security. If the amortized cost is greater than the present value of the expected cash flows, the difference is considered credit loss and recognized in the Condensed Consolidated Statements of Income.

     The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at September 30, 2010:

		Less than 12 Months								Greater than 12 Months
		Fair Value								Fair Value
		of								of
		Investments								Investments
		With				Gross				With				Gross
		Unrealized				Unrealized				Unrealized				Unrealized
		Losses				Losses				Losses				Losses
		(Dollars in thousands)
Debt Securities
U.S. government securities		$	—			$	—			$	—			$	—
Government agency mortgage-backed securities			3,052				(9	)			—				—
Government agency obligations			—				—				—				—
Collateralized mortgage obligations and other asset-backed securities			8,548				(105	)			6,219				(444	)
Obligations of states and political subdivisions			—				—				1,216				(62	)
Corporate bonds			1,672				(30	)			955				(2	)
Total Debt Securities			13,272				(144	)			8,390				(508	)
Preferred Stocks			—				—				377				(129	)
Total		$	13,272			$	(144	)		$	8,767			$	(637	)

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES — (Continued)

     The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at December 31, 2009:

		Less than 12 Months								Greater than 12 Months
		Fair Value								Fair Value
		of								of
		Investments								Investments
		With				Gross				With				Gross
		Unrealized				Unrealized				Unrealized				Unrealized
		Losses				Losses				Losses				Losses
		(Dollars in thousands)
Debt Securities
U.S. government securities		$	359			$	(3	)		$	—			$	—
Government agency mortgage-backed securities			3,854				(16	)			—				—
Government agency obligations			—				—				—				—
Collateralized mortgage obligations and other asset-backed securities			8,438				(1,291	)			9,635				(1,742	)
Obligations of states and political subdivisions			14,044				(237	)			1,179				(56	)
Corporate bonds			4,551				(404	)			5,563				(101	)
Total Debt Securities			31,246				(1,951	)			16,377				(1,899	)
Preferred Stocks			—				—				375				(131	)
Total		$	31,246			$	(1,951	)		$	16,752			$	(2,030	)

     Below is a table that illustrates the unrecognized impairment loss by sector. The increase in spread relative to U.S. Treasury Bonds was the primary factor leading to impairment for the periods ended September 30, 2010. All asset sectors were affected by the overall increase in spreads as can be seen from the table below. In addition to the level of interest rates, we also look at a variety of other factors such as direction of credit spreads for an individual issue as well as the magnitude of specific securities that have declined below amortized cost.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES — (Continued)

		Unrealized
		Loss at
		September 30,
Sector		2010
		(Dollars in thousands)
Debt Securities
U.S. Treasuries		$	—
U.S. Agencies			—
U.S. government securities			—
Government agency mortgage-backed securities			(9	)
Government agency obligations			—
MBS Passthroughs			(4	)
CMOs			(198	)
Asset Backed Securities			(210	)
Commercial MBS			(137	)
Collateralized mortgage obligations and other asset-backed securities			(549	)
Obligations of states and political subdivisions			(62	)
Corporate Bonds			(3	)
High Yield Bonds			(29	)
Corporate Bonds			(32	)
Total Debt Securities			(652	)
Preferred Stocks			(129	)
Short-term investments			—
Total		$	(781	)

     At September 30, 2010, there were 72 unrealized loss positions with a total unrealized loss of $0.8 million. This represents approximately 1.3% of the quarter end amortized cost of available-for-sale assets of $616.2 million. This unrealized loss position is a function of the purchase of specific securities in a lower interest rate or spread environment than what prevails as of September 30, 2010. Some of these losses are due to the increase in spreads of select corporate bonds or structured securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of the core fixed income portfolio excluding cash, convertible securities, and equity is approximately 3.6 years, and 3.3 years on a taxable equivalent basis. There have been certain instances over the past year where due to market based opportunities; we have elected to sell a small portion of the portfolio. These situations were unique and infrequent occurrences and in our opinion, do not reflect an indication that we intend to sell or will be required to sell these securities before they mature or recover in value.

     The most significant risk or uncertainty inherent in our assessment methodology is that the current credit rating of a particular issue changes over time. If the rating agencies should change their rating on a particular security in our portfolio, it could lead to a reclassification of that specific issue. The majority of our unrecognized impairment losses are investment grade and “AAA” or “AA” rated securities. Should the credit quality of individual issues decline for whatever reason then it would lead us to reconsider the classification of that particular security. Within the non-investment grade sector, we continue to monitor the particular status of each issue. Should prospects for any one issue deteriorate, we would potentially alter our classification of that particular issue.

     The table below illustrates the breakdown of impaired securities by investment grade and non-investment grade as well as the duration that these sectors have been trading below amortized cost. The average duration of the impairment has been greater than 12 months. The unrealized loss of impaired securities as a percent of the amortized cost of those securities is 3.4% as of September 30, 2010.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES — (Concluded)

		% of Total				Total				Total				Average Unrealized Loss				% of Loss
		Amortized Cost				Amortized Cost				Unrealized Losses				as % of Amortized Cost				> 12 Months
						(Dollars in thousands)
Non Investment Grade			34.7	%		$	7,929			$	384				4.8	%			88.2	%
Investment Grade			65.3				14,891				397				2.7				75.1
Total			100.0	%		$	22,820			$	781				3.4	%			81.6	%

     The majority of these securities are rated investment grade, BBB- or better. Of the $0.4 million of unrealized loss within non-investment grade, Alt-A and sub-prime Asset Backed Securities accounted for 54.2% of this loss. The next highest percent of the loss within non-investment grade were non-agency CMOs, which accounted for 37.2% of the loss. The remaining portion of the loss, or 8.6%, was within non-investment grade corporate bonds and one non-agency MBS passthrough. These issues are continually monitored and may be classified in the future as being other than temporarily impaired.

     The highest concentration of temporarily impaired securities is Asset Backed Securities at 26.9% of the total loss. The next largest concentration of temporarily impaired securities is CMOs at 25.3% of the loss, followed by Commercial MBS at 17.5%, Preferred Stocks at 16.5%, Municipal Bonds at 8.0%, Corporates at 4.0% and MBS Passthroughs at 1.8%. These securities have been affected primarily by the widening of spreads and/or general level of interest rates, and will continue to be monitored.

     For the nine months ended September 30, 2010, we sold approximately $4.3 million of market value of fixed income securities, excluding convertibles, which were trading below amortized cost while recording a realized loss of $0.1 million. This loss represented 2.5% of the amortized cost of the positions. These sales were unique opportunities to sell specific positions due to changing market conditions.

5. FAIR VALUE MEASUREMENTS

     According to FASB guidance for fair value measurements and disclosures, fair value is the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets, or “market approach” as defined by the FASB guidance.

     FASB guidance establishes a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”). The estimated fair values of the Company’s fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. The prices provided by this service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices, except as otherwise disclosed. The Company obtains an understanding of the methods, models and inputs used by the independent pricing service, and has controls in place to validate that amounts provided represent fair values, consistent with this standard. The Company’s controls include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service, a review of specific securities and an assessment for proper classification within the fair value hierarchy. The hierarchy level assigned to each security in our available-for-sale, hybrid securities, and alternative investments portfolios is based on our assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The three hierarchy levels are defined as follows:

•

Level 1 — Valuations based on unadjusted quoted market prices in active markets for identical securities. The fair values of fixed maturity and equity securities and short-term investments included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The Level 1 category includes publicly traded equity securities, highly liquid U.S. Government notes, treasury bills and mortgage-backed securities issued by the Government National Mortgage Association; highly liquid cash management funds; and short-term certificates of deposit.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. FAIR VALUE MEASUREMENTS — (Continued)

	•		Level 2 — Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of fixed maturity and equity securities and short-term investments included in the Level 2 category were based on the market values obtained from an independent pricing service that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other market information and price quotes from well established independent broker-dealers. The independent pricing service monitors market indicators, industry and economic events, and for broker-quoted only securities, obtains quotes from market makers or broker-dealers that it recognizes to be market participants. The Level 2 category includes corporate bonds, municipal bonds, redeemable preferred stocks and certain publicly traded common stocks with no trades on the measurement date.
	•		Level 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement, and involve management judgment.

     If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement. A number of our investment grade corporate bonds are frequently traded in active markets and traded market prices for these securities existed at September 30, 2010. These securities were classified as Level 2 at September 30, 2010 because our third party pricing service uses valuation models which use observable market inputs in addition to traded prices.

     The following table presents our investments measured at fair value on a recurring basis as of September 30, 2010 classified by the fair value measurements standard valuation hierarchy (as discussed above):

						Fair Value Measurements Using
		Total				Level 1				Level 2				Level 3
		(Dollars in thousands)
Available for sale investments:
Fixed maturity securities		$	622,866			$	3,845			$	619,021			$	—
Equity securities			—				—				—				—
Short-term investments			40,710				40,710				—				—
Hybrid securities			73,351				—				73,351				—
Alternative investments			34,667				—				14,207				20,460
Total		$	771,594			$	44,555			$	706,579			$	20,460

     The following table presents our investments measured at fair value on a recurring basis as of December 31, 2009 classified by the fair value measurements standard valuation hierarchy (as discussed above):

						Fair Value Measurements Using
		Total				Level 1				Level 2				Level 3
						(Dollars in thousands)
Available for sale investments:
Fixed maturity securities		$	587,148			$	4,121			$	583,027			$	—
Equity securities			—				—				—				—
Short-term investments			12,216				12,216				—				—
Hybrid securities			69,525				—				69,525				—
Alternative investments			30,601				—				12,427				18,174
Total		$	699,490			$	16,337			$	664,979			$	18,174

     Recent FASB guidance that we adopted in the first quarter of 2010 requires separate disclosure of the amounts of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers. There were no transfers between Level 1 and Level 2 during the three and nine months ended September 30, 2010.

     Level 3 assets at September 30, 2010 include a $20.5 million investment in a limited partnership. At times, this limited partnership will invest in highly illiquid high yield convertible securities for which observable inputs are not available. The general partner of this limited partnership values this investment through an internally developed pricing model. If a security is listed on a recognized exchange,

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

5. FAIR VALUE MEASUREMENTS — (Concluded)

it will be valued at the last sale price or the average of the highest current independent bid and lowest current independent offer for the security if there is not a reported transaction in the security on that day. If a security is traded over the counter, it shall be valued at the average of the highest current independent bid and lowest current independent offer reported upon the closing of trading on that day. If the market for a security exists predominantly through a limited number of market makers, the general partner will attain the bid and offer for the security made by at least two market makers in the security. The security shall then be valued at the mid-point of the quote that represents the fair value of the security, as determined under the circumstances and in the good faith judgment of the general partner. If the general partner determines in good faith, however, that the application of these rules does not properly reflect a security’s fair market value, then such security shall be valued at fair value as determined in good faith by the general partner on the basis of all relevant facts and circumstances. All records with regard to valuation shall be retained by the limited partnership. With respect to securities denominated in currencies other than the U.S. dollar, the value of such securities shall be converted to U.S. dollars upon the close of each month by utilizing the spot currency exchange rate as set forth by Bloomberg Financial Services (or such other source deemed appropriate by the general partner). As of September 30, 2010, 4.1% of the reported market value of this limited partnership was valued by a good faith judgment of the general partner and the balance by observable market inputs.

		Three Months Ended				Nine Months Ended
		September 30, 2010				September 30, 2010
Level 3 investments, beginning of period		$	19,402			$	18,174
Purchases			—				—
Transfers to Level 2			—				—
Transfers to Level 3			—				—
Change in market value			1,058				2,286
Level 3 investments as of September 30, 2010		$	20,460			$	20,460

     We use derivatives to hedge our exposure to interest rate fluctuations. For these derivatives, we used quoted market prices to estimate fair value and included the estimate as a Level 2 measurement.

     The Company’s financial instruments include investments, cash and cash equivalents, premiums and reinsurance balances receivable, reinsurance recoverable on paid losses, line of credit and long-term debt. At September 30, 2010, the carrying amounts of the Company’s financial instruments, including its derivative financial instruments, approximated fair value, except for the $67.0 million of the Company’s junior subordinated debentures. The fair value of these junior subordinated debentures is estimated to be $35.4 million at September 30, 2010. The estimate of fair value for the Company’s junior subordinated debentures is a Level 3 measurement. We use a discounted cash flow model based on the contractual terms of the junior subordinated debentures and a discount rate of 8.53%, which is based on yields of comparable securities. The fair values of the Company’s investments, as determined by quoted market prices, are disclosed in Note 3.

6. INCOME TAXES

     At September 30, 2010 and December 31, 2009, we have taken no uncertain tax positions which would require additional disclosure per current FASB accounting guidance. Although the IRS is not currently examining any of our income tax returns, tax years 2007, 2008 and 2009 remain open and are subject to examination.

     The Company files a consolidated federal income tax return with its subsidiaries. Taxes are allocated among the Company’s subsidiaries based on the Tax Allocation Agreement employed by these entities, which provides that taxes of the entities are calculated on a separate-return basis at the highest marginal tax rate.

     Income taxes in the accompanying unaudited Condensed Consolidated Statements of Income differ from the statutory tax rate of 35.0% primarily due to state income taxes, non-deductible expenses including acquisition-related expenses, the nontaxable portion of dividends received, tax-exempt interest and a one-time purchase accounting adjustment.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

7. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

     The Company establishes a reserve for both reported and unreported covered losses, which includes estimates of both future payments of losses and related loss adjustment expenses. The following represents changes in those aggregate reserves for the Company during the periods presented below:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
						(Dollars in thousands)
Balance, beginning of period		$	527,042			$	426,908			$	488,444			$	372,721
Less reinsurance recoverables			182,616				146,157				164,488				128,552
Net Balance, beginning of period			344,426				280,751				323,956				244,169
Incurred Related To
Current year			31,175				31,645				96,758				101,972
Prior years			11,356				(1,300	)			11,356				(5,671	)
Total Incurred			42,531				30,345				108,114				96,301
Paid Related To
Current year			797				6,461				5,024				10,900
Prior years			24,099				13,266				64,985				38,201
Total Paid			24,896				19,727				70,009				49,101
Net Balance			362,061				291,369				362,061				291,369
Plus reinsurance recoverables			204,825				156,896				204,825				156,896
Balance, end of period		$	566,886			$	448,265			$	566,886			$	448,265

8. REINSURANCE

     Net written and earned premiums, including reinsurance activity, were as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
						(Dollars in thousands)
Written Premiums
Direct		$	80,936			$	77,607			$	236,132			$	228,619
Assumed			2,913				4,201				15,584				13,588
Ceded			(40,075	)			(35,483	)			(101,858	)			(92,615	)
Net Written Premiums		$	43,774			$	46,325			$	149,858			$	149,592
Earned Premiums
Direct		$	79,092			$	77,907			$	231,936			$	226,125
Assumed			4,536				4,529				17,062				13,276
Ceded			(33,934	)			(29,907	)			(96,160	)			(81,752	)
Earned but unbilled premiums			(458	)			(1,017	)			(425	)			(2,110	)
Net Earned Premiums		$	49,236			$	51,512			$	152,413			$	155,539