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

For the quarterly period ended March 31, 2009

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

For the transition period from                      to                     

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		48034
Southfield, Michigan		(Zip Code)
(Address of Principal Executive Offices)

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 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. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller reporting company o

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 May 5, 2009 was 17,929,837.

 

 

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			19
3. Quantitative and Qualitative Disclosures about Market Risk			35
4. Controls and Procedures			35
PART II — OTHER INFORMATION
6. Exhibits			36
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

		March 31,				December 31,
		2009				2008
		(Unaudited)
		(Dollars in thousands,
		except share and per share data)
ASSETS
Investments
Debt securities		$	528,271			$	495,799
Equity securities and other			24,714				15,089
Short-term			38,537				32,142
Total Investments			591,522				543,030
Cash and cash equivalents			14,586				31,833
Premiums and reinsurance balances receivable			56,930				56,398
Accrued investment income			5,648				5,400
Accrued profit sharing commissions			12,095				11,315
Reinsurance recoverable on paid and unpaid losses			145,023				135,617
Prepaid reinsurance premiums			51,902				48,921
Deferred acquisition costs			27,147				27,369
Intangible assets, net of accumulated amortization			38,776				39,351
Goodwill			25,483				25,483
Deferred federal income taxes			—				2,161
Other assets			16,529				16,775
Total Assets		$	985,641			$	943,653
LIABILITIES AND STOCKHOLDERS’ EQUITY
Loss and loss adjustment expense reserves		$	400,152			$	372,721
Unearned premium reserves			148,137				147,849
Long-term debt			67,013				67,013
Funds held under reinsurance treaties			55,867				49,419
Premiums payable to insurance companies			27,279				27,831
Reinsurance payable on paid losses			1,400				1,167
Deferred federal income taxes			415				—
Accounts payable, accrued expenses, and other liabilities			10,994				16,016
Total Liabilities			711,257				682,016
Stockholders’ Equity
Common stock, $0.01 par value; authorized 100,000,000 shares; issued and outstanding 17,929,837 and 17,836,337 shares			179				178
Paid-in-capital			162,569				161,957
Accumulated other comprehensive income (loss)			426				(3,027	)
Retained earnings			111,709				103,028
Treasury stock; 33,600 and 33,600 shares			(499	)			(499	)
Total Stockholders’ Equity			274,384				261,637
Total Liabilities and Stockholders’ Equity		$	985,641			$	943,653

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Income

		Three Months Ended
		March 31,
		2009				2008
		(Dollars in thousands, except share and per share data)
Operating Revenue
Net earned premiums		$	52,594			$	43,571
Commissions and fees			6,894				4,053
Net investment income			6,434				4,848
Net realized gains on investments			1,757				1
Total Operating Revenues			67,679				52,473
Operating Expenses
Losses and loss adjustment expenses, net			30,493				23,444
Amortization of deferred acquisition expenses			13,329				8,213
Underwriting, agency and other expenses			9,223				5,984
Amortization of intangible assets			575				399
Total Operating Expenses			53,620				38,040
Operating Income			14,059				14,433
Interest Expense			1,416				1,464
Change in Fair Value of Derivative Instruments			(106	)			435
Income From Continuing Operations Before Income Taxes			12,749				12,534
Income Taxes			4,068				3,898
Income From Continuing Operations			8,681				8,636
Income From Discontinued Operations, Net of Taxes			—				1,085
Net Income		$	8,681			$	9,721
Basic Net Income Per Share:
Income From Continuing Operations		$	0.49			$	0.48
Income From Discontinued Operations			—				0.06
Total		$	0.49			$	0.54
Diluted Net Income Per Share:
Income From Continuing Operations		$	0.48			$	0.46
Income From Discontinued Operations			—				0.06
Total		$	0.48			$	0.52
Weighted Average Shares Outstanding:
Basic			17,775,560				18,106,063
Diluted			18,109,331				18,793,264

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity

										Accumulated
										Other
		Common				Paid-in				Comprehensive				Retained				Treasury
		Stock				Capital				Income				Earnings				Stock				Total
		(Dollars in thousands, except share data)
Balance, January 1, 2008		$	180			$	165,836			$	1,177			$	62,187			$	—			$	229,380
Exercise of stock options			3				518				—				—				—				521
Stock-based compensation expense			—				327				—				—				—				327
Common stock repurchased and held in treasury			—				—				—				—				(499	)			(499	)
Comprehensive income:
Net income			—				—				—				9,721				—				9,721
Other comprehensive income, net of tax
Unrealized holding gains on securities arising during the period, net of tax of ($436)			—				—				809				—				—				809
Change in fair value of interest rate swap, net of tax of $324			—				—				(602	)			—				—				(602	)
Less reclassification adjustment for gains included in net income, net of tax of $92			—				—				(170	)			—				—				(170	)
Total other comprehensive income			—				—				—				—				—				37
Total comprehensive income			—				—				—				—				—				9,758
Balance, March 31, 2008		$	183			$	166,681			$	1,214			$	71,908			$	(499	)		$	239,487
Balance, January 1, 2009		$	178			$	161,957			$	(3,027	)		$	103,028			$	(499	)		$	261,637
Issuance of restricted stock			1				(1	)			—				—				—				—
Stock-based compensation expense			—				613				—				—				—				613
Comprehensive income:
Net income			—				—				—				8,681				—				8,681
Other comprehensive income, net of tax
Unrealized holding gains on securities arising during the period, net of tax of ($1,899)			—				—				3,527				—				—				3,527
Change in fair value of interest rate swap, net of tax of ($25)			—				—				46				—				—				46
Less reclassification adjustment for gains included in net income, net of tax of $64			—				—				(120	)			—				—				(120	)
Total other comprehensive income			—				—				—				—				—				3,453
Total comprehensive income			—				—				—				—				—				12,134
Balance, March 31, 2009		$	179			$	162,569			$	426			$	111,709			$	(499	)		$	274,384

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

		Three Months Ended
		March 31,
		2009				2008
		(Dollars in thousands)
Cash Flows from Operating Activities
Net Income		$	8,681			$	9,721
Less: Income from discontinued operations			—				1,085
Income from continuing operations			8,681				8,636
Adjustments to reconcile income from continuing operations to net cash provided by operating activities
Depreciation and amortization			998				750
Realized gains on investments			(1,757	)			(1	)
Deferrals of acquisition costs, net			222				(5,058	)
Deferred income taxes			2,575				(221	)
Stock-based compensation expense			613				327
Increase (decrease) in cash resulting from changes in assets and liabilities
Premiums and reinsurance balances receivable			(532	)			(1,443	)
Accrued investment income			(248	)			47
Receivable from related entity			—				75
Accrued profit sharing commissions			(780	)			2,889
Reinsurance recoverable on paid and unpaid losses			(9,406	)			(9,999	)
Prepaid reinsurance premiums			(2,981	)			4,975
Loss and loss adjustment expense reserves			27,431				24,459
Unearned premium reserves			288				8,802
Funds held under reinsurance treaties			6,448				2,547
Reinsurance payable on paid losses			233				842
Premiums payable to insurance companies			(552	)			(3,745	)
Other			(5,151	)			(8,743	)
Net Cash Provided By Operating Activities — Continuing Operations			26,082				25,139
Net Cash Provided By Operating Activities — Discontinued Operations			—				1,023
Net Cash Provided By Operating Activities — Total			26,082				26,162
Cash Flows From Investing Activities
Cost of short-term investments acquired			(127,598	)			(135,182	)
Proceeds from disposals of short-term investments			121,202				155,618
Cost of debt and equity securities acquired			(63,161	)			(52,616	)
Proceeds from debt and equity securities			26,228				27,410
Acquisition, net of cash acquired			—				(18,466	)
Cost of fixed asset purchases			—				(544	)
Net Cash Used In Investing Activities			(43,329	)			(23,780	)
Cash Flows From Financing Activities
Issuance of common stock, net of issuance costs			—				—
Stock issued on stock options exercised			—				521
Repurchase of common stock			—				(499	)
Issuance of long-term debt			—				—
Net Cash Provided By Financing Activities			—				22
Net Increase (Decrease) In Cash and Cash Equivalents			(17,247	)			2,404
Cash and Cash Equivalents, beginning of period			31,833				18,432
Cash and Cash Equivalents, end of period		$	14,586			$	20,836
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest		$	1,372			$	1,787
Income taxes		$	—			$	—

See accompanying notes to condensed consolidated financial statements.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

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 2008 audited consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2008 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, 2008 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 intangible assets.

     Recently Issued Accounting Standards

     In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2”). FSP FAS 115-2 modifies the existing other-than-temporary impairment guidance to require the recognition of an other-than-temporary impairment when an entity has the intent to sell a debt security or when it is more likely than not an entity will be required to sell the debt security before its anticipated recovery. Additionally, FSP FAS 115-2 changes the presentation and amount of other-than-temporary losses recognized in the income statement for instances when the Company determines that there is a credit loss on a debt security but it is more likely than not that the entity will not be required to sell the security prior to the anticipated recovery of its remaining cost basis. For these debt securities, the amount representing the credit loss will be reported as an impairment loss in the Condensed Consolidated Statement of Income and the amount related to all other factors will be reported in accumulated other comprehensive income. FSP FAS 115-2 also requires the presentation of other-than-temporary impairments separately from realized gains and losses on the face of the income statement. In addition to the changes in measurement and presentation, FSP FAS 115-2 is intended to enhance the existing disclosure requirements for other-than-temporary impairments and requires all disclosures related to other-than-temporary impairments in both interim and annual periods. The provisions of FSP FAS 115-2 are effective for interim periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We did not elect to early adopt FSP FAS 115-2/124-2 effective March 31, 2009 as this standard would have no material impact on the Company’s results of operations, financial position, or liquidity.

     In April 2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly” (“FSP FAS 157-4”). Under FSP FAS 157-4, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly; the entity shall place little, if any weight on that transaction price as an indicator of fair value. FSP FAS 157-4 is effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We did not elect to adopt FSP FAS 157-4 effective March 31, 2009 as this standard would not have a material impact on the Company’s results of operations, financial position, or liquidity.

     In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP FAS 107-1 and APB 28-1”). FSP FAS 107-1 and APB 28-1 require disclosures about fair value of financial instruments in interim and annual financial statements. FSP FAS 107-1 and APB 28-1 are effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We did not elect to adopt FSP FAS 107-1 and APB 28-1 effective March 31, 2009.

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

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Concluded)

     We adopted the following accounting standards in the first quarter 2009, none of which had a material effect on the Company’s results of operations, financial position, or liquidity:

	•		SFAS No. 141(R), “Business Combinations;”
	•		SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51;”
	•		SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities;”
	•		FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities;” and
	•		FSP FAS No. 157-2, “Effective Date of FASB Statement No. 157.”

2. MERGERS AND ACQUISITIONS

American Management Corporation

     On February 1, 2008, we completed the acquisition of all of the issued and outstanding shares of common stock of American Management Corporation (“AMC”). AMC is a managing general agency (“MGA”) that has focused primarily on the niche fuel-related marketplace for over 20 years. In addition, AMC owns and operates American Underwriters Insurance Company (“AUIC”), a single state, non-standard auto insurance company domiciled in the state of Arkansas, and AMC Re, Inc. (“AMC Re”), a captive reinsurer incorporated under the laws of Arkansas. AMC underwrites premiums for third party carriers and for AUIC. The acquisition gave the Company access to an established and experienced specialty admitted underwriting franchise with a definable niche market.

     The cash purchase price was $38.1 million, which was financed through cash on hand. We incurred $0.8 million in acquisition related costs, which are included in the initial cost of the investment of $38.9 million. In connection with the acquisition, the Company and the seller entered into an escrow agreement whereby $4.0 million of the cash purchase price was escrowed with a major financial institution to partially secure the majority selling shareholder’s indemnity obligations of up to $12.0 million under the stock purchase agreement.

     The results of operations of AMC and the estimated fair value of assets acquired and liabilities assumed are included in our consolidated financial statements beginning on the acquisition date. The estimated excess of the purchase price over the net tangible and intangible assets acquired of $13.4 million was recorded as goodwill in the amount of $25.5 million. We have completed the valuations of certain tangible and intangible assets acquired with the new business and have finalized the allocation of the excess of the purchase price over the net assets acquired. The acquired goodwill is not expected to be deductible for income tax purposes.

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

2. MERGERS AND ACQUISITIONS — (Concluded)

     The following table represents the final allocation of the purchase price to assets acquired and liabilities assumed at the acquisition date:

		$ in thousands
Assets Acquired
Investments		$	8,988
Cash and cash equivalents			20,012
Premiums receivable			19,570
Other assets			1,133
Goodwill			25,483
Intangible assets:
Agent relationships			9,150
Tradename			2,130
Customer relationships			520
Total Assets Acquired		$	86,986
Liabilities Assumed
Premiums payable to insurance companies		$	23,218
Loss and loss adjustment expense reserves			4,490
Unearned premium reserves			1,734
Deferred federal income taxes			3,917
Accounts payable, accrued expenses, and other liabilities			14,745
Total Liabilities Assumed			48,104
Net Assets Acquired		$	38,882

     Agent relationships are being amortized as the economic benefits of these intangible assets are utilized over their estimated useful lives of approximately 18 years. The tradename is being amortized on a straight-line basis over its estimated useful life of 20 years. The customer relationships are being amortized on a straight-line basis, which approximates the utilization of the economic benefits of these assets, over their estimated useful lives of 15 years.

     In connection with the AMC acquisition, we entered into an operating lease agreement for real property in Conway, Arkansas with an entity owned by the former majority shareholder and current president of AMC. The lease term is for ten years, with annual rent of approximately $0.5 million, payable in monthly installments.

3. DISCONTINUED OPERATIONS

     On June 27, 2008, the Company sold all of the outstanding shares of capital stock of ARPCO Holdings, Inc. and its subsidiaries (“ARPCO”) for a purchase price of $43.0 million. The net assets disposed of in the transaction were $7.2 million and were principally intangible assets.

     The operating results of discontinued operations included in the accompanying Condensed Consolidated Statements of Income are as follows:

		Three Months Ended
		March 31,
		2009				2008
		(Dollars in thousands)
Revenues		$	—			$	2,976
Income Before Income Taxes		$	—			$	1,773

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

4. NET INCOME PER SHARE

     Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding for the period. Diluted net income 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
		March 31,
		2009				2008
		(Dollars in thousands, except share and per share data)
Income from Continuing Operations		$	8,681			$	8,636
Income from Discontinued Operations			—				1,085
Net income as reported			8,681				9,721
Net income allocated to unvested restricted stock shares			(28	)			(13	)
Net income available to common		$	8,653			$	9,708
Weighted-average number of common and common equivalent shares outstanding:
Basic number of common shares outstanding			17,775,560				18,106,063
Dilutive effect of stock options			333,669				686,122
Dilutive effect of unvested restricted stock			102				1,079
Dilutive number of common and common equivalent shares outstanding			18,109,331				18,793,264
Basic Net Income Per Common Share:
Income from Continuing Operations		$	0.49			$	0.48
Income from Discontinued Operations			—				0.06
Total		$	0.49			$	0.54
Diluted Net Income Per Common Share:
Income from Continuing Operations		$	0.48			$	0.46
Income from Discontinued Operations			—				0.06
Total		$	0.48			$	0.52
Anti-dilutive shares excluded from diluted net income per common share			1,221,688				706,188

     On January 1, 2009, we adopted FASB FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (“FSP EITF 03-6-1”), 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. FSP EITF 03-6-1 did not have an impact on our reported earnings per share amounts.

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

5. INVESTMENTS

     The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at March 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		$	5,039			$	254			$	—			$	5,293
Government agency mortgage-backed securities			81,037				3,643				(12	)			84,668
Government agency obligations			3,145				65				—				3,210
Collateralized mortgage obligations and other asset-backed securities			74,406				929				(6,316	)			69,019
Obligations of states and political subdivisions			204,477				8,107				(560	)			212,024
Corporate bonds			111,061				2,672				(4,662	)			109,071
Total Debt Securities			479,165				15,670				(11,550	)			483,285
Preferred stocks			1,416				—				(618	)			798
Short-term investments			38,537				—				—				38,537
Total		$	519,118			$	15,670			$	(12,168	)		$	522,620

     The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at December 31, 2008 by major security type were as follows:

						Gross Unrealized
		Amortized Cost				Gains				Losses				Market Value
		(Dollars in thousands)
Debt Securities
U.S. government securities		$	5,256			$	307			$	—			$	5,563
Government agency mortgage-backed securities			82,548				2,422				(39	)			84,931
Government agency obligations			3,163				76				—				3,239
Collateralized mortgage obligations and other asset-backed securities			71,378				337				(7,087	)			64,628
Obligations of states and political subdivisions			205,425				5,634				(694	)			210,365
Corporate bonds			89,383				1,499				(3,874	)			87,008
Total Debt Securities			457,153				10,275				(11,694	)			455,734
Preferred stocks			1,416				—				(367	)			1,049
Short-term investments			32,142				—				—				32,142
Total		$	490,711			$	10,275			$	(12,061	)		$	488,925

     The amortized cost and market value of debt securities classified as available-for-sale, by contractual maturity, as of March 31, 2009 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		$	73,469			$	73,567
Due after one year through five years			175,422				179,279
Due after five years through ten years			108,355				109,530
Due after ten years			6,429				6,557
			363,675				368,933
Government agency mortgage-backed securities			81,037				84,668
Collateralized mortgage obligations and other asset-backed securities			74,406				69,019
Total		$	519,118			$	522,620

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

5. INVESTMENTS — (Concluded)

Hybrid Instruments

     As of March 31, 2009 and December 31, 2008, the market value of convertible securities accounted for as hybrid instruments was $51.2 million and $43.5 million, respectively. Convertible bonds and bond units had a market value of $44.2 million and $39.0 million and were included in Debt securities in the Condensed Consolidated Balance Sheets at March 31, 2009 and December 31, 2008, respectively. Convertible preferred stocks had a market value of $7.0 million and $4.5 million and were included in Equity securities and other in the Condensed Consolidated Balance Sheets at March 31, 2009 and December 31, 2008, respectively. The Company recorded an increase in the fair value of the hybrid instruments of $2.5 million in Net realized gains on investments for the three months ended March 31, 2009. As of March 31, 2009 and December 31, 2008, there were no convertible securities that were not accounted for as hybrid instruments in accordance with SFAS 155.

Alternative Investments

     During March 2008 the Company invested $10.0 million in a limited partnership, which invests in high yield convertible securities. An additional $2.0 million was invested during January 2009 for a total cost of $12.0 million. The market value of this investment was $7.9 million at March 31, 2009. During June 2008, the Company invested $5.0 million in a limited partnership, which invests in distressed structured finance products. An additional $5.0 million was invested during March 2009 for a total cost of $10.0 million. The market value of this investment was $9.8 million at March 31, 2009. The Company elected the fair value option for these investments in accordance with SFAS 159. 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. These investments are recorded in Equity securities and other in the Condensed Consolidated Balance Sheets.

6. INCOME TAXES

     At March 31, 2009 and December 31, 2008, FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”, did not have an impact on our financial position or results of operations, and we have taken no tax positions which would require disclosure under FIN 48. Although the IRS is not currently examining any of our income tax returns, tax years 2005, 2006 and 2007 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, and the nontaxable portion of dividends received and tax-exempt interest.

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
(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
		March 31,
		2009				2008
		(Dollars in thousands)
Balance, beginning of period		$	372,721			$	272,365
Less reinsurance recoverables			128,552				91,444
Net Balance, beginning of period			244,169				180,921
AUIC net reserves, date of acquisition			—				4,490
Incurred Related To
Current year			31,243				23,444
Prior years			(750	)			—
Total Incurred			30,493				23,444
Paid Related To
Current year			906				334
Prior years			12,547				10,275
Total Paid			13,453				10,609
Net Balance			261,209				198,246
Plus reinsurance recoverables			138,943				103,068
Balance, end of period		$	400,152			$	301,314

8. REINSURANCE

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

		Three Months Ended
		March 31,
		2009				2008
		(Dollars in thousands)
Written Premiums
Direct		$	73,120			$	76,214
Assumed			4,758				4,993
Ceded			(28,053	)			(22,704	)
Net Written Premiums		$	49,825			$	58,503
Earned Premiums
Direct		$	73,304			$	68,653
Assumed			4,287				3,752
Ceded			(25,072	)			(27,679	)
Earned but unbilled premiums			75				(1,155	)
Net Earned Premiums		$	52,594			$	43,571

     The Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company customarily collateralizes reinsurance balances due from unauthorized reinsurers through funds withheld, grantor trusts, or stand-by letters of credit issued by highly rated banks.

     The Company’s 2009 and 2008 ceded reinsurance program includes quota share reinsurance agreements with authorized reinsurers that were entered into and are accounted for on a “funds withheld” basis. Under the funds withheld basis, the Company

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

8. REINSURANCE (Concluded)

records the ceded premiums payable to the reinsurer, less ceded paid losses and loss adjustment expenses receivable from the reinsurer, less any amounts due to the reinsurer for the reinsurer’s margin, or cost of the reinsurance contract, as a liability, and reported $55.9 million and $49.4 million as Funds held under reinsurance treaties in the accompanying Condensed Consolidated Balance Sheets at March 31, 2009 and December 31, 2008, respectively. As specified under the terms of the agreements, the Company credits the funds withheld balance at stated interest crediting rates applied to the funds withheld balance. If the funds withheld liability is exhausted, interest crediting would cease and additional claim payments would be recoverable from the reinsurer.

     Interest cost on reinsurance contracts accounted for on a funds withheld basis is incurred during all periods in which a funds withheld liability exists or as otherwise specified under the terms of the contract and is included in Underwriting, agency and other expenses. The amount subject to interest crediting rates was $22.2 million and $17.9 million at March 31, 2009 and 2008, respectively.

9. SHARE REPURCHASE PROGRAM

     The Board of Directors of the Company authorized a share repurchase plan to purchase up to 1.5 million shares of common stock through open market or privately negotiated transactions. The repurchase program expires on August 18, 2009. During the three months ended March 31, 2009, the Company did not repurchase any shares of common stock. As of March 31, 2009, the Company has 801,423 shares of remaining capacity under the share repurchase program. Shares purchased under the program are retired and returned to the status of authorized but unissued shares.

10. STOCK COMPENSATION PLANS

     The 1998 Stock Compensation Plan (the “1998 Plan”) was established September 3, 1998. Under the terms of the plan, directors, officers, employees and key individuals may be granted options to purchase the Company’s common stock. Option and vesting periods and option exercise prices are determined by the Compensation Committee of the Board of Directors, provided no stock options shall be exercisable more than ten years after the grant date. All outstanding stock options under the plan became fully vested on August 17, 2005 under the change in control provision in the plan. Of the 4,625,000 shares of the Company’s common stock initially reserved for future grant under the 1998 Plan, shares available for future grant totaled 2,443,387 at March 31, 2009, however, the Company does not intend to issue any additional awards under this plan.

     The First Mercury Financial Corporation Omnibus Incentive Plan of 2006 (the “Omnibus Plan”) was established October 16, 2006. The Company has reserved 1,500,000 shares of its common stock for future granting of stock options, stock appreciation rights (“SAR”), restricted stock, restricted stock units (“RSU”), deferred stock units (“DSU”), performance shares, performance cash awards, and other stock or cash awards to employees and non-employee directors at any time prior to October 15, 2016. All of the terms of the vesting or other restrictions will be determined by the Company’s Compensation Committee of the Board of Directors. The exercise price will not be less than the fair market value of the shares on the date of grant. During the three months ended March 31, 2009, the Company granted 197,500 stock options and 93,500 shares of restricted stock to employees under the Omnibus Plan. The stock options and shares of restricted stock vest in three equal installments over a period of three years commencing on March 5, 2010. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. During the three months ended March 31, 2008, the Company granted 148,500 stock options and 15,000 shares of restricted stock to employees under the Omnibus plan. The stock options and shares of restricted stock vest in three equal installments over a period of three years commencing on March 6, 2009. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. Shares available for future grants under the Omnibus Plan totaled 185,740 at March 31, 2009. A proposal currently pending before the Company’s stockholders would amend and restate the Omnibus Plan to increase the number of shares authorized for issuance thereunder by 1,650,000 shares (which would bring the total number of shares reserved under the Omnibus Plant to 3,150,000) and to make certain other changes to the Omnibus Plan. The Company’s stockholders are voting on this proposal at the 2009 annual stockholders meeting scheduled for May 13, 2009.

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

10. STOCK COMPENSATION PLANS (Continued)

     The following table summarizes stock option activity for the three months ended March 31, 2009 and 2008.

		1998 Plan								Omnibus Plan
		Number of				Weighted Average				Number of				Weighted Average
		Options				Exercise Price				Options				Exercise Price
Oustanding at January 1, 2008			927,775			$	2.24				573,688			$	19.10
Granted during the period			—				—				148,500				14.93
Forfeited during the period			—				—				12,700				18.77
Exercised during the period			287,960				1.81				—				—
Cancelled during the period			—				—				—				—
Outstanding at March 31, 2008			639,815			$	2.48				709,488			$	18.24
Oustanding at January 1, 2009			431,050			$	2.82				932,188			$	17.93
Granted during the period			—				—				197,500				13.01
Forfeited during the period			—				—				—				—
Exercised during the period			—				—				—				—
Cancelled during the period			—				—				—				—
Outstanding at March 31, 2009			431,050			$	2.82				1,129,688			$	17.07
Exercisable at:
March 31, 2008			639,815			$	2.48				150,355			$	18.75
March 31, 2009			431,050				2.82				379,465				18.43

     The aggregate intrinsic value of fully vested options outstanding and exercisable under the 1998 Plan was $5.0 million at March 31, 2009. There was no aggregate intrinsic value of options expected to vest under the Omnibus Plan at March 31, 2009.

     There were no stock options exercised during the three months ended March 31, 2009.

     The number of stock option awards outstanding and exercisable at March 31, 2009 by range of exercise prices was as follows:

		Options Outstanding													Options Exercisable
						Weighted-Average				Weighted-Average								Weighted-Average
Range of		Outstanding as of				Remaining				Exercise Price Per				Exercisable as of				Exercise Price Per
Exercisable Price		March 31, 2009				Contractual Life				Share				March 31, 2009				Share
1998 Plan
$1.51 - $1.95			319,125			3.85 Years				$	1.71				319,125			$	1.71
$4.86 - $6.49			111,925			1.55					5.97				111,925				5.97
Total			431,050			3.25					2.82				431,050				2.82
Omnibus Plan
$10.98 - $14.93			352,000			9.52 Years				$	13.72				47,495			$	14.93
$17.00 - $20.75			777,688			7.33					18.59				331,970				18.94
Total			1,129,688			8.01					17.07				379,465				18.43

     As of March 31, 2009, there was approximately $5.5 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Omnibus Plan. That cost is expected to be recognized over a weighted-average period of 2.2 years.

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

10. STOCK COMPENSATION PLANS — (Concluded)

     The fair value of stock options granted during the three months ended March 31, 2009 and 2008 were determined on the dates of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

		Three Months Ended
		March 31,
		2009				2008
Omnibus Plan
Expected term			6.0				6.0
Expected stock price volatility			41.11	%			29.23	%
Risk-free interest rate			2.16	%			2.90	%
Expected dividend yield			—				—
Estimated fair value per option		$	5.53			$	5.13

     The expected term of options was determined based on the simplified method from SEC Staff Accounting Bulletin 107 (“SAB 107”), as amended by Staff Accounting Bulletin 110 (“SAB 110”). Expected stock price volatility was based on an average of the volatility factors utilized by companies within the Company’s peer group with consideration given to the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid dividends in the past.

     The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made. The Company recognized stock-based compensation expense of $0.6 million and $0.3 million for the three months ended March 31, 2009 and 2008, respectively.

11. FAIR VALUE MEASUREMENTS

     Our available-for-sale investment portfolio consists of fixed maturity and equity securities and short-term investments, and is recorded at fair value in the accompanying Condensed Consolidated Balance Sheets in accordance with FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). The change in the fair value of these investments is recorded as a component of Other comprehensive income (loss).

     We adopted FASB Statement No. 159, “The Fair Value Option of Financial Assets and Financial Liabilities” (“SFAS 159”) effective January 1, 2008. Under this standard, we are permitted to elect to measure financial instruments and certain other items at fair value, with the change in fair value recorded in earnings. On January 1, 2008, we elected not to measure any eligible items using the fair value option in accordance with SFAS 159. We believe the current accounting is appropriate for our available-for-sale investments as we have the intent and ability to hold our investments, therefore, SFAS 159 did not have any impact on our consolidated financial condition or results of operations on the adoption date.

     We also adopted FASB Statement No. 157, “Fair Value Measurements” (“SFAS 157”) effective January 1, 2008. SFAS 157 defines fair value as 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, and establishes a framework to make the measurement of fair value more consistent and comparable. 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 SFAS 157. The implementation of SFAS 157 did not have any impact on our consolidated financial condition or results of operations. The implementation of SFAS 157 resulted in expanded disclosures about securities measured at fair value, as discussed below.

     SFAS 157 established 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 hierarchy level assigned to each security in our available-for-sale, hybrid securities, and

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

11. FAIR VALUE MEASUREMENTS (Continued)

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.

     • 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 March 31, 2009. These securities were classified as Level 2 at March 31, 2009 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 March 31, 2009 classified by the SFAS No. 157 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		$	483,285			$	5,293			$	477,379			$	613
Equity securities			798				—				798				—
Short-term investments			38,537				38,537				—				—
Hybrid securities			51,172				—				51,172				—
Alternative investments			17,730				—				9,831				7,899
Total		$	591,522			$	43,830			$	539,180			$	8,512

     Level 3 assets above include one asset-backed security collateralized by home equity loans with a market value of $0.6 million within fixed maturity securities. Liquidity remains extremely low in markets for non-agency residential mortgage-backed securities, especially those with ratings below AAA. This security’s market value was adjusted to a model price that assumed stressed default assumptions, which generated a 20.9% principal loss, and included a 10.5% discount rate. Also included within Level 3 assets is a $7.9 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 manager of this limited partnership valued this investment through an internally developed model.

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

11. FAIR VALUE MEASUREMENTS — (Concluded)

		Quarter Ended
		March 31, 2009
Level 3 investments as of January 1, 2009		$	6,282
Purchases			2,000
Increase in market value			230
Level 3 investments as of March 31, 2009		$	8,512

     The Company uses derivatives to hedge its exposure to interest rate fluctuations. For these derivatives, the Company uses quoted market prices to estimate fair value and includes the estimate as a Level 2 measurement.

12. ACCUMULATED OTHER COMPREHENSIVE INCOME

     The Company’s accumulated other comprehensive income included the following:

		March 31,
		2009				2008
		(Dollars in thousands)
Unrealized holding gains on securities, net of tax		$	1,956			$	2,440
Fair value of interest rate swap, net of tax			(1,530	)			(1,226	)
Total accumulated other comprehensive income		$	426			$	1,214

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     This Quarterly Report on Form 10-Q contains forward-looking statements that relate to future periods and includes statements regarding our anticipated performance. Generally, the words “anticipates,” “believes,” “expects,” “intends,” “estimates,” “projects,” “plans” and similar expressions identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements or industry results to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. These risks, uncertainties and other important factors include, among others: recent and future events and circumstances impacting financial, stock, and capital markets, and the responses to such events by governments and financial communities; the impact of catastrophic events and the occurrence of significant severe weather conditions on our operating results; our ability to maintain or the lowering or loss of one of our financial or claims-paying ratings; our actual incurred losses exceeding our loss and loss adjustment expense reserves; the failure of reinsurers to meet their obligations; our inability to obtain reinsurance coverage at reasonable prices; the failure of any loss limitations or exclusions or changes in claims or coverage; our ability to successfully integrate acquisitions that we make such as our acquisition of AMC; our lack of long-term operating history in certain specialty classes of insurance; our ability to acquire and retain additional underwriting expertise and capacity; the concentration of our insurance business in relatively few specialty classes; the increasingly competitive property and casualty marketplace; fluctuations and uncertainty within the excess and surplus lines insurance industry; the extensive regulations to which our business is subject and our failure to comply with those regulations; our ability to maintain our risk-based capital at levels required by regulatory authorities; our inability to realize our investment objectives; and the risks identified in our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K. Given these uncertainties, you are cautioned not to place undue reliance on these forward-looking statements. We assume no obligation to update or revise them or provide reasons why actual results may differ.

     The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes included elsewhere in this Form 10-Q.

     Overview

     We are a provider of insurance products and services to the specialty commercial insurance markets, primarily focusing on niche and underserved segments where we believe that we have underwriting expertise and other competitive advantages. During our 35 years of underwriting security risks, we have established CoverX ^® as a recognized brand among insurance agents and brokers and developed significant underwriting expertise and a cost-efficient infrastructure. Over the last eight years, we have leveraged our brand, expertise and infrastructure to expand into other specialty classes of business, particularly focusing on smaller accounts that receive less attention from competitors.

     First Mercury Financial Corporation (“FMFC”) is a holding company for our operating subsidiaries. Our operations are conducted with the goal of producing overall profits by strategically balancing underwriting profits from our insurance subsidiaries with the commissions and fee income generated by our non-insurance subsidiaries. FMFC’s principal operating subsidiaries are CoverX Corporation (“CoverX”), First Mercury Insurance Company (“FMIC”), First Mercury Casualty Company (“FMCC”), First Mercury Emerald Insurance Services, Inc. (“FM Emerald”), and American Management Corporation (“AMC”).

     CoverX produces and underwrites insurance policies for which we retain risk and receive premiums. As a wholesale insurance broker, CoverX markets our insurance policies through a nationwide network of wholesale and retail insurance brokers who then distribute these policies through retail insurance brokers. CoverX also provides underwriting services with respect to the insurance policies it markets in that it reviews the applications submitted for insurance coverage, decides whether to accept all or part of the coverage requested and determines applicable premiums. CoverX receives commissions from affiliated insurance companies, reinsurers, and non-affiliated insurers as well as policy fees from wholesale and retail insurance brokers.

     FM Emerald is a wholesale insurance agency producing commercial lines business on primarily an excess and surplus lines basis for CoverX via a producer agreement. As a wholesale insurance agency, FM Emerald markets insurance products for CoverX through a nationwide network of wholesale and retail insurance brokers who then distribute these products through retail insurance brokers.

     FMIC and FMCC are two of our insurance subsidiaries. FMIC writes substantially all the policies produced by CoverX. FMCC provides reinsurance to FMIC. FMIC and FMCC have entered into an intercompany pooling reinsurance agreement wherein all premiums, losses and expenses of FMIC and FMCC, including all past liabilities, are combined and apportioned between FMIC and FMCC in accordance with fixed percentages. FMIC also provides claims handling and adjustment services for policies produced by CoverX and directly written by third parties.

     On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Condensed Consolidated Statements of Income. ARPCO provided third party administrative services for risk sharing pools of governmental entity risks, including underwriting, claims, loss control and reinsurance services. ARPCO was solely a fee-based business and received fees for these services and commissions on excess per occurrence insurance placed in the commercial market with third party companies on behalf of the pools.

     On February 1, 2008, we acquired 100% of the issued and outstanding common stock of American Management Corporation. AMC is a managing general agency writing primarily commercial lines package policies focused primarily on the niche fuel-related marketplace. AMC distributes these insurance policies through a nationwide distribution system of independent general agencies. AMC underwrites these policies for third party insurance carriers and receives commission income for its services. AMC also provides claims handling and adjustment services for policies produced by AMC and directly written for third parties. In addition, AMC owns and operates American Underwriters Insurance Company (“AUIC”), a single state, non-standard auto insurance company domiciled in the state of Arkansas, and AMC Re, Inc. (“AMC Re”), a captive reinsurer incorporated under the provisions of the laws of Arkansas. Effective July 1, 2008, FMIC and AUIC entered into an intercompany reinsurance agreement wherein all premiums and losses of AUIC, including all past liabilities, are 100% assumed by FMIC.

     GAAP and Non-GAAP Financial Performance Metrics

     Throughout this report, we present our operations in the way we believe will be most meaningful, useful, and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP (generally accepted accounting principles in the United States of America) presentation of net income and certain statutory reporting information, we show certain non-GAAP financial measures that we believe are valuable in managing our business and drawing comparisons to our peers. These measures are gross written premiums, net written premiums, and combined ratio.

     Following is a list of non-GAAP measures found throughout this report with their definitions, relationships to GAAP measures, and explanations of their importance to our operations:

     Gross written premiums. While net premiums earned is the related GAAP measure used in the statements of earnings, gross written premiums is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses, and loss costs.

     Net written premiums. While net premiums earned is the related GAAP measure used in the statements of earnings, net written premiums is the component of net premiums earned that measures the difference between gross written premiums and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in our insurance underwriting operations. It is an indicator of future earnings potential subject to our expenses and loss costs.

     Combined ratio. This ratio is a common industry measure of profitability for any underwriting operation, and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses, net of insurance underwriting commissions and fees, divided by net premiums earned. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of pre-tax underwriting income.

     Critical Accounting Policies

     The critical accounting policies discussed below are important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgments concerning future results and developments in making these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of material contingent assets and liabilities. We evaluate our estimates on a continual basis using information that we believe to be relevant. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements.

     Readers are also urged to review “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” and Note 1 to the audited consolidated financial statements thereto included in the Annual Report on

Form 10-K for the year ended December 31, 2008 on file with the Securities and Exchange Commission for a more complete description of our critical accounting policies and estimates.

     Use of Estimates

     In preparing our consolidated 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 intangible assets.

     Loss and Loss Adjustment Expense Reserves

     The reserves for losses and loss adjustment expenses represent our estimated ultimate costs of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. Our reserves reflect our estimates at a given time of amounts that we expect to pay for losses that have been reported, which are referred to as Case reserves, and losses that have been incurred but not reported and the expected development of losses and allocated loss adjustment expenses on reported cases, which are referred to as IBNR reserves. We do not discount the reserves for losses and loss adjustment expenses.

     We allocate the applicable portion of our estimated loss and loss adjustment expense reserves to amounts recoverable from reinsurers under ceded reinsurance contracts and report those amounts separately from our loss and loss adjustment expense reserves as an asset on our balance sheet.

     The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process, requiring the use of informed estimates and judgments. Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are our estimates based upon various factors, including:

	•		actuarial projections of what we, at a given time, expect to be the cost of the ultimate settlement and administration of claims reflecting facts and circumstances then known;
	•		estimates of future trends in claims severity and frequency;
	•		assessment of asserted theories of liability; and
	•		analysis of other factors, such as variables in claims handling procedures, economic factors, and judicial and legislative trends and actions.

     Most or all of these factors are not directly or precisely quantifiable, particularly on a prospective basis, and are subject to a significant degree of variability over time. In addition, the establishment of loss and loss adjustment expense reserves makes no provision for the broadening of coverage by legislative action or judicial interpretation or for the extraordinary future emergence of new types of losses not sufficiently represented in our historical experience or which cannot yet be quantified. Accordingly, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimated reserves are included in the results of operations in the period in which the estimate is revised.

     Our reserves consist of reserves for property and liability losses, consistent with the coverages provided for in the insurance policies directly written or assumed by the Company under reinsurance contracts. In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions and may, in fact, vary significantly from our assumptions. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We continually review our estimates and adjust them as we believe appropriate as our experience develops or new information becomes known to us.

     Our reserves for losses and loss adjustment expenses at March 31, 2009 and December 31, 2008, gross and net of ceded reinsurance were as follows:

		March 31,				December 31,
		2009				2008
		(Dollars in thousands)
Gross
Case reserves		$	95,135			$	91,057
IBNR and ULAE reserves			305,017				281,664
Total reserves		$	400,152			$	372,721
Net of reinsurance
Case reserves		$	64,259			$	62,497
IBNR and ULAE reserves			196,950				181,672
Total		$	261,209			$	244,169

     Revenue Recognition

     Premiums. Premiums are recognized as earned using the daily pro rata method over the terms of the policies. When premium rates change, the effect of those changes will not immediately affect earned premium. Rather, those changes will be recognized ratably over the period of coverage. Unearned premiums represent the portion of premiums written that relate to the unexpired terms of policies-in-force. As policies expire, we audit those policies comparing the estimated premium rating units that were used to set the initial premium to the actual premiums rating units for the period and adjust the premiums accordingly. Premium adjustments identified as a result of these audits are recognized as earned when identified.

     Commissions and Fees. Wholesale agency commissions and fee income from unaffiliated companies are earned at the effective date of the related insurance policies produced or as services are provided under the terms of the administrative and service provider contracts. Related commissions to retail agencies are concurrently expensed at the effective date of the related insurance policies produced. Profit sharing commissions due from certain insurance companies, based on losses and loss adjustment expense experience, are earned when determined and communicated by the applicable insurance company.

     Investments

     Our marketable investment securities, including money market accounts held in our investment portfolio, are classified as available-for-sale and, as a result, are reported at market value. Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements,” which resulted in no material changes in valuation techniques we previously used to measure fair values. See Note 11 to the Condensed Consolidated Financial Statements for a more complete description. A decline in the market value of any security below cost that is deemed other than temporary is charged to earnings and results in the establishment of a new cost basis for the security. In most cases, declines in market value that are deemed temporary are excluded from earnings and reported as a separate component of stockholders’ equity, net of the related taxes, until realized. The exception to this rule relates to investments in convertible securities with embedded derivatives and our alternative investments. Convertible securities were accounted for under FASB Statement No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”) for the three months ended March 31, 2009 and 2008. Alternative investments consist of our investments in limited partnerships, which invest in high yield convertible securities and distressed structured finance products. These alternative investments are accounted for under FASB Statement No. 159, “The Fair Value Option of Financial Assets and Financial Liabilities” (“SFAS 159”), for the three months ended March 31, 2009 and 2008.

     Premiums and discounts are amortized or accreted over the life of the related debt security as an adjustment to yield using the effective-interest method. Dividend and interest income are recognized when earned. Realized gains and losses are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

     Impairment of Investment Securities

     Impairment of investment securities results in a charge to operations when a market decline below cost is other-than-temporary. 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 and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.

     As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other-than-temporary decline. The Company’s ability to hold such securities is supported by sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment and other disbursement obligations arising from its underwriting operations without selling such investments. With respect to securities where the decline in value is determined to be temporary and the security’s value 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 the 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.

     Deferred Policy Acquisition Costs

     Policy acquisition costs related to direct and assumed premiums consist of commissions, underwriting, policy issuance, and other costs that vary with and are primarily related to the production of new and renewal business, and are deferred, subject to ultimate recoverability, and expensed over the period in which the related premiums are earned. Investment income is included in the calculation of ultimate recoverability.

     Goodwill and Intangible Assets

     In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill and intangible assets that are not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test for goodwill shall consist of a comparison of the fair value of the goodwill with the carrying amount of the reporting unit to which it is assigned. The impairment test for intangible assets shall consist of a comparison of the fair value of the intangible assets with their carrying amounts. If the carrying amount of the goodwill or intangible assets exceed their fair value, an impairment loss shall be recognized in an amount equal to that excess.

     In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the carrying value of long-lived assets, including amortizable intangibles and property and equipment, are evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred relative to a given asset or assets. Impairment is deemed to have occurred if projected undiscounted cash flows associated with an asset are less than the carrying value of the asset. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. The amount of the impairment loss recognized is equal to the excess of the carrying value of the asset over its then estimated fair value.

     Results of Operations

     Three Months Ended March 31, 2009 Compared to Three Months Ended March 31, 2008

     The following table summarizes our results for the three months ended March 31, 2009 and 2008:

		Three Months Ended
		March 31,
		2009				2008				Change
		(Dollars in thousands)
Operating Revenue
Net earned premiums		$	52,594			$	43,571				21	%
Commissions and fees			6,894				4,053				70
Net investment income			6,434				4,848				33
Net realized gains on investments			1,757				1				N/M
Total Operating Revenues			67,679				52,473				29
Operating Expenses
Losses and loss adjustment expenses, net			30,493				23,444				30
Amortization of intangible assets			575				399				44
Other operating expenses			22,552				14,197				59
Total Operating Expenses			53,620				38,040				41
Operating Income			14,059				14,433				(3	)
Interest Expense			1,310				1,899				(31	)
Income From Continuing Operations Before Income Taxes			12,749				12,534				2
Income Taxes			4,068				3,898				4
Income From Continuing Operations			8,681				8,636				1	%
Income From Discontinued Operations, Net of Income Taxes			—				1,085				(100	)
Net Income		$	8,681			$	9,721				(11	)%
Loss Ratio			58.0	%			53.8	%		4.2 points
Underwriting Expense Ratio			30.4	%			21.2	%		9.2 points
Combined Ratio			88.4	%			75.0	%		13.4 points

     Operating Revenue

     Net Earned Premiums

		Three Months Ended
		March 31,
		2009				2008				Change
		(Dollars in thousands)
Written premiums
Direct		$	73,120			$	76,214				(4	)%
Assumed			4,758				4,993				(5	)
Ceded			(28,053	)			(22,704	)			24
Net written premiums		$	49,825			$	58,503				(15	)%
Earned premiums
Direct		$	73,304			$	68,653				7	%
Assumed			4,287				3,752				14
Ceded			(25,072	)			(27,679	)			(9	)
Earned but unbilled premiums			75				(1,155	)			(106	)
Net earned premiums		$	52,594			$	43,571				21	%

     Direct written premiums decreased $3.1 million, or 4%, primarily due to decreases in premium production from the Company’s Security and Specialty underwriting platforms offset somewhat by increases in production from the Company’s FM Emerald underwriting platform during the three months ended March 31, 2009. Direct earned premiums increased $4.7 million in the three months ended March 31, 2009, or 7%, compared to the three months ended March 31, 2008.

     Assumed written premiums decreased $0.2 million, or 5%, and assumed earned premiums increased $0.5 million, or 14%. The decrease in assumed written premiums is primarily due to a decrease in production for the admitted legal liability business.

     Ceded written premiums increased $5.3 million, or 24%, and ceded earned premiums decreased $2.6 million, or 9%, for the three months ended March 31, 2009 compared to the three months ended March 31, 2008. Ceded written premiums increased to 36% of direct and assumed written premiums during the first quarter of 2009 compared to 28% of direct and assumed written premiums during the first quarter of 2008 principally due to purchasing more quota share reinsurance during the first quarter of 2009 for the Company’s primary casualty business compared to the first quarter of 2008. The increase in quota share cessions was offset somewhat by lower cessions under our excess of loss treaties during the first quarter of 2009 and the elimination of a 50% quota share on a contract underwriting class of business during the fourth quarter of 2008, which impacted the first quarter of 2009. Ceded earned premiums decreased primarily due to ceded written premiums continuing to be earned on the Company’s 2008 quota share reinsurance treaties.

     Earned but unbilled premiums increased $1.2 million, or 106%, primarily due to the net earned premiums subject to audit during the three months ended March 31, 2009 increasing compared to the net premiums earned subject to audit during the three months ended March 31, 2008.

     Commissions and Fees

		Three Months Ended
		March 31,
		2009				2008				Change
		(Dollars in thousands)
Insurance underwriting commissions and fees		$	1,357			$	1,329				2	%
Insurance services commissions and fees			5,537				2,724				103
Total commissions and fees		$	6,894			$	4,053				70	%