|
|
 | | | |
- close
- close
- close
- close
First Mercury Financial 10-Q 2010 Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2010
OR
For the transition period from _______________ to _______________
Commission File Number 001-33077
FIRST MERCURY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
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 May 6, 2010 was 17,721,956.
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
2
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. – FINANCIAL INFORMATION
Condensed Consolidated Balance Sheets
See accompanying notes to condensed consolidated financial statements.
3
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Income
(Unaudited)
See accompanying notes to condensed consolidated financial statements.
4
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Stockholders’ Equity
(Unaudited)
See accompanying notes to condensed consolidated financial statements.
5
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
See accompanying notes to condensed consolidated financial statements.
6
Table of Contents
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.
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. Specfically, 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 in the first quarter of 2010 is included in Note 5, “Fair Value
Measurements” to the condensed consolidated financial statements.
In June 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 in the first
quarter of 2010 did not have a material effect on the Company’s results of operations, financial
position or liquidity.
Prospective Accounting Standards
The Emerging Issues Task Force (EITF or “Task Force”) Issue No. 09-G intends to clarify the
definition of what constitutes an acquisition cost and the types of acquisition costs capitalized
by an insurance entity. In November 2009, the Task Force reached a consensus-for-exposure that
would limit the costs an entity can include in Deferred Acquisition Costs (“DAC”) to those that are
“directly related to” the acquisition of new and renewal insurance contracts. They clarified that
the direct costs only included those that result in the successful acquisition of a policy and
exclude all cost incurred for unsuccessful efforts, along with indirect costs.
7
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – (Concluded)
The consensus-for-exposure would require that an entity include only actual costs, not costs
expected to be incurred, in DAC.
On March 18, 2010, the Task Force affirmed the previous conclusions from the proposed
consensus that indirect costs and costs of unsuccessful activities should not be included in
capitalized acquisition costs. The Task Force also agreed that advertising cost should be
capitalized only when certain requirements are met. There were further questions on how accounting
for advertising costs interacts with the DAC impairment model and further analysis was requested.
The Task Force plans to discuss that question and the effective date and transition at the next
EITF meeting in June.
If the Task Force reaches a final consensus at a subsequent meeting and it is ratified by the
Financial Accounting Standards Board (FASB), as currently proposed, it would be effective for
interim and annual periods beginning on or after December 15, 2010, with either prospective or
retrospective application permitted, as currently drafted. Early adoption would also be
permitted.
This issue, if ratified, has the potential to significantly impact the way insurance companies
account for DAC, and therefore, could potentially have a significant impact on the results of
operations. It would result in the need to identify and recognize, as period costs, those amounts
associated with unsuccessful acquisition efforts in addition to indirect costs. Amounts associated
with successful acquisition efforts would continue to be capitalized and charged to expense in
proportion to premium revenue recognized. As an example, under current guidance, underwriter
salaries are capitalized and amortized over the period in which the associated premium written is
earned as revenue. Under the proposed guidance, companies would be required to identify the
portion of underwriter salaries that could be attributed to unsuccessful acquisition efforts and
expense that amount in the current period. We will continue to monitor the progress of this issue.
8
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 2. 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:
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 March 31, 2010 by major security type
were as follows:
9
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 3. INVESTMENTS – (Concluded)
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:
The amortized cost and market value of debt securities classified as available-for-sale,
by contractual maturity, as of March 31, 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.
As of March 31, 2010 and December 31, 2009, the market value of convertible securities
accounted for as hybrid instruments was $69.8 million and $69.5 million, respectively. Convertible
bonds and bond units had a market value of $63.4 million and $61.4 million and were included in
Debt securities in the Condensed Consolidated Balance Sheets at March 31, 2010 and December 31,
2009, respectively. Convertible preferred stocks had a market value of $6.4 million and $8.2
million and were included in Equity securities and other in the Condensed Consolidated Balance
Sheets at March 31, 2010 and December 31, 2009, respectively. As of March 31, 2010 and December
31, 2009, there were no convertible securities that were not 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 $19.4 million at March 31, 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 $12.9 million
at March 31, 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. For the three months ended March 31, 2010, the Company recorded $0.6 million in Net
investment income and $1.1 million in Net realized gains on investments related to these
alternative investments. These investments are recorded in Equity securities and other in the
Condensed Consolidated Balance Sheet.
10
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES
Impairment of Investment Securities
Impairment of investment securities results when a market decline below 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 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 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.
11
Table of Contents
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 Consolidated Statements of Income for which a portion of the OTTI was recognized
in other comprehensive income for the period January 1, 2010 through March 31, 2010:
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 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 March 31, 2010:
12
Table of Contents
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:
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 period ended March 31, 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.
13
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES — (Concluded)
At March 31, 2010, there were 133 unrealized loss positions with a total unrealized loss of
$2.0 million. This represents approximately 0.3% of quarter end available-for-sale assets of
$649.1 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 March 31, 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 3.8 years, and 3.5 years on a taxable equivalent basis. We
do not intend to sell and it is not expected we will need to sell these temporarily impaired
securities before maturity. In light of our operating cash flow over the past 24 months, liquidity
needs from the portfolio are minimal. As a result, we would not expect to have to liquidate
temporarily impaired securities to pay claims or for any other purposes. 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 3.5% as of March
31, 2010.
The majority of these securities are “AAA” or “AA” rated. Of the $1.0 million of
unrealized loss within non-investment grade, CMOs accounted for 49.9% of this loss. Within CMOs
75.5% were collateralized by prime loans with the balance in Alt-A and sub-prime. The next highest
percent of the loss within non-investment grade were Alt-A and sub-prime home equity asset-backed
securities at 49.5% of the loss. The remaining portion of the loss, or 0.6% was within
non-investment grade corporate issues. 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 CMOs at 36.2% of the total
loss. Within CMOs, 57.9% are rated AAA including the 39.2% of the CMO exposure that is agency
issued, and have primarily been affected by the general level of interest rates as well. The next
largest concentration of temporarily impaired securities is Asset Backed Securities at 27.1% of the
total loss. The next largest concentration of temporarily impaired securities is Commercial MBS at
approximately 16.3% of the total loss. Both ABS and CMBS have been affected primarily by the
widening of spreads and/or the general level of interest rates. The next largest concentration of
temporarily impaired securities is Municipal Bonds at approximately 11.4% of the total loss.
For the three months ended March 31, 2010, we sold approximately $2.1 million of market value
of fixed income securities excluding convertibles, which were trading below amortized cost while
recording a realized loss of $0.4 million. This loss represented 16.8% of the amortized cost of
the positions. These sales were unique opportunities to sell specific positions due to changing
market conditions.
14
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 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.
• 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, 2010.
These securities were classified as Level 2 at March 31, 2010 because our third party pricing
service uses valuation models which use observable market inputs in addition to traded prices.
15
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 5. FAIR VALUE MEASUREMENTS — (Continued)
The following table presents our investments measured at fair value on a recurring basis as of
March 31, 2010 classified by the fair value measurements standard valuation hierarchy (as discussed
above):
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):
Recent FASB guidance adopted by the Company 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 first quarter of 2010.
Level 3 assets at March 31, 2010 include a $19.4 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 pricing model as follows. If a security is listed on a
recognized exchange, it shall 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 shall 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, under the circumstances and in the good
faith judgment of the General Partner, represents the fair value of the security. Notwithstanding
the foregoing, upon a good faith determination by the General Partner that the application of such
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 Partnership. All
determinations of values by the General Partner shall be final and conclusive as to all Partners.
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 March 31, 2010, 10.3% 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.
16
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 5. FAIR VALUE MEASUREMENTS — (Concluded)
The Company uses derivatives to hedge its exposure to interest rate fluctuations. For
these derivatives, the Company 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 March 31, 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 $33.5 million at March 31, 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 9.03%, which was 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 March 31, 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 2006, 2007 and 2008 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, tax-exempt interest and a one-time purchase
accounting adjustment.
17
Table of Contents
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:
8. REINSURANCE
Net written and earned premiums, including reinsurance activity, were as follows:
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 2010 and 2009 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 records the
18
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 8. REINSURANCE – (Concluded)
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 $74.1 million and $71.7 million as
Funds held under reinsurance treaties in the accompanying Condensed Consolidated Balance Sheets at
March 31, 2010 and December 31, 2009, 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 $21.7 million and $22.2 million at March 31, 2010 and 2009,
respectively.
9. SHARE REPURCHASE PROGRAM
On August 20, 2009, the Board of Directors of the Company authorized a share repurchase plan
to purchase up to 1.0 million shares of common stock through open market or privately negotiated
transactions. The repurchase program expires on August 20, 2010. During the three months ended
March 31, 2010, the Company did not repurchase any shares of common stock under the August 2009
share repurchase plan. As of March 31, 2010, the Company had 1.0 million 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. SPECIAL DIVIDEND
On February 22, 2010, the Company’s Board of Directors declared a one-time, special cash
dividend of $2.00 per share which was paid March 31, 2010. The special dividend was funded in part
from borrowings under the Company’s credit agreement. The special dividend was $35.3 million.
11. STOCK COMPENSATION PLANS
The 1998 Stock Compensation Plan (as amended, 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, 2010.
On May 13, 2009, the Company adopted an amendment to the 1998 Plan prohibiting the issuance of any
additional awards under the 1998 Plan.
The First Mercury Financial Corporation Omnibus Incentive Plan of 2006 (the “Omnibus Plan”)
was established October 16, 2006. The Company 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. On May 13, 2009, the Company’s stockholders approved the amendment and restatement of the
Omnibus Plan to increase the number of shares authorized for issuance thereunder by 1,650,000
shares, which brings the total number of shares reserved under the Omnibus Plan to 3,150,000. All
of the terms of awards made under the Omnibus Plan, including vesting and other restrictions are
determined by the Compensation Committee of the Company’s Board of Directors. The exercise price
of any stock option will not be less than the fair market value of the shares on the date of grant.
During the three months ended March 31, 2010, the Company granted 89,000 shares of restricted
stock to employees under the Omnibus Plan. The shares of restricted stock awarded during such
period vest in three equal installments over a period of three years. Stock-based compensation will
be recognized over the expected vesting period of the shares of restricted stock. No stock options
were granted by the Company during the three months ended March 31, 2010. 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
awarded during such period vest in three equal installments over a
period of three years. Stock-based compensation will be recognized over the expected
19
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 11. STOCK COMPENSATION PLANS – (Continued)
vesting period of the stock options and
shares of restricted stock. Shares available for future grants under the Omnibus Plan totaled
1,739,036 at March 31, 2010.
The following table summarizes stock option activity for the three months ended March 31, 2010
and 2009.
The aggregate intrinsic value of fully vested options outstanding and exercisable under
the 1998 Plan was $0.6 million at March 31, 2010. There was $0.1 million of aggregate intrinsic
value of options expected to vest under the Omnibus Plan at March 31, 2010.
The total intrinsic value of stock options exercised was $4.4 million for the three months
ended March 31, 2010.
The number of stock option awards outstanding and exercisable at March 31, 2010 by range of
exercise prices was as follows:
20
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 11. STOCK COMPENSATION PLANS – (Concluded)
A summary of the Company’s restricted stock activity was as follows:
The fair value of stock options granted during the three months ended March 31, 2010 and
2009 were determined on the dates of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions:
The expected term of options was determined based on the simplified method per FASB
accounting guidance for stock compensation. 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 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 $0.5 million and $0.6 million for the three months ended March 31, 2010 and
2009, respectively.
As of March 31, 2010, there was approximately $3.7 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
21
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited) 12. ACCUMULATED OTHER COMPREHENSIVE INCOME
The Company’s accumulated other comprehensive income included the following:
13. INSURANCE REGULATION
In September 2009, First Mercury Insurance Company (“FMIC”) and CoverX Corporation
(“CoverX”) received from the California Department of Insurance (the “California Department”) an
Accusation and an Order to Cease and Desist (collectively the “Pleadings”). The Pleadings (i)
allege that FMIC and CoverX transacted business in California without the proper licenses, (ii)
order FMIC and CoverX to stop transacting any business in California for which they do not have a
license and (iii) seek the revocation of CoverX’s existing California fire and casualty producer
license. In October 2009, the Pleadings were expanded to include First Mercury Emerald Insurance
Services, Inc. (“Emerald”). Although the Pleadings seek to revoke CoverX’s and Emerald’s existing
California fire and casualty producer licenses, the California Department has agreed that CoverX
and Emerald may continue to produce California business, and that FMIC may continue to insure
California risks as long as those risks are produced by CoverX and Emerald personnel located
outside the State of California. The Pleadings also assert a right to seek monetary penalties, but
no demand for payment has been made. FMIC, CoverX and Emerald have denied the allegations in the
Pleadings, and CoverX and Emerald have requested a hearing on the action to revoke their respective
fire and casualty producer licenses. FMIC, CoverX and Emerald have also been conferring with the
California Department to obtain surplus lines broker licenses and resolve these issues. While it
is not possible to predict with certainty the outcome of any legal proceeding, we believe the
outcome of these proceedings will not result in a material adverse effect on our consolidated
financial condition or results of operations.
14. RESTRUCTURING
Following a review of the Company’s operating structure with the Board of Directors in early
2010, the Company determined that a restructuring of certain components of the Company’s insurance
underwriting operations and corporate support functions was necessary to improve the Company’s cost
structure. As a result of this decision, the Company recorded a pretax restructuring charge of
$5.0 million related to reductions in staffing levels, lease termination costs and other items.
The restructuring is substantially complete and the Company does not anticipate any additional
restructuring charges as a result of this plan.
15. SUBSEQUENT EVENT
On April 30, 2010, the Company amended its existing credit agreement with its lender since the
payment of the special dividend would have resulted in a violation of a covenant in the credit
agreement. The amendment extended the maturity date of the credit agreement from September 30,
2011 to September 30, 2013 and revised certain restrictive covenants.
22
Table of Contents
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 the economic recession and the volatility in
the financial markets on our investment portfolio; 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 estimates for accrued profit sharing commissions are based on loss
ratio performance and could be reduced if the underlying loss ratios deteriorate; 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 36 years of underwriting
security risks, we have established CoverX ® as a recognized brand among insurance
agents and brokers and have developed significant underwriting expertise and a cost-efficient
infrastructure. Over the last nine 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 markets, produces and binds insurance policies pursuant to guidelines that we establish
and 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 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 based on guidelines that we provide. 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
23
Table of Contents
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.
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 and other performance 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 performance 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 earned premiums is the related GAAP measure used in the
statements of earnings, gross written premiums is the component of net earned premiums 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 earned premiums is the related GAAP measure used in the
statements of earnings, net written premiums is the component of net earned premiums 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 loss adjustment
expenses divided by net earned premiums. 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 earned premiums. 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, 2009 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 investments, intangible assets and goodwill.
24
Table of Contents
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 for the time value of money.
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:
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, 2010 and December 31, 2009,
gross and net of ceded reinsurance were as follows:
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
25
Table of Contents
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.
The Company underwrote retroactive loss portfolio transfer (“LPT”) contracts during 2009 and
2010 in which the insured loss events occurred prior to the inception of the contract. These
contracts were evaluated to determine whether they met the established criteria for reinsurance
accounting. When reinsurance accounting is appropriate, written premiums are fully earned and
corresponding losses and loss expenses recognized at the inception of the contract. These
contracts can cause significant variances in gross written premiums, net written premiums, net
earned premiums, and net incurred losses in the years in which they are written. Reinsurance
contracts sold not meeting the established criteria for reinsurance accounting are recorded using
the deposit method. The Company has no LPT contracts that are accounted for using the deposit
method.
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 and reinsurance
companies, based on losses and loss adjustment expense experience, are earned when determined and
communicated by the applicable contract.
Investments
Our marketable investment securities, including fixed maturity and equity securities, and
short-term investments, are classified as available-for-sale and, as a result, are reported at
market value. The changes in the fair value of these investments are recorded as a component of
Other comprehensive income (loss). Convertible securities are accounted for under the accounting
guidance for hybrid securities whereby changes in fair value are reflected in Net realized gains
(losses) on investments in the Condensed Consolidated Statements of Income. Alternative
investments consist of our investments in limited partnerships, which invest in high yield
convertible securities and distressed structured finance products. At the date of inception, we
elected the fair value accounting option for these alternative investments in accordance with FASB
guidance, whereby changes in fair value are reflected in Net investment income and Net realized
gains (losses) on investments in the Condensed Consolidated Statements of Income.
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.
• 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
26
Table of Contents
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, 2010.
These securities were classified as Level 2 at March 31, 2010 because our third party pricing
service uses valuation models which use observable market inputs in addition to traded prices.
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 when a market decline below 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 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 additional 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 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 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.
27
Table of Contents
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 the accounting guidance for goodwill and intangible assets that are not
subject to amortization, these intangible assets 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 exceeds their
fair value, an impairment loss shall be recognized in an amount equal to that excess.
In accordance with the accounting guidance 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.
All of the Company’s goodwill is allocated to the reporting unit of AMC since AMC has its own
distinct business platform with discrete financial information. The Company acquired AMC to gain
access to an established and experienced specialty admitted underwriting franchise with a definable
niche market. The expertise of AMC’s specialty admitted underwriting franchise is not
significantly correlated to our existing underwriting operations and we did not allocate any
goodwill to our existing insurance underwriting operations based on this fact.
28
Table of Contents
Results of Operations
Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009
The following table summarizes our results for the three months ended March 31, 2010 and 2009:
29
Table of Contents
Operating Revenue
Net Earned Premiums
Direct written premiums increased $2.0 million, or 3%, primarily due to increases in
premium production from the Company’s Excess/Umbrella Casualty and Professional Liability lines of
business partially offset by decreases in production from the Company’s Primary General Liability
and Commercial Property lines of business during the three months ended March 31, 2010. Direct
earned premiums increased $1.4 million in the three months ended March 31, 2010, or 2%, compared to
the three months ended March 31, 2009.
Assumed written premiums increased $3.8 million, or 80%, and assumed earned premiums increased
$3.6 million, or 83%. The increase in assumed written and earned premiums is primarily due to $3.3
million of premiums from assumed retroactive reinsurance transactions consummated during the three
months ended March 31, 2010.
Ceded written premiums increased $3.1 million, or 11%, and ceded earned premiums increased
$5.5 million, or 22%, for the three months ended March 31, 2010 compared to the three months ended
March 31, 2009. Ceded written premiums increased to 37% of direct and assumed written premiums
during the three months ended March 31, 2010 compared to 36% of direct and assumed written premiums
during the three months ended March 31, 2009 principally due to purchasing more quota share and
excess of loss reinsurance during the quarter ended March 31, 2010 for the Company’s primary
casualty business compared to the same period of 2009. The increase in quota share cessions was
partially offset by assumed reinsurance transactions that were fully retained by the Company.
Earned but unbilled premiums decreased $0.5 million, or 615%, primarily due to the net earned
premiums subject to audit during the three months ended March 31, 2010 decreasing compared to the
net premiums earned subject to audit during the three months ended March 31, 2009.
30
Table of Contents
Commissions and Fees
Insurance underwriting commissions and fees increased 8% from the three months ended
March 31, 2009 to the three months ended March 31, 2010, principally due to higher policy and
inspection fees. Insurance services commissions and fees, which were principally AMC commission
and fee income and not related to premiums, increased $0.8 million, as the result of increased AMC
commission and fee income of $0.9 million, offset by a decrease of $0.1 million of
commission income related to our workers’ compensation service program, during the first quarter of
2010 compared to the first quarter of 2009.
Net Investment Income and Realized Gains on Investments. During the three months ended March
31, 2010, net investment income was $8.7 million, a $2.2 million, or 35%, increase from $6.4
million reported for the three months ended March 31, 2009, primarily due to the increase in
invested assets over the period and an increase in the book yield of the portfolio. At March 31,
2010, invested assets were $751.2 million, a $159.7 million, or 27%, increase over $591.5 million
of invested assets at March 31, 2009. This increase was due to cash flows from net written
premiums and from the cash retained on our quota share reinsurance contracts on a “funds withheld”
basis. The annualized investment yield on total investments (net of investment expenses) was 4.9%
and 4.6% at March 31, 2010 and 2009, respectively. The annualized taxable equivalent yield on
total investments (net of investment expenses) was 5.3% and 5.2% at March 31, 2010 and 2009,
respectively.
During the three months ended March 31, 2010, net realized gains were $4.2 million compared to
net realized gains of $1.8 million during the three months ended March 31, 2009. Net realized
gains for the three months ended March 31, 2010 were principally due to net gains on the sale of
certain available for sale securities of $2.1 million and the mark to market increase in
securities carried at market of approximately $2.5 million. Those securities that are marked to
market include convertible securities held both as individually-owned securities and an investment
in a limited partnership, and an investment in a structured finance limited partnership.
Convertible bond prices are a function of the underlying equity and the fixed income component
whose values changed with the stock market and changes in spread of corporate bonds, respectively.
The structured finance limited partnership is valued based on a portfolio of non-agency mortgage
securities, and the hedges that may accompany positions. The value of these components in the
limited partnership changed in value for a variety of reasons including, but not limited to,
changes in spread for mortgage product, changes in prepayment rates, default rates, severity rates,
changes in the overall level of rates and the corresponding value of the underlying loans, and
changes in the value of the properties by which these loans are collateralized.
Other-Than-Temporary Impairment Losses on Investments. During the three months ended March
31, 2010 other-than-temporary impairment losses on investments were $0.5 million compared to
other-than-temporary impairment losses on investments of $0.1 million during the three months ended
March 31, 2009.
Operating Expenses
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred increased
$3.5 million, or 12%, for the three months ended March 31, 2010 compared to the three months ended
March 31, 2009. This increase was primarily due to an increase in the accident year loss and loss
adjustment expense ratio from decreased premium rates, a higher loss ratio on assumed retroactive
reinsurance transactions and an increase in the loss ratio for a Professional Liability line of
business. There was no development of December 31, 2009 prior years’ loss and loss adjustment
expense reserves for the quarter ended March 31, 2010. Losses and loss adjustment expenses for the
quarter ended March 31, 2009 included approximately $0.8 million of favorable development of
December 31, 2008 prior years’ loss and loss adjustment expense reserves.
31
Table of Contents
Other Operating Expenses
During the three months ended March 31, 2010, other operating expenses increased $1.7
million, or 8%, from the three months ended March 31, 2009. Amortization of deferred acquisition
expenses were approximately flat for the three months ended March 31, 2010 compared to the three
months ended March 31, 2009. Other underwriting and operating expenses, which consist of
commissions, and other acquisition costs, and higher general and underwriting expenses, net of acquisition
cost deferrals, increased by $1.9 million, or 21%. The increase was principally due to higher
commissions and other acquisition costs and higher operating expenses of $1.4 million
and an increase of $0.5 million in general and underwriting expenses related to our insurance
services operations, which are unrelated to premiums, principally due to increased premium
production for unaffiliated carriers.
Restructuring. During the first quarter of 2010, the Company recorded a pretax restructuring
charge of $5.0 million related to reductions in staffing levels, lease termination costs and other
items.
Interest Expense. Interest expense decreased 6% from the three months ended March 31, 2009
compared to the three months ended March 31, 2010. This decrease was primarily due to a $0.1
million decrease in the change in fair value of the interest rate swaps on junior subordinated
debentures as discussed in “Liquidity and Capital Resources” below.
Income Taxes. Our effective tax rates were approximately 20.9% for the three months ended
March 31, 2010 and 31.9% for the three months ended March 31, 2009 and differed from the federal
statutory rate primarily due to state income taxes, non-deductible expenses, the nontaxable portion
of dividends received and tax-exempt interest, and a one-time purchase accounting adjustment. The
decrease in the effective tax rate is primarily due to the nontaxable portion of dividends received
and tax-exempt interest constituting a greater portion of overall pretax income for the three months
ended March 31, 2010 compared to the same period of 2009 and due to a one-time purchase accounting
adjustment.
Liquidity and Capital Resources
Sources and Uses of Funds
FMFC. FMFC is a holding company with all of its operations being conducted by its
subsidiaries. Accordingly, FMFC has continuing cash needs primarily for administrative expenses,
debt service, shareholder dividends and taxes. Funds to meet these obligations come primarily from
management and administrative fees from all of our subsidiaries, and dividends from our
non-insurance subsidiaries.
Insurance Subsidiaries. The primary sources of our insurance subsidiaries’ cash are net
written premiums, claims handling fees, amounts earned from investments and the sale or maturity of
invested assets. Additionally, FMFC has in the past and may in the future contribute capital to
its insurance subsidiaries.
The primary uses of our insurance subsidiaries’ cash include the payment of claims and related
adjustment expenses, underwriting fees and commissions, taxes, making investments and paying
dividends. Because the payment of individual claims cannot be predicted with certainty, our
insurance subsidiaries rely on our paid claims history and industry data in determining the
expected payout of claims and estimated loss reserves. To the extent that FMIC, FMCC, and AUIC
have an unanticipated shortfall in cash, they may either liquidate securities held in their
investment portfolios or obtain capital from FMFC. However, given the cash generated by our
insurance subsidiaries’ operations and the relatively short duration of their investment
portfolios, we do not currently foresee any such shortfall.
Non-insurance Subsidiaries. The primary sources of our non-insurance subsidiaries’ cash are
commissions and fees, policy fees, administrative fees and claims handling and loss control fees.
The primary uses of our non-insurance subsidiaries’ cash are
32
Table of Contents
commissions paid to brokers, operating
expenses, taxes and dividends paid to FMFC. There are generally no restrictions on the payment of
dividends by our non-insurance subsidiaries, except as may be set forth in our borrowing
arrangements.
Cash Flows
Our sources of funds have consisted primarily of net written premiums, commissions and fees,
investment income and proceeds from the issuance of equity securities and debt. We use operating
cash primarily to pay operating expenses and losses and loss adjustment expenses, for purchasing
investments and for paying shareholder dividends. A summary of our cash flows is as follows:
Net cash provided by operating activities for the three months ended March 31, 2010 and
2009 was primarily from cash received on net written premiums and less cash disbursed for operating
expenses and losses and loss adjustment expenses. Cash received from net written premiums for the
three months ended March 31, 2010 and 2009 was retained on a “funds withheld” basis in accordance
with the quota share reinsurance contracts.
Net cash used in investing activities for the three months ended March 31, 2010 and 2009
primarily resulted from our net investment in short-term, debt and equity securities.
Net cash used in financing activities for the three months ended March 31, 2010 was primarily
for the payment of shareholders’ dividends, partially offset by borrowings of $26.0 million on the
Company’s revolving credit facility and funds received from the exercise of stock options.
Based on historical trends, market conditions, and our business plans, we believe that our
existing resources and sources of funds will be sufficient to meet our liquidity needs in the next
twelve months. Because economic, market and regulatory conditions may change, however, there can
be no assurances that our funds will be sufficient to meet our liquidity needs. In addition,
competition, pricing, the frequency and severity of losses, and interest rates could significantly
affect our short-term and long-term liquidity needs.
Stockholders’ Equity
Our total stockholders’ equity was $289.7 million, or $16.43 per outstanding share, as of
March 31, 2010 compared to $316.1 million, or $18.40 per outstanding share, as of December 31,
2009. Our tangible stockholders’ equity attributable to common shareholders was $240.1 million, or
$13.61 per outstanding share, as of March 31, 2010 compared to $266.1 million, or $15.49 per
outstanding share as of December 31, 2009. Below is a reconciliation of our total stockholders’
equity to our tangible stockholders’ equity attributable to common shareholders:
33
Table of Contents
Book value per share is total common stockholders’ equity divided by the number of common
shares outstanding. Tangible book value per share is book value per share excluding the value of
intangible assets, goodwill, and the deferred tax liability related to intangible assets divided by
the number of common shares outstanding.
Long-term debt
Junior Subordinated Debentures. We have $67.0 million cumulative principal amount of floating
rate junior subordinated debentures outstanding. The debentures were issued in connection with the
issuance of trust preferred stock by our wholly-owned, non-consolidated trusts. Cumulative
interest on $46.4 million cumulative principal amount of the debentures is payable quarterly in
arrears at a variable annual rate, reset quarterly, equal to the three month LIBOR plus 3.75% for
$8.2 million, the three month LIBOR plus 4.00% for $12.4 million, and the three month LIBOR plus
3.0% for $25.8 million principal amount of the debentures. Cumulative interest on $20.6 million of
the cumulative principal amount of the debentures is payable quarterly in arrears at a fixed annual
rate of 8.25% through December 15, 2012, and a variable annual rate, reset quarterly, equal to the
three month LIBOR plus 3.30% thereafter. For our floating rate junior subordinated debentures, we
have entered into interest rate swap agreements to pay a fixed rate of interest. See “Derivative
Financial Instruments” for further discussion. At March 31, 2010, the three month LIBOR rate was
0.29%. We may defer the payment of interest for up to 20 consecutive quarterly periods; however,
no such deferral has been made.
Credit Agreement. In October 2006, we entered into a credit agreement which provided for
borrowings of up to $30.0 million. At December 31, 2009, borrowings under the credit agreement
bear interest at our election as follows: (i) at a rate per annum equal to the greater of the
lender’s prime rate and the federal funds rate plus 0.5%, each minus 0.75%; or, (ii) a rate per
annum equal to LIBOR plus an applicable margin which is currently 0.75% or 1.0% based on our
leverage ratio. On February 22, 2010, in connection with receipt of a temporary waiver of any
event of default through May 1, 2010, the interest rate on borrowings under the credit agreement
was changed to equal the greater of: (i) the prime rate, (ii) a rate per annum equal to the greater
of the lender’s prime rate and the federal funds rate plus 0.5% and (iii) a rate per annum equal to
LIBOR plus an applicable margin which is currently 2.0% plus 1.0%; or, with respect to certain
other borrowings, a rate per annum equal to LIBOR plus an applicable margin which is currently
2.0%. The obligations under the credit agreement are guaranteed by our material non-insurance
subsidiaries. At March 31, 2010, there were $30.0 million of borrowings under the agreement, which
represents the full amount of the lender’s commitment to the Company. The credit agreement also
contains various restrictive covenants that relate to the Company’s shareholders’ equity, leverage
ratio, fixed charge coverage ratio, surplus and risk based capital, and A.M. Best Ratings of its
insurance subsidiaries. At March 31, 2010, the Company was not in compliance with the fixed charge
coverage ratio of the covenant related to the credit agreement as a result of the special dividend. On February 22, 2010, the Company
received a temporary waiver of any event of default as of March 31, 2010 related to the fixed
charge coverage ratio covenant in the Company’s credit agreement through May 1, 2010. On April 30,
2010, the Company amended its existing credit agreement with its lender since the payment of the
special dividend would have resulted in a violation of a covenant in the credit agreement. The
amendment extended the maturity date of the credit agreement from September 30, 2011 to September
30, 2013 and revised certain restrictive covenants. In connection with the amendment, the interest
rate on borrowings under the credit agreement was changed to (i) a rate negotiated from time to
time between the Company and the lender (if agreed to by the lender in its discretion), (ii) a rate
per annum equal to the greater of the lender’s prime rate or Adjusted One Month LIBOR Rate (as
defined in the amendment and including a 2.5% floor) and (iii) a rate per annum equal to LIBOR plus
an applicable margin which ranges from
34
Table of Contents
1.75% to 2.25% (depending on the Company’s applicable
Leverage Ratio (as defined in the credit agreement)). As of April 30, 2010, the applicable margin
for clause (iii) above was 2.0%.
Derivative Financial Instruments. Financial derivatives are used as part of the overall asset
and liability risk management process. We use interest rate swap agreements with a combined
notional amount of $45.0 million in order to reduce our exposure to
interest rate fluctuations with respect to our junior subordinated debentures. In June 2009,
the Company entered into two interest rate swap agreements which expire in August 2014. Under one
of the swap agreements we pay interest at a fixed rate of 3.695% and under the other swap agreement
we pay interest at a fixed rate of 3.710%. Under our third swap agreement, which expires in
December 2011, we pay interest at a fixed rate of 5.013%. Under all three swap agreements, we
receive interest at the three month LIBOR, which is equal to the contractual rate under the junior
subordinated debentures. At March 31, 2010, we had no exposure to credit loss on the interest rate
swap agreements.
Cash and Invested Assets
Our cash and invested assets consist of fixed maturity securities, convertible securities,
equity securities, and cash and cash equivalents. At March 31, 2010, our investments had a market
value of $751.2 million and consisted of the following investments:
The following table shows the composition of the investment portfolio by remaining time
to maturity at March 31, 2010. 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 our investments in putable bonds fluctuate
inversely with interest rates and therefore may also differ from contractual maturities.
35
Table of Contents
The effective duration of the portfolio as of March 31, 2010 is approximately 3.4 years
and the taxable equivalent duration is 3.1 years. Excluding cash and cash equivalents, equity and
convertible securities, the portfolio duration and taxable equivalent duration are 3.8 years and
3.5 years, respectively. The shorter taxable equivalent duration reflects the significant portion
of the portfolio in municipal securities. The annualized investment yield on total investments
(net of investment expenses) was 4.9% at March 31, 2010 and 4.6% at March 31, 2009. The annualized
taxable equivalent yield on total investments (net of investment expenses) was 5.3% at March 31,
2010 and 5.2% at March 31, 2009.
The majority of our portfolio consists of AAA or AA rated securities with a Standard and
Poor’s weighted average credit quality of A+ at March 31, 2010. The fixed income portfolio had a
weighted average credit quality of AA- at March 31, 2010. The majority of the investments rated
BBB and below are convertible securities and opportunistic investments in high yield credit and
non-agency mortgage securities. Consistent with our investment policy, we review any security if
it falls below BBB- and assess whether it should be held or sold. The following table shows the
ratings distribution of our investment portfolio as of March 31, 2010 as a percentage of total
market value.
Within Mortgages, the Company invests in residential collateralized mortgage obligations
(“CMO”) that typically have high credit quality and are expected to provide an advantage in yield
compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO
tranches which offer the most favorable return given the risks involved. One significant risk
evaluated is prepayment sensitivity. While prepayment risk (either shortening or lengthening of
duration) and its effect on total return cannot be fully controlled, particularly when interest
rates move dramatically, the investment process generally favors securities that control this risk
within expected interest rate ranges. The Company does not purchase residual interests in CMO’s.
At March 31, 2010, the Company held CMO’s classified as available-for-sale with a fair value
of $96.4 million. Approximately 53.4% of those CMO holdings were guaranteed by or fully
collateralized by securities issued by a full faith and credit agency such as GNMA, or government
sponsored enterprises (“GSE”) such as FNMA or FHLMC. In addition, at March 31, 2010, the Company
held $55.1 million of mortgage-backed pass-through securities issued by one of the GSE’s and
classified as available-for-sale.
The Company held commercial mortgage-backed securities (“CMBS”) of $59.8 million, of which
83.0% are pre-2006 vintage, at March 31, 2010. The weighted average credit support (adjusted for
defeasance) of our CMBS portfolio was 44.0% and comprised mainly of super senior structures. The
weighted average loan to value at origination was 67.3%. The average credit rating of these
securities was AAA. The CMBS portfolio was supported by loans that were diversified across
economic sectors and geographical areas. It is not believed that this portfolio exposes the
Company to a material adverse impact on its results of operations, financial position or liquidity,
due to the underlying credit strength of these securities.
The Company’s fixed maturity investment portfolio included asset-backed securities and
collateralized mortgage obligations collateralized by sub-prime mortgages and alternative
documentation mortgages (“Alt-A”) with market values of $10.8 million and $18.8 million at March
31, 2010, respectively. Included in these securities is a recent allocation to a manager who
specializes in opportunities in the non-agency mortgage sector. The Company defines sub-prime
mortgage-backed securities as investments with weighted average FICO scores below 650. Alt-A
securities are defined by above-prime interest rates, high loan-to-value ratios, high
debt-to-income ratios, low loan documentation (e.g., limited or no verification of income and
assets), or other characteristics that are inconsistent with conventional underwriting standards
employed by government-sponsored mortgage entities. The average credit rating on these securities
and obligations held by the Company at March 31, 2010 was B-.
36
Table of Contents
The Company’s fixed maturity investment portfolio at March 31, 2010 included securities issued
by numerous municipalities with a total carrying value of $202.9 million. Approximately $18.3
million, or 9.0%, were pre-refunded (escrowed with Treasuries). Approximately $89.0 million, or
43.9%, of the securities were enhanced by third-party insurance for the payment of principal and
interest in the event of an issuer default. Such insurance, prior to the downgrades of many of the
third party insurers, resulted in a rating of AAA being assigned by independent rating agencies to
those securities. The downgrade of credit ratings of insurers of these securities could result in
a corresponding downgrade in the ratings of the securities from AA+ to the underlying rating of the
respective security without giving effect to the benefit of insurance. Of the total $89.0 million
of insured municipal securities in the Company’s investment portfolio at March 31, 2010, 98.8% were
rated at A- or above, and approximately 73.0% were rated AA- or above, without the benefit of
insurance. The average underlying credit rating of the entire municipal bond portfolio was AA at
March 31, 2010. The Company believes that a loss of the benefit of insurance would not result in a
material adverse impact on the Company’s results of operations, financial position or liquidity,
due to the underlying credit strength of the issuers of the securities, as well as the Company’s
ability and intent to hold the securities.
The Company’s investment portfolio does not contain any exposure to Collateralized Debt
Obligations (“CDO”) or investments collateralized by CDOs. In addition, the Company’s investment
portfolio does not contain any exposure to auction-rate securities.
Cash and cash equivalents consisted of cash on hand of $15.5 million at March 31, 2010.
The amortized cost, gross unrealized gains and losses, and market value of marketable
investment securities classified as available-for-sale at March 31, 2010 by major security type
were as follows:
At March 31, 2010, there were 133 unrealized loss positions with a total unrealized loss
of $2.0 million. This represents approximately 0.3% of quarter end available-for-sale assets of
$649.1 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 March 31, 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 3.8 years, and 3.5 years on a taxable equivalent basis. We
do not intend to sell and it is not expected we will need to sell these temporarily impaired
securities. In light of our operating cash flow over the past 24 months, liquidity needs from the
portfolio are minimal. As a result, we would not expect to have to liquidate temporarily impaired
securities to pay claims or for any other purposes. 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.
37
Table of Contents
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 March 31, 2010:
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:
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 three months ended March 31, 2010. All asset sectors were affected by the overall increase in
spreads as can be seen from the table below. In addition to the general level of 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.
38
Table of Contents
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 rated investment
grade. 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 3.5% as of March 31,
2010.
The majority of these securities are “AAA” or “AA” rated. Of the $1.0 million of
unrealized loss within non-investment grade, CMOs accounted for 49.9% of this loss. Within CMOs,
75.5% were collateralized by prime loans with the balance in Alt-A and sub-prime. The next highest
percent of the loss within non-investment grade were Alt-A and sub-prime home equity asset-backed
securities at 49.5% of the loss. The remaining portion of the loss, or 0.6%, was within
non-investment grade corporate issues. 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 CMOs at 36.2% of the total
loss. Within CMOs 57.9% are rated AAA including the 39.2% of the CMO exposure that is agency
issued, and have primarily been affected by the general level of interest rates as well. The next
largest concentration of temporarily impaired securities is Asset Backed Securities at 27.1% of the
total loss. The next largest concentration of temporarily impaired securities is Commercial MBS at
approximately 16.3% of the total loss. Both ABS and CMBS have been affected primarily by the
widening of spreads and/or the general level of interest rates. The next largest concentration of
temporarily impaired securities is Municipal Bonds at approximately 11.4% of the total loss.
For the three months ended March 31, 2010, we sold approximately $2.1 million of market value
of fixed income securities excluding convertibles, which were trading below amortized cost while
recording a realized loss of $0.4 million. This loss represented
39
Table of Contents
16.8% of the amortized cost of the positions. These sales were unique opportunities to sell
specific positions due to changing market conditions. These situations were exceptions to our
general assertion regarding our ability and intent to hold securities with unrealized losses until
they mature or recover in value.
During the three months ended March 31, 2010, net realized gains were $4.2 million compared to
net realized gains of $1.8 million during the three months ended March 31, 2009. Net realized
gains for the three months ended March 31, 2010 were principally due to net gains on the sale of
certain available for sale securities of $2.1 million and the mark to market increase in
securities carried at market of approximately $2.5 million. Those securities that are marked to
market include convertible securities held both as individually-owned securities and an investment
in a limited partnership, and an investment in a structured finance limited partnership.
Convertible bond prices are a function of the underlying equity and the fixed income component
whose values changed with the stock market and changes in spread of corporate bonds, respectively.
The structured finance limited partnership is valued based on a portfolio of non-agency mortgage
securities, and the hedges that may accompany positions. The value of these components in the
limited partnership changed in value for a variety of reasons including, but not limited to,
changes in spread for mortgage product, changes in prepayment rates, default rates, severity rates,
changes in the overall level of rates and the corresponding value of the underlying loans, and
changes in the value of the properties by which these loans are collateralized.
Deferred Policy Acquisition Costs
We defer a portion of the costs of acquiring insurance business, primarily commissions and
certain policy underwriting and issuance costs, which vary with and are primarily related to the
production of insurance business. For the three months ended March 31, 2010, $13.7 million of the
costs were deferred. Deferred policy acquisition costs totaled $26.2 million, or 29.1% of unearned
premiums (net of reinsurance), at three months ended March 31, 2010.
Reinsurance
The following table illustrates our direct written premiums and premiums ceded for the three
months ended March 31, 2010 and 2009:
The following table illustrates the effect of our reinsurance ceded strategies on our results
of operations:
Our net cash flows relating to ceded reinsurance activities (premiums paid less losses
recovered and ceding commissions received) were approximately $13.4 million net cash paid for the
three months ended March 31, 2010 compared to net cash paid of $8.3 million for the three months
ended March 31, 2009.
The assuming reinsurer is obligated to indemnify the ceding company to the extent of the
coverage ceded. The inability to recover amounts due from reinsurers could result in significant
losses to us. To protect us from reinsurance recoverable losses, FMIC seeks to enter into
reinsurance agreements with financially strong reinsurers. Our senior executives evaluate the
credit risk of each reinsurer
40
Table of Contents
before entering into a contract and monitor the financial strength of the reinsurer. On March 31,
2010, substantially all reinsurance contracts to which we were a party were with companies with
A.M. Best ratings of “A” or better. One reinsurance contract to which we were a party was with a
reinsurer that does not carry an A.M. Best rating. For this contract, we required full
collateralization of our recoverable via a grantor trust and an irrevocable letter of credit. In
addition, ceded reinsurance contracts contain trigger clauses through which FMIC can initiate
cancellation including immediate return of all ceded unearned premiums at its option, or which
result in immediate collateralization of ceded reserves by the assuming company in the event of a
financial strength rating downgrade, thus limiting credit exposure. On March 31, 2010, there was
no allowance for uncollectible reinsurance, as all reinsurance balances were current and there were
no disputes with reinsurers.
On March 31, 2010 and December 31, 2009, FMFC had a net amount of recoverables from reinsurers
of $237.3 million and $228.7 million, respectively, on a consolidated basis.
Recent Accounting Pronouncements
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. Specfically, 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 in the first quarter of 2010 is included in Note 5, “Fair Value
Measurements” to the condensed consolidated financial statements.
In June 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 in the first
quarter of 2010 did not have a material effect on the Company’s results of operations, financial
position or liquidity.
Prospective Accounting Standards
The Emerging Issues Task Force (EITF or “Task Force”) Issue No. 09-G intends to clarify the
definition of what constitutes an acquisition cost and the types of acquisition costs capitalized
by an insurance entity. In November 2009, the Task Force reached a consensus-for-exposure that
would limit the costs an entity can include in DAC to those that are “directly related to” the
acquisition of new and renewal insurance contracts. They clarified that the direct costs only
included those that result in the successful acquisition of
a policy and exclude all cost incurred for unsuccessful efforts, along with indirect costs. The
consensus-for-exposure would require that an entity include only actual costs, not costs expected
to be incurred, in DAC.
On March 18, 2010, the Task Force affirmed the previous conclusions from the proposed
consensus that indirect costs and costs of unsuccessful activities should not be included in
capitalized acquisition costs. The Task Force also agreed that advertising cost should be
capitalized only when certain requirements are met. There were further questions on how accounting
for advertising costs interacts with the DAC impairment model and further analysis was requested.
The Task Force plans to discuss that question and the effective date and transition at the next
EITF meeting in June.
If the Task Force reaches a final consensus at a subsequent meeting and it is ratified by the
Financial Accounting Standards Board (FASB), as currently proposed, it would be effective for
interim and annual periods beginning on or after December 15, 2010, with either prospective or
retrospective application permitted, as currently drafted. Early adoption would also be
permitted.
41
Table of Contents
This issue, if ratified, has the potential to significantly impact the way insurance companies
account for DAC, and therefore, could potentially have a significant impact on the results of
operations. It would result in the need to identify and recognize, as period
costs, those amounts associated with unsuccessful acquisition efforts in addition to indirect
costs. Amounts associated with successful acquisition efforts would continue to be capitalized and
charged to expense in proportion to premium revenue recognized. As an example, under current
guidance, underwriter salaries are capitalized and amortized over the period in which the
associated premium written is earned as revenue. Under the proposed guidance, companies would be
required to identify the portion of underwriter salaries that could be attributed to unsuccessful
acquisition efforts and expense that amount in the current period. We will continue to monitor the
progress of this issue.
42
Table of Contents
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 for a
complete discussion of the Company’s market risk. There have been no material changes to the
market risk information included in the Company’s Annual Report on Form 10-K.
Item 4. Controls and Procedures
The Company’s chief executive officer and chief financial officer have concluded, based on
their evaluation as of the end of the period covered by this report, that the Company’s disclosure
controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and
15d-15(e)) are effective to ensure that information required to be disclosed in the reports that
the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the Securities and Exchange
Commission’s rules and forms, and that such information is accumulated and communicated to our
management, including our chief executive officer and chief financial officer, as appropriate, to
allow timely decisions regarding financial disclosures. There was no change in the Company’s
internal control over financial reporting that occurred during the quarter ended March 31, 2010
that has materially affected or is reasonably likely to materially affect, the Company’s internal
control over financial reporting.
43
Table of Contents
PART II. — OTHER INFORMATION
Item 1. Legal Proceedings
In September 2009, FMIC and CoverX received from the California Department of Insurance (the
“California Department”) an Accusation and an Order to Cease and Desist (collectively the
“Pleadings”). The Pleadings (i) allege that FMIC and CoverX transacted business in California
without the proper licenses, (ii) order FMIC and CoverX to stop transacting any business in
California for which they do not have a license and (iii) seek the revocation of CoverX’s existing
California fire and casualty producer license. In October 2009, the Pleadings were expanded to
include FM Emerald. Although the Pleadings seek to revoke CoverX’s and FM Emerald’s existing
California fire and casualty producer licenses, the California Department has agreed that CoverX
and FM Emerald may continue to produce California business, and that FMIC may continue to insure
California risks as long as these risks are produced by CoverX and FM Emerald personnel located
outside the State of California, which is how the Company is currently conducting business. The
Pleadings also assert a right to seek monetary penalties, but no demand for payment has been made.
FMIC, CoverX and FM Emerald have denied the allegations in the Pleadings, and CoverX and FM Emerald
have requested a hearing on the action to revoke their respective fire and casualty producer
licenses. FMIC, CoverX and FM Emerald have also been conferring with the California Department to
obtain surplus lines broker licenses and resolve these issues. While it is not possible to predict
with certainty the outcome of any legal proceeding, we believe the outcome of these proceedings
will not result in a material adverse effect on our consolidated financial condition or results of
operations.
We are, from time to time, involved in various legal proceedings in the ordinary course of
business, including litigation involving claims with respect to policies that we write. We do not
believe that the resolution of any currently pending legal proceedings, either individually or
taken as a whole, will have a material adverse effect on our business, results of operations or
financial condition.
Item 6. Exhibits
See Index of Exhibits following the signature page, which is incorporated herein by reference.
44
Table of Contents
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
45
Table of Contents
INDEX OF EXHIBITS
46 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| |||||||
