Attached files
file | filename |
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EX-10.34 - EX-10.34 - FIRST MERCURY FINANCIAL CORP | k48528exv10w34.htm |
EX-31.(B) - EX-31.(B) - FIRST MERCURY FINANCIAL CORP | k48528exv31wxby.htm |
EX-32.(B) - EX-32.(B) - FIRST MERCURY FINANCIAL CORP | k48528exv32wxby.htm |
EX-31.(A) - EX-31.(A) - FIRST MERCURY FINANCIAL CORP | k48528exv31wxay.htm |
EX-32.(A) - EX-32.(A) - FIRST MERCURY FINANCIAL CORP | k48528exv32wxay.htm |
Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2009
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from _______________ to _______________
Commission File Number 001-33077
FIRST MERCURY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware | 38-3164336 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
29110 Inkster Road Suite 100 Southfield, Michigan (Address of Principal Executive Offices) |
48034 (Zip Code) |
Registrants 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.
Large accelerated filer o | Accelerated filer þ | Non-accelerated filer o (Do not check if a smaller reporting company) | Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date.
The number of shares of Common Stock, par value $0.01, outstanding on November 6, 2009 was
17,174,906.
TABLE OF CONTENTS
Item |
Page | |||||||
PART I FINANCIAL INFORMATION |
||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
7 | ||||||||
25 | ||||||||
47 | ||||||||
47 | ||||||||
PART II OTHER INFORMATION |
||||||||
48 | ||||||||
48 | ||||||||
48 | ||||||||
EX-10.34 | ||||||||
EX-31.(A) | ||||||||
EX-31.(B) | ||||||||
EX-32.(A) | ||||||||
EX-32.(B) |
2
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
ITEM 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets
September 30, | December 31, | |||||||
2009 | 2008 | |||||||
(Unaudited) | ||||||||
(Dollars in thousands, | ||||||||
except share and per share data) | ||||||||
ASSETS |
||||||||
Investments |
||||||||
Debt securities |
$ | 631,033 | $ | 495,799 | ||||
Equity securities and other |
32,224 | 15,089 | ||||||
Short-term |
10,754 | 32,142 | ||||||
Total Investments |
674,011 | 543,030 | ||||||
Cash and cash equivalents |
16,205 | 31,833 | ||||||
Premiums and reinsurance balances receivable |
52,468 | 56,398 | ||||||
Accrued investment income |
5,940 | 5,400 | ||||||
Accrued profit sharing commissions |
13,841 | 11,315 | ||||||
Reinsurance recoverable on paid and unpaid losses |
167,802 | 135,617 | ||||||
Prepaid reinsurance premiums |
59,784 | 48,921 | ||||||
Deferred acquisition costs |
26,310 | 27,369 | ||||||
Intangible assets, net of accumulated amortization |
37,642 | 39,351 | ||||||
Goodwill |
25,483 | 25,483 | ||||||
Deferred federal income taxes |
| 2,161 | ||||||
Other assets |
23,771 | 16,775 | ||||||
Total Assets |
$ | 1,103,257 | $ | 943,653 | ||||
LIABILITIES AND STOCKHOLDERS EQUITY |
||||||||
Loss and loss adjustment expense reserves |
$ | 448,265 | $ | 372,721 | ||||
Unearned premium reserves |
150,655 | 147,849 | ||||||
Long-term debt |
67,013 | 67,013 | ||||||
Funds held under reinsurance treaties |
67,093 | 49,419 | ||||||
Premiums payable to insurance companies |
31,363 | 27,831 | ||||||
Reinsurance payable on paid losses |
1,179 | 1,167 | ||||||
Deferred federal income taxes |
14,504 | | ||||||
Accounts payable, accrued expenses, and other liabilities |
15,713 | 16,016 | ||||||
Total Liabilities |
795,785 | 682,016 | ||||||
Stockholders Equity |
||||||||
Common stock, $0.01 par value; authorized 100,000,000 shares; issued
and outstanding 17,174,906 and 17,836,337 shares |
172 | 178 | ||||||
Paid-in-capital |
153,752 | 161,957 | ||||||
Accumulated other comprehensive income (loss) |
16,306 | (3,027 | ) | |||||
Retained earnings |
139,090 | 103,028 | ||||||
Treasury stock; 130,600 and 33,600 shares |
(1,848 | ) | (499 | ) | ||||
Total Stockholders Equity |
307,472 | 261,637 | ||||||
Total Liabilities and Stockholders Equity |
$ | 1,103,257 | $ | 943,653 | ||||
See accompanying notes to condensed consolidated financial statements.
3
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Income
(Unaudited)
(Unaudited)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands, except share and per share data) | ||||||||||||||||
Operating Revenue |
||||||||||||||||
Net earned premiums |
$ | 51,512 | $ | 49,092 | $ | 155,539 | $ | 139,222 | ||||||||
Commissions and fees |
7,445 | 4,757 | 23,916 | 15,896 | ||||||||||||
Net investment income |
7,540 | 5,571 | 21,105 | 15,635 | ||||||||||||
Net realized gains (losses) on investments (1) |
13,766 | (7,128 | ) | 25,204 | (8,714 | ) | ||||||||||
Other-than-temporary impairment losses on
investments (1) |
(292 | ) | (3,476 | ) | (426 | ) | (3,701 | ) | ||||||||
Total Operating Revenues |
79,971 | 48,816 | 225,338 | 158,338 | ||||||||||||
Operating Expenses |
||||||||||||||||
Losses and loss adjustment expenses, net |
30,345 | 27,537 | 96,301 | 76,713 | ||||||||||||
Amortization of deferred acquisition expenses |
13,960 | 10,798 | 40,889 | 28,107 | ||||||||||||
Underwriting, agency and other expenses |
10,169 | 8,999 | 28,919 | 26,599 | ||||||||||||
Amortization of intangible assets |
559 | 553 | 1,709 | 1,466 | ||||||||||||
Total Operating Expenses |
55,033 | 47,887 | 167,818 | 132,885 | ||||||||||||
Operating Income |
24,938 | 929 | 57,520 | 25,453 | ||||||||||||
Interest Expense |
1,446 | 1,440 | 4,278 | 4,380 | ||||||||||||
Change in Fair Value of Derivative Instruments |
(171 | ) | (64 | ) | (401 | ) | 110 | |||||||||
Income (Loss) From Continuing Operations Before
Income Taxes |
23,663 | (447 | ) | 53,643 | 20,963 | |||||||||||
Income Taxes |
8,018 | (948 | ) | 17,707 | 5,592 | |||||||||||
Income From Continuing Operations |
15,645 | 501 | 35,936 | 15,371 | ||||||||||||
Income (Loss) From Discontinued Operations,
Net of Income Taxes |
| (447 | ) | | 23,106 | |||||||||||
Net Income |
$ | 15,645 | $ | 54 | $ | 35,936 | $ | 38,477 | ||||||||
Basic Net Income Per Share: |
||||||||||||||||
Income From Continuing Operations |
$ | 0.90 | $ | 0.03 | $ | 2.03 | $ | 0.84 | ||||||||
Income (Loss) From Discontinued Operations |
| (0.02 | ) | | 1.27 | |||||||||||
Total |
$ | 0.90 | $ | 0.01 | $ | 2.03 | $ | 2.11 | ||||||||
Diluted Net Income Per Share: |
||||||||||||||||
Income From Continuing Operations |
$ | 0.89 | $ | 0.03 | $ | 1.99 | $ | 0.82 | ||||||||
Income (Loss) From Discontinued Operations |
| (0.02 | ) | | 1.23 | |||||||||||
Total |
$ | 0.89 | $ | 0.01 | $ | 1.99 | $ | 2.05 | ||||||||
Weighted Average Shares Outstanding: |
||||||||||||||||
Basic |
17,144,077 | 18,206,904 | 17,537,754 | 18,190,915 | ||||||||||||
Diluted |
17,486,020 | 18,726,246 | 17,877,126 | 18,778,070 | ||||||||||||
(1) | 2008 amounts were reclassified to conform to current periods presentation. |
See accompanying notes to condensed consolidated financial statements.
4
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Stockholders Equity
(Unaudited)
(Unaudited)
Accumulated | ||||||||||||||||||||||||
Other | ||||||||||||||||||||||||
Common | Paid-in | Comprehensive | Retained | Treasury | ||||||||||||||||||||
Stock | Capital | Income (Loss) | Earnings | Stock | Total | |||||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||||||
Balance, January 1, 2008 |
$ | 180 | $ | 165,836 | $ | 1,177 | $ | 62,187 | $ | | $ | 229,380 | ||||||||||||
Exercise of stock options |
3 | 597 | | | | 600 | ||||||||||||||||||
Stock-based compensation expense |
| 1,602 | | | | 1,602 | ||||||||||||||||||
Stock-based compensation excess tax benefits |
| 1,135 | | | | 1,135 | ||||||||||||||||||
Common stock repurchased and held in treasury |
| | | | (499 | ) | (499 | ) | ||||||||||||||||
Common stock repurchased and retired |
(2 | ) | (3,221 | ) | | | | (3,223 | ) | |||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||
Net income |
| | | 38,477 | | 38,477 | ||||||||||||||||||
Other comprehensive loss, net of tax |
||||||||||||||||||||||||
Unrealized holding losses on securities
arising during the period, net of tax of $5,750 |
| | (10,678 | ) | | | (10,678 | ) | ||||||||||||||||
Change in fair value of interest rate swap, net of tax of $35 |
| | (65 | ) | | | (65 | ) | ||||||||||||||||
Less
reclassification adjustment for
losses included in net income, net of tax of ($1,251) |
| | 2,323 | | | 2,323 | ||||||||||||||||||
Total other comprehensive loss |
| | | | | (8,420 | ) | |||||||||||||||||
Total comprehensive income |
| | | | | 30,057 | ||||||||||||||||||
Balance, September 30, 2008 |
$ | 181 | $ | 165,949 | $ | (7,243 | ) | $ | 100,664 | $ | (499 | ) | $ | 259,052 | ||||||||||
Balance, January 1, 2009 |
$ | 178 | $ | 161,957 | $ | (3,027 | ) | $ | 103,028 | $ | (499 | ) | $ | 261,637 | ||||||||||
Issuance of restricted stock |
1 | (1 | ) | | | | | |||||||||||||||||
Exercise of stock options |
1 | 8 | | | | 9 | ||||||||||||||||||
Stock-based compensation expense |
| 2,288 | | | | 2,288 | ||||||||||||||||||
Stock-based compensation excess tax benefits |
| (21 | ) | | | | (21 | ) | ||||||||||||||||
Common stock repurchased and held in treasury |
| | | | (1,349 | ) | (1,349 | ) | ||||||||||||||||
Common stock repurchased and retired |
(8 | ) | (10,479 | ) | | | | (10,487 | ) | |||||||||||||||
Payment of shareholder dividend |
| | | (873 | ) | | (873 | ) | ||||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||
Net income |
| | | 35,936 | | 35,936 | ||||||||||||||||||
Cumulative effect of adoption of FASB ASC 320-10 at April 1, 2009 |
| | (999 | ) | 999 | | | |||||||||||||||||
Other comprehensive income, net of tax |
||||||||||||||||||||||||
Unrealized holding losses on securities arising during
the period having credit losses recognized in the condensed
consolidated statements of income, net of tax $422 |
| | (783 | ) | | | (783 | ) | ||||||||||||||||
Unrealized holding gains on securities arising during the
period having no credit losses recognized in the condensed
consolidated statements of income, net of tax ($12,377) |
| | 22,986 | | | 22,986 | ||||||||||||||||||
Change in fair value of interest rate swaps, net of tax of $268 |
| | (498 | ) | | | (498 | ) | ||||||||||||||||
Less reclassification adjustment for
gains included in net income, net of tax of $739 |
| | (1,373 | ) | | | (1,373 | ) | ||||||||||||||||
Total other comprehensive income |
| | | | | 20,332 | ||||||||||||||||||
Total comprehensive income |
| | | | | 56,268 | ||||||||||||||||||
Balance, September 30, 2009 |
$ | 172 | $ | 153,752 | $ | 16,306 | $ | 139,090 | $ | (1,848 | ) | $ | 307,472 | |||||||||||
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)
(Unaudited)
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Cash Flows from Operating Activities |
||||||||
Net Income |
$ | 35,936 | $ | 38,477 | ||||
Less: Income from discontinued operations |
| 23,106 | ||||||
Income from continuing operations |
35,936 | 15,371 | ||||||
Adjustments to reconcile income from continuing operations to
net cash provided by operating activities |
||||||||
Depreciation and amortization |
3,051 | 2,549 | ||||||
Realized (gains) losses on investments |
(25,204 | ) | 8,714 | |||||
Other-than-temporary impairment losses on investments |
426 | 3,701 | ||||||
Deferrals of acquisition costs, net |
1,060 | (10,073 | ) | |||||
Deferred income taxes |
5,716 | (6,011 | ) | |||||
Stock-based compensation expense |
2,288 | 1,602 | ||||||
Increase (decrease) in cash resulting from changes in assets and liabilities |
||||||||
Premiums and reinsurance balances receivable |
3,930 | 5,740 | ||||||
Accrued investment income |
(540 | ) | (353 | ) | ||||
Accrued profit sharing commissions |
(2,526 | ) | 4,649 | |||||
Reinsurance recoverable on paid and unpaid losses |
(32,185 | ) | (36,330 | ) | ||||
Prepaid reinsurance premiums |
(10,863 | ) | 4,234 | |||||
Loss and loss adjustment expense reserves |
75,544 | 79,395 | ||||||
Unearned premium reserves |
2,806 | 16,506 | ||||||
Funds held under reinsurance treaties |
17,674 | 9,757 | ||||||
Reinsurance payable on paid losses |
12 | (3,236 | ) | |||||
Premiums payable to insurance companies |
3,532 | (1,206 | ) | |||||
Other |
(14,051 | ) | (3,297 | ) | ||||
Net Cash Provided By Operating Activities Continuing Operations |
66,606 | 91,712 | ||||||
Net Cash Provided By Operating Activities Discontinued Operations |
| 1,928 | ||||||
Net Cash Provided By Operating Activities Total |
66,606 | 93,640 | ||||||
Cash Flows From Investing Activities |
||||||||
Cost of short-term investments acquired |
(238,579 | ) | (425,261 | ) | ||||
Proceeds from disposals of short-term investments |
259,966 | 410,493 | ||||||
Cost of debt and equity securities acquired |
(215,156 | ) | (207,143 | ) | ||||
Proceeds from debt and equity securities |
121,256 | 113,138 | ||||||
Acquisition, net of cash acquired |
| (18,869 | ) | |||||
Cost of fixed asset purchases |
| (543 | ) | |||||
Net Cash Used In Investing Activities Continuing Operations |
(72,513 | ) | (128,185 | ) | ||||
Net Cash Provided By Investing Activities Discontinued Operations |
| 41,830 | ||||||
Net Cash Used In Investing Activities Total |
(72,513 | ) | (86,355 | ) | ||||
Cash Flows From Financing Activities |
||||||||
Stock issued on stock options exercised |
9 | 600 | ||||||
Purchase of common stock |
(10,487 | ) | | |||||
Payment of shareholder dividend |
(873 | ) | | |||||
Cash used for excess tax benefits |
(21 | ) | | |||||
Purchase of treasury stock |
(1,349 | ) | (3,722 | ) | ||||
Net borrowings under credit facility |
3,000 | | ||||||
Net Cash Used In Financing Activities |
(9,721 | ) | (3,122 | ) | ||||
Net Increase (Decrease) In Cash and Cash Equivalents |
(15,628 | ) | 4,163 | |||||
Cash and Cash Equivalents, beginning of period |
31,833 | 18,432 | ||||||
Cash and Cash Equivalents, end of period |
$ | 16,205 | $ | 22,595 | ||||
Supplemental Disclosure of Cash Flow Information: |
||||||||
Cash paid during the period for: |
||||||||
Interest |
$ | 4,137 | $ | 4,559 | ||||
Income taxes |
$ | 8,100 | $ | 18,400 |
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)
(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 Companys 2008 audited consolidated financial statements and
footnotes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2008
for a more complete description of the Companys business and accounting policies. In the opinion
of management, all adjustments necessary for a fair presentation of the consolidated financial
statements have been included. Such adjustments consist only of normal recurring items. Interim
results are not necessarily indicative of results of operations for the full year. The
consolidated balance sheet as of December 31, 2008 was derived from the Companys audited annual
consolidated financial statements.
Significant intercompany transactions and balances have been eliminated.
Use of Estimates
In preparing the financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the disclosures of
contingent assets and liabilities as of the date of the consolidated financial statements, and
revenues and expenses reported for the periods then ended. Actual results may differ from those
estimates. Material estimates that are susceptible to significant change in the near term relate
primarily to the determination of the reserves for losses and loss adjustment expenses and
valuation of intangible assets and goodwill.
Recently Issued Accounting Standards
On July 1, 2009, the FASB issued Topic 105, Generally Accepted Accounting Principles which
established the Accounting Standards Codification (ASC) as the single official source of
authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to
guidance issued by the Securities and Exchange Commission (SEC). All other nongrandfathered,
non-SEC accounting literature not included in the ASC is deemed nonauthoritative. The ASC
supersedes all existing, non-SEC accounting and reporting standards applied by nongovernmental
entities in the preparation of financial statements in conformity with generally accepted
accounting principles (GAAP). The ASC is effective for interim and annual reporting periods ending
after September 15, 2009. As the ASC reorganizes GAAP literature but does not change GAAP, the
implementation of the ASC did not have a material impact on the Companys financial statements.
In May 2009, the FASB issued new accounting guidance related to subsequent events. This new
guidance establishes general standards of accounting for and disclosures of events that occur after
the balance sheet date but before the financial statements are issued or are available to be
issued. It provides direction for the period after the balance sheet date during which management
of a reporting entity should evaluate events or transactions that may occur for potential
recognition or disclosure in the financial statements, the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date in its financial
statements and the disclosures that an entity should make about events or transactions that
occurred after the balance sheet date. We adopted the new guidance during the second quarter of
2009, and its application had no impact on our condensed consolidated financial statements. We
evaluate subsequent events through the date the accompanying financial statements were issued,
which was November 9, 2009.
In April 2009, the FASB issued new accounting guidance for the recognition and presentation of
other-than-temporary-impairments on investments. The new guidance modifies the existing
other-than-temporary impairment guidance to require the recognition of an other-than-temporary
impairment when an entity has the intent to sell a debt security or when it is more likely than not
an entity will be required to sell the debt security before its anticipated recovery. Additionally,
the new guidance changes the presentation and amount of other-than-temporary losses recognized in
the income statement for instances when the Company determines that there is a credit loss on a
debt security but it is more likely than not that the entity will not be required to sell the
security prior to the anticipated recovery of its remaining cost basis. For these debt securities,
the amount representing the credit loss will be reported as an impairment loss in the Condensed
Consolidated Statements of Income and the amount related to all other factors will be reported in
Accumulated other comprehensive income. It also requires the presentation of other-than-temporary
impairments
7
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Concluded)
separately from realized gains and losses on the face of the income statement. In addition to the
changes in measurement and presentation, the new guidance is intended to enhance the existing
disclosure requirements for other-than-temporary impairment and requires all disclosures related to
other-than-temporary impairments in both interim and annual periods. The adoption of the new
guidance in the second quarter of 2009 resulted in a
$1.0 million increase in Retained Earnings,
which was offset by a corresponding decrease in Accumulated other comprehensive income (loss) of
the same amount.
In April 2009, the FASB issued new accounting guidance pertaining to the determination of fair
value of assets and liabilities when volume and activity level have significantly decreased and for
transactions that are not orderly. Under the new guidance, if an entity determines that there has
been a significant decrease in the volume and level of activity for the asset or the liability in
relation to the normal market activity for the asset or liability (or similar assets or
liabilities), then transactions or quoted prices may not accurately reflect fair value. In
addition, if there is evidence that the transaction for the asset or liability is not orderly, the
entity shall place little, if any, weight on that transaction price as an indicator of fair value.
The adoption of this guidance in the second quarter of 2009 did not have a material effect on the
Companys results of operations, financial position, or liquidity.
In April 2009, the FASB issued new accounting guidance which requires disclosures about the
fair value of financial instruments in interim and annual financial statements. The adoption of
this guidance in the second quarter of 2009 is included in Note 11, Fair Value Measurements to
the condensed consolidated financial statements.
During the first quarter of 2009, the Company adopted various accounting standards related to
business combinations, noncontrolling interests in consolidated financial statements, disclosures
about derivative instruments and hedging activities, participating securities and undistributed
earnings and fair value measurements and disclosures. The adoption of the new standards did not
have a material effect on the Companys results of operations, financial position, or liquidity.
2. MERGERS AND ACQUISITIONS
American Management Corporation
On February 1, 2008, we completed the acquisition of all of the issued and outstanding shares
of common stock of American Management Corporation (AMC). AMC is a managing general agency
(MGA) that has focused primarily on the niche fuel-related marketplace for over 20 years. In
addition, AMC owns and operates American Underwriters Insurance Company (AUIC), a single state,
non-standard auto insurance company domiciled in the state of Arkansas, and AMC Re, Inc. (AMC
Re), a captive reinsurer incorporated under the laws of Arkansas. AMC underwrites premiums for
third party carriers and for AUIC. The acquisition gave the Company access to an established and
experienced specialty admitted underwriting franchise with a definable niche market.
The cash purchase price was $38.1 million, which was financed through cash on hand. We
incurred $0.8 million in acquisition related costs, which are included in the initial cost of the
investment of $38.9 million. In connection with the acquisition, the Company and the seller
entered into an escrow agreement whereby $4.0 million of the cash purchase price was escrowed with
a major financial institution to partially secure the majority selling shareholders indemnity
obligations of up to $12.0 million under the stock purchase agreement.
The results of operations of AMC and the estimated fair value of assets acquired and
liabilities assumed are included in our consolidated financial statements beginning on the
acquisition date. The estimated excess of the purchase price over the net tangible and intangible
assets acquired of $13.4 million was recorded as goodwill in the amount of $25.5 million. We have
completed the valuations of certain tangible and intangible assets acquired with the new business
and have finalized the allocation of the excess of the purchase price over the net assets acquired.
The acquired goodwill is not expected to be deductible for income tax purposes and has been
allocated to AMC as a reporting unit.
8
Table of Contents
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
2. MERGERS AND ACQUISITIONS (Concluded)
The following table represents the final allocation of the purchase price to assets acquired
and liabilities assumed at the acquisition date:
$ in thousands | ||||
Assets Acquired |
||||
Investments |
$ | 8,988 | ||
Cash and cash equivalents |
20,012 | |||
Premiums receivable |
19,570 | |||
Other assets |
1,133 | |||
Goodwill |
25,483 | |||
Intangible assets: |
||||
Agent relationships |
9,150 | |||
Tradename |
2,130 | |||
Customer relationships |
520 | |||
Total Assets Acquired |
$ | 86,986 | ||
Liabilities Assumed |
||||
Premiums payable to insurance companies |
$ | 23,218 | ||
Loss and loss adjustment expense reserves |
4,490 | |||
Unearned premium reserves |
1,734 | |||
Deferred federal income taxes |
3,917 | |||
Accounts payable, accrued expenses, and other liabilities |
14,745 | |||
Total Liabilities Assumed |
48,104 | |||
Net Assets Acquired |
$ | 38,882 | ||
Agent relationships are being amortized as the economic benefits of these intangible assets
are utilized over their estimated useful lives of approximately 18 years. The tradename is being
amortized on a straight-line basis over its estimated useful life of 20 years. The customer
relationships are being amortized on a straight-line basis, which approximates the utilization of
the economic benefits of these assets, over their estimated useful lives of 15 years.
In connection with the AMC acquisition, we entered into an operating lease agreement for real
property in Conway, Arkansas with an entity owned by the former majority shareholder and current
president of AMC. The lease term is for ten years, with annual rent of approximately $0.5 million,
payable in monthly installments.
3. DISCONTINUED OPERATIONS
On June 27, 2008, the Company sold all of the outstanding shares of capital stock of ARPCO
Holdings, Inc. and its subsidiaries (ARPCO) for a purchase price of $43.0 million. The net
assets disposed of in the transaction were $7.2 million and were principally intangible assets.
The operating results of discontinued operations included in the accompanying Condensed
Consolidated Statements of Income are as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Revenues |
$ | | $ | | $ | | $ | 5,884 | ||||||||
Income Before
Income Taxes |
$ | | $ | | $ | | $ | 3,533 |
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. NET INCOME PER SHARE
Basic net income per share is computed by dividing net income by the weighted-average number
of shares of common stock outstanding for the period. Diluted net income per share reflects the
potential dilution that could occur if common stock equivalents were issued and exercised.
The following is a reconciliation of basic number of common shares outstanding to diluted
common and common equivalent shares outstanding:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands, except share and per share data) | ||||||||||||||||
Income from Continuing Operations |
$ | 15,645 | $ | 501 | $ | 35,936 | $ | 15,371 | ||||||||
Income from Discontinued Operations |
| (447 | ) | | 23,106 | |||||||||||
Net income as reported |
15,645 | 54 | 35,936 | 38,477 | ||||||||||||
Net income allocated to unvested restricted stock shares |
(141 | ) | (0 | ) | (316 | ) | (154 | ) | ||||||||
Net income available to common |
$ | 15,504 | $ | 54 | $ | 35,620 | $ | 38,323 | ||||||||
Weighted-average number of common and common equivalent shares outstanding: |
||||||||||||||||
Basic number of common shares outstanding |
17,144,077 | 18,206,904 | 17,537,754 | 18,190,915 | ||||||||||||
Dilutive effect of stock options |
341,943 | 516,236 | 339,372 | 580,948 | ||||||||||||
Dilutive effect of unvested restricted stock |
| 3,106 | | 6,207 | ||||||||||||
Dilutive number of common and common equivalent shares outstanding |
17,486,020 | 18,726,246 | 17,877,126 | 18,778,070 | ||||||||||||
Basic Net Income Per Common Share: |
||||||||||||||||
Income from Continuing Operations |
$ | 0.90 | $ | 0.03 | $ | 2.03 | $ | 0.84 | ||||||||
Income from Discontinued Operations |
| (0.02 | ) | | 1.27 | |||||||||||
Total |
$ | 0.90 | $ | 0.01 | $ | 2.03 | $ | 2.11 | ||||||||
Diluted Net Income Per Common Share: |
||||||||||||||||
Income from Continuing Operations |
$ | 0.89 | $ | 0.03 | $ | 1.99 | $ | 0.82 | ||||||||
Income from Discontinued Operations |
| (0.02 | ) | | 1.23 | |||||||||||
Total |
$ | 0.89 | $ | 0.01 | $ | 1.99 | $ | 2.05 | ||||||||
Anti-dilutive shares excluded from diluted net income per common share |
1,112,688 | 932,188 | 1,112,688 | 932,188 | ||||||||||||
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.
10
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS
The amortized cost, gross unrealized gains and losses, and market value of marketable
investment securities classified as available-for-sale at September 30, 2009 by major security type
were as follows:
Gross Unrealized | ||||||||||||||||
Amortized Cost | Gains | Losses | Market Value | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | 3,776 | $ | 146 | $ | | $ | 3,922 | ||||||||
Government agency mortgage-backed securities |
101,160 | 4,491 | (8 | ) | 105,643 | |||||||||||
Government agency obligations |
989 | 39 | | 1,028 | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
109,734 | 5,176 | (2,996 | ) | 111,914 | |||||||||||
Obligations of states and political
subdivisions |
189,101 | 11,661 | (60 | ) | 200,702 | |||||||||||
Corporate bonds |
137,912 | 11,317 | (700 | ) | 148,529 | |||||||||||
Total Debt Securities |
542,672 | 32,830 | (3,764 | ) | 571,738 | |||||||||||
Preferred stocks |
1,416 | 50 | (193 | ) | 1,273 | |||||||||||
Short-term investments |
10,754 | | | 10,754 | ||||||||||||
Total |
$ | 554,842 | $ | 32,880 | $ | (3,957 | ) | $ | 583,765 | |||||||
The amortized cost, gross unrealized gains and losses, and market value of marketable
investment securities classified as available-for-sale at December 31, 2008 by major security type
were as follows:
Gross Unrealized | ||||||||||||||||
Amortized Cost | Gains | Losses | Market Value | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | 5,256 | $ | 307 | $ | | $ | 5,563 | ||||||||
Government agency mortgage-backed securities |
82,548 | 2,422 | (39 | ) | 84,931 | |||||||||||
Government agency obligations |
3,163 | 76 | | 3,239 | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
71,378 | 337 | (7,087 | ) | 64,628 | |||||||||||
Obligations of states and political subdivisions |
205,425 | 5,634 | (694 | ) | 210,365 | |||||||||||
Corporate bonds |
89,383 | 1,499 | (3,874 | ) | 87,008 | |||||||||||
Total Debt Securities |
457,153 | 10,275 | (11,694 | ) | 455,734 | |||||||||||
Preferred stocks |
1,416 | | (367 | ) | 1,049 | |||||||||||
Short-term investments |
32,142 | | | 32,142 | ||||||||||||
Total |
$ | 490,711 | $ | 10,275 | $ | (12,061 | ) | $ | 488,925 | |||||||
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.
As mentioned above, the Company considers its intent and ability to hold a security until the
value recovers as part of the process of evaluating whether a securitys unrealized loss represents
an other-than-temporary decline. The Companys ability to hold such securities is supported by
sufficient cash flow from its operations and from maturities within its investment portfolio in
order to meet its claims payment and other disbursement obligations arising from its underwriting
operations without selling such investments. With respect to securities where the decline in value
is determined to be temporary and the securitys 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
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Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (Continued)
context of overall risk monitoring, changing information and market conditions. Management of the
Companys 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 Companys 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 securitys 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.
The table below represents the gross and net presentation of other-than-temporary impairment
losses on investments:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Other-than-temporary impairment losses on
investments: |
||||||||||||||||
Total losses |
$ | (761 | ) | $ | (3,476 | ) | $ | (1,631 | ) | $ | (3,701 | ) | ||||
Portion of
losses recognized in accumulated other comprehensive income |
469 | | 1,205 | | ||||||||||||
Other-than-temporary impairment losses on
investments |
$ | (292 | ) | $ | (3,476 | ) | $ | (426 | ) | $ | (3,701 | ) | ||||
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (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 July 1, 2009 through September 30, 2009:
Additions for | ||||||||||||||||||||||||
OTTI | Additions for | Adjustments | September 30, | |||||||||||||||||||||
July 1, 2009 | Securities | OTTI | to Book | 2009 | ||||||||||||||||||||
Cumulative | Where No | Securities | Reductions Due | Value of | Cumulative | |||||||||||||||||||
OTTI Credit | Credit Losses | Where Credit | to Sales or | Credit- | OTTI Credit | |||||||||||||||||||
Losses | Were | Losses Have | Intend/Required | Impaired | Losses | |||||||||||||||||||
Recognized | Recognized | Been | to Sell of | Securities due | Recognized | |||||||||||||||||||
for Securities | Prior to | Recognized Prior to | Credit-Impaired | to Changes in | for Securities | |||||||||||||||||||
Still Held | July 1, 2009 | July 1, 2009 | Securities | Cash Flows | Still Held | |||||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||||||
Debt securities: |
||||||||||||||||||||||||
Mortgage-backed securities,
collateralized mortgage
obligations
and passthrough securities |
$ | 261 | $ | 40 | $ | 252 | $ | | $ | | $ | 553 | ||||||||||||
All other corporate bonds |
569 | | | | | 569 | ||||||||||||||||||
Total debt securities |
$ | 830 | $ | 40 | $ | 252 | $ | | $ | | $ | 1,122 | ||||||||||||
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 April 1, 2009 (the effective date of the new accounting guidance in ASC 320-10) through
September 30, 2009:
Additions for | ||||||||||||||||||||||||
OTTI | Additions for | Adjustments | September 30, | |||||||||||||||||||||
April 1, 2009 | Securities | OTTI | to Book | 2009 | ||||||||||||||||||||
Cumulative | Where No | Securities | Reductions Due | Value of | Cumulative | |||||||||||||||||||
OTTI Credit | Credit Losses | Where Credit | to Sales or | Credit- | OTTI Credit | |||||||||||||||||||
Losses | Were | Losses Have | Intend/Required | Impaired | Losses | |||||||||||||||||||
Recognized | Recognized | Been | to Sell of | Securities due | Recognized | |||||||||||||||||||
for Securities | Prior to | Recognized Prior to | Credit-Impaired | to Changes in | for Securities | |||||||||||||||||||
Still Held | April 1, 2009 | April 1, 2009 | Securities | Cash Flows | Still Held | |||||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||||||
Debt securities: |
||||||||||||||||||||||||
Mortgage-backed securities,
collateralized mortgage obligations
and passthrough securities |
$ | 164 | $ | 389 | $ | | $ | | $ | | $ | 553 | ||||||||||||
All other corporate bonds |
569 | | | | | 569 | ||||||||||||||||||
Total debt securities |
$ | 733 | $ | 389 | $ | | $ | | $ | | $ | 1,122 | ||||||||||||
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (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 September 30, 2009:
Less than 12 Months | Greater than 12 Months | |||||||||||||||
Fair Value | Fair Value | |||||||||||||||
of | of | |||||||||||||||
Investments | Investments | |||||||||||||||
With | Gross | With | Gross | |||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||
Losses | Losses | Losses | Losses | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | | $ | | $ | | $ | | ||||||||
Government agency mortgage-backed securities |
1,680 | (1 | ) | 194 | (7 | ) | ||||||||||
Government agency obligations |
| | | | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
6,351 | (262 | ) | 14,157 | (2,734 | ) | ||||||||||
Obligations of states and political
subdivisions |
| | 3,645 | (60 | ) | |||||||||||
Corporate bonds |
1,252 | (1 | ) | 8,542 | (699 | ) | ||||||||||
Total Debt Securities |
9,283 | (264 | ) | 26,538 | (3,500 | ) | ||||||||||
Preferred Stocks |
| | 313 | (193 | ) | |||||||||||
Total |
$ | 9,283 | $ | (264 | ) | $ | 26,851 | $ | (3,693 | ) | ||||||
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, 2008:
Less than 12 Months | Greater than 12 Months | |||||||||||||||
Fair Value | Fair Value | |||||||||||||||
of | of | |||||||||||||||
Investments | Investments | |||||||||||||||
With | Gross | With | Gross | |||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||
Losses | Losses | Losses | Losses | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | | $ | | $ | | $ | | ||||||||
Government agency mortgage-backed securities |
3,902 | (37 | ) | 326 | (2 | ) | ||||||||||
Government agency obligations |
| | | | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
48,125 | (5,143 | ) | 5,963 | (1,944 | ) | ||||||||||
Obligations of states and political subdivisions |
14,063 | (427 | ) | 8,809 | (267 | ) | ||||||||||
Corporate bonds |
42,402 | (2,549 | ) | 12,824 | (1,325 | ) | ||||||||||
Total Debt Securities |
108,492 | (8,156 | ) | 27,922 | (3,538 | ) | ||||||||||
Preferred Stocks |
832 | (78 | ) | 216 | (289 | ) | ||||||||||
Total |
$ | 109,324 | $ | (8,234 | ) | $ | 28,138 | $ | (3,827 | ) | ||||||
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (Continued)
Below is a table that illustrates the unrecognized impairment loss by sector. The increase in
spread relative to U.S. Treasury Bonds was the primary factor leading to impairment for the periods
ended September 30, 2009. 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.
Unrealized | ||||
Loss at | ||||
Sector | September 30, 2009 | |||
(Dollars in thousands) | ||||
Debt Securities |
||||
U.S. Treasuries |
$ | | ||
U.S. Agencies |
| |||
U.S. government securities |
| |||
Government agency mortgage-backed securities |
(8 | ) | ||
Government agency obligations |
| |||
MBS Passthroughs |
(23 | ) | ||
CMOs |
(1,331 | ) | ||
Asset Backed Securities |
(631 | ) | ||
Commercial MBS |
(1,011 | ) | ||
Collateralized mortgage obligations and other
asset-backed securities |
(2,996 | ) | ||
Obligations of states and political subdivisions |
(60 | ) | ||
Corporate Bonds |
(700 | ) | ||
High Yield Bonds |
| |||
Corporate Bonds |
(700 | ) | ||
Total Debt Securities |
(3,764 | ) | ||
Preferred Stocks |
(193 | ) | ||
Short-term investments |
| |||
Total |
$ | (3,957 | ) | |
At September 30, 2009, there were 108 unrealized loss positions with a total unrealized loss
of $4.0 million. This represents approximately 0.7% of quarter end available-for-sale assets of
$583.8 million. This unrealized loss position is a function of the purchase of specific securities
in a lower interest rate or spread environment than what prevails as of September 30, 2009. Some
of these losses are due to the increase in spreads of select corporate bonds or structured
securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of
the core fixed income portfolio excluding cash, convertible securities, and equity is approximately
3.6 years. 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 growth 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 vast 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.
15
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (Continued)
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 9.9% as of
September 30, 2009.
% of Total | Total | Total | Average Unrealized Loss | % of Loss | ||||||||||||||||
Amortized Cost | Amortized Cost | Unrealized Losses | as % of Amortized Cost | > 12 Months | ||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||
Non Investment Grade |
19.0 | % | $ | 7,615 | $ | 1,859 | 24.4 | % | 98.7 | % | ||||||||||
Investment Grade |
81.0 | 32,477 | 2,098 | 6.5 | 88.5 | |||||||||||||||
Total |
100.0 | % | $ | 40,092 | $ | 3,957 | 9.9 | % | 93.3 | % | ||||||||||
The majority of these securities are AAA or AA rated. Of the $1.9 million of unrealized
loss within non-investment grade, CMOs accounted for 43.0% of this loss. Within CMOs 80.2% 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 33.9% of the loss. The remaining portion of the loss, or 23.1% within non-investment grade was
a financial corporate issue rated BB+ by Standard and Poors. 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 33.6% of the total
loss. Within CMOs, 72.4% are rated AAA, including the 60.4% 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 Commercial MBS at approximately 25.5%
of the total loss. These securities are all AAA rated and have been affected primarily by the
widening of spreads within this sector and/or the general level of interest rates. The next
largest concentration of temporarily impaired securities is Corporate Bonds at approximately 17.7%
of the total loss. Within Corporate Bonds 98.6% are rated investment grade or better, and their
temporary impairment results primarily from the widening of credit spreads.
For the nine months ended September 30, 2009, we sold approximately $4.8 million of market
value of fixed income securities excluding convertibles, which were trading below amortized cost
while recording a realized loss of $0.2 million. This loss represented 3.3% 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. This
position is further supported by the insignificant losses as a percentage of amortized cost for the
respective periods.
Hybrid Instruments
As of September 30, 2009 and December 31, 2008, the market value of convertible securities
accounted for as hybrid instruments was $66.1 million and $43.5 million, respectively. Convertible
bonds and bond units had a market value of $58.0 million and $39.0 million and were included in
Debt securities in the Condensed Consolidated Balance Sheets at September 30, 2009 and December 31,
2008, respectively. Convertible preferred stocks had a market value of $8.1 million and $4.5
million and were included in Equity securities and other in the Condensed Consolidated Balance
Sheets at September 30, 2009 and December 31, 2008, respectively. The Company recorded an increase
in the fair value of the hybrid instruments of $9.3 million and $16.1 million in Net realized gains
on investments for the three and nine months ended September 30, 2009. As of September 30, 2009
and December 31, 2008, there were no convertible securities that were not accounted for as hybrid
instruments in accordance with FASB ASC guidance.
Alternative Investments
The Company has $12.0 million invested in a limited partnership, which invests in high yield
convertible securities. The market value of this investment was $12.3 million at September 30,
2009. In addition, the Company invested $10.0 million in another limited partnership, which
invests in distressed structured finance products. The market value of this investment was $11.8
million at September 30, 2009. The Company elected the fair value option for these investments in
accordance with FASB ASC guidance. The change in fair value of these investments is allocated
between Net investment income and Net realized gains (losses) on investments in the Condensed
Consolidated Statements of Income. For the three months ended September 30, 2009, the Company
recorded $0.4 million in Net investment income and $12.4 million in Net realized gains (losses) on
investments related to these alternative
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
5. INVESTMENTS (Concluded)
investments. For the nine months ended September 30, 2009, the Company recorded $1.4 million in
Net investment income and $21.1 million in Net realized gains (losses) on investments related to
these alternative investments. These investments are recorded in Equity securities and other in
the Condensed Consolidated Balance Sheets.
6. INCOME TAXES
At September 30, 2009 and December 31, 2008, current FASB accounting guidance, which clarifies
accounting for uncertainty in income taxes recognized in an entitys financial statements, did not
have an impact on our financial position or results of operations, and we have taken no tax
positions which would require additional disclosure. 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 Companys subsidiaries based on the Tax Allocation Agreement employed by these
entities, which provides that taxes of the entities are calculated on a separate-return basis at
the highest marginal tax rate.
Income taxes in the accompanying unaudited Condensed Consolidated Statements of Income differ
from the statutory tax rate of 35.0% primarily due to state income taxes, non-deductible expenses,
and the nontaxable portion of dividends received and tax-exempt interest.
7. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The Company establishes a reserve for both reported and unreported covered losses, which
includes estimates of both future payments of losses and related loss adjustment expenses. The
following represents changes in those aggregate reserves for the Company during the periods
presented below:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Balance, beginning of period |
$ | 426,908 | $ | 324,502 | $ | 372,721 | $ | 272,365 | ||||||||
Less reinsurance recoverables |
146,157 | 113,909 | 128,552 | 91,444 | ||||||||||||
Net Balance, beginning of period |
280,751 | 210,593 | 244,169 | 180,921 | ||||||||||||
AUIC net reserves, date of acquisition |
| | | 4,490 | ||||||||||||
Incurred Related To |
||||||||||||||||
Current year |
31,645 | 32,382 | 101,972 | 81,558 | ||||||||||||
Prior years |
(1,300 | ) | (4,845 | ) | (5,671 | ) | (4,845 | ) | ||||||||
Total Incurred |
30,345 | 27,537 | 96,301 | 76,713 | ||||||||||||
Paid Related To |
||||||||||||||||
Current year |
6,461 | 4,010 | 10,900 | 6,348 | ||||||||||||
Prior years |
13,266 | 7,273 | 38,201 | 28,929 | ||||||||||||
Total Paid |
19,727 | 11,283 | 49,101 | 35,277 | ||||||||||||
Net Balance |
291,369 | 226,847 | 291,369 | 226,847 | ||||||||||||
Plus reinsurance recoverables |
156,896 | 129,403 | 156,896 | 129,403 | ||||||||||||
Balance, end of period |
$ | 448,265 | $ | 356,250 | $ | 448,265 | $ | 356,250 | ||||||||
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
8. REINSURANCE
Net written and earned premiums, including reinsurance activity, were as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Written Premiums |
||||||||||||||||
Direct |
$ | 77,607 | $ | 72,746 | $ | 228,619 | $ | 224,720 | ||||||||
Assumed |
4,201 | 4,253 | 13,588 | 13,399 | ||||||||||||
Ceded |
(35,483 | ) | (27,453 | ) | (92,615 | ) | (77,828 | ) | ||||||||
Net Written Premiums |
$ | 46,325 | $ | 49,546 | $ | 149,592 | $ | 160,291 | ||||||||
Earned Premiums |
||||||||||||||||
Direct |
$ | 77,907 | $ | 70,985 | $ | 226,125 | $ | 209,208 | ||||||||
Assumed |
4,529 | 4,422 | 13,276 | 12,405 | ||||||||||||
Ceded |
(29,907 | ) | (26,566 | ) | (81,752 | ) | (82,063 | ) | ||||||||
Earned but unbilled premiums |
(1,017 | ) | 251 | (2,110 | ) | (328 | ) | |||||||||
Net Earned Premiums |
$ | 51,512 | $ | 49,092 | $ | 155,539 | $ | 139,222 | ||||||||
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 Companys 2009 and 2008 ceded reinsurance program includes quota share reinsurance
agreements with authorized reinsurers that were entered into and are accounted for on a funds
withheld basis. Under the funds withheld basis, the Company records the
ceded premiums payable to the reinsurer, less ceded paid losses and loss adjustment expenses
receivable from the reinsurer, less any amounts due to the reinsurer for the reinsurers margin, or
cost of the reinsurance contract, as a liability, and reported $67.1 million and $49.4 million as
Funds held under reinsurance treaties in the accompanying Condensed Consolidated Balance Sheets at
September 30, 2009 and December 31, 2008, respectively. As specified under the terms of the
agreements, the Company credits the funds withheld balance at stated interest crediting rates
applied to the funds withheld balance. If the funds withheld liability is exhausted, interest
crediting would cease and additional claim payments would be recoverable from the reinsurer.
Interest cost on reinsurance contracts accounted for on a funds withheld basis is incurred
during all periods in which a funds withheld liability exists or as otherwise specified under the
terms of the contract and is included in Underwriting, agency and other expenses. The amount
subject to interest crediting rates was $22.8 million and $20.2 million at September 30, 2009 and
2008, 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
September 30, 2009, the Company did not repurchase any shares of common stock under the August 2009
share repurchase plan. As of September 30, 2009, 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.
The Companys prior share repurchase program, announced in August 2008, originally authorized
the repurchase of up to 1.5 million shares of the Companys outstanding common stock. During the
three months ended September 30, 2009, the Company repurchased the remaining 413,665 shares of
common stock for $5.4 million at an average cost of $13.06 per share. These purchases fulfilled
the remaining capacity of the Companys 1.5 million share repurchase plan.
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
10. 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 Companys 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 Companys common stock initially reserved for future
grant under the 1998 Plan, shares available for future grant totaled 2,443,387 at September 30,
2009, however, 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 Companys 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 Companys 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 September 30, 2009, the Company granted 25,000 stock options and
25,000 shares of restricted stock to employees under the Omnibus Plan. During the nine months
ended September 30, 2009, the Company granted 222,500 stock options and 118,500 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 vesting period of the stock options
and shares of restricted stock. During the nine months ended September 30, 2009, the Company
granted 19,704 shares of restricted stock to non-employee directors under the Omnibus Plan. These
shares of restricted stock vested immediately, but are not transferable for one year after the
grant date, and stock-based compensation was recognized immediately. During the three months ended
September 30, 2008, the Company did not make any stock option grants under the Omnibus Plan.
During the nine months ended September 30, 2008, the Company granted 374,500 stock options to
employees. During the three and nine months ended September 30, 2008, the Company granted 10,000
and 55,500 shares of restricted
stock, respectively, to employees under the Omnibus Plan. The stock options and shares of
restricted stock vest in three equal installments over a period of three years. Stock-based
compensation is recognized over the expected vesting period of the stock options and shares of
restricted stock. During the nine months ended September 30, 2008, the Company granted 12,124
shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of
restricted stock vested immediately, but were not transferable for one year after the grant date,
and stock-based compensation expense was recognized immediately. Shares available for future
grants under the Omnibus Plan totaled 1,860,036 at September 30, 2009.
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
10. STOCK COMPENSATION PLANS (Continued)
The following table summarizes stock option activity for the nine months ended September 30,
2009 and 2008.
1998 Plan | Omnibus Plan | |||||||||||||||
Weighted Average | Weighted Average | |||||||||||||||
Number of Options | Exercise Price | Number of Options | Exercise Price | |||||||||||||
Oustanding at January 1, 2008 |
927,775 | $ | 2.24 | 573,688 | $ | 19.10 | ||||||||||
Granted during the period |
| | 374,500 | 16.38 | ||||||||||||
Forfeited during the period |
(5,088 | ) | 4.86 | (12,700 | ) | 18.77 | ||||||||||
Exercised during the period |
(302,575 | ) | 1.80 | (3,300 | ) | 17.00 | ||||||||||
Cancelled during the period |
| | | | ||||||||||||
Outstanding at September 30, 2008 |
620,112 | $ | 2.49 | 932,188 | $ | 18.02 | ||||||||||
Oustanding at January 1, 2009 |
431,050 | $ | 2.82 | 932,188 | $ | 17.93 | ||||||||||
Granted during the period |
| | 222,500 | 13.04 | ||||||||||||
Forfeited during the period |
| | (42,000 | ) | 16.71 | |||||||||||
Exercised during the period |
(5,088 | ) | 1.62 | | | |||||||||||
Cancelled during the period |
| | | | ||||||||||||
Outstanding at September 30, 2009 |
425,962 | $ | 2.83 | 1,112,688 | $ | 17.00 | ||||||||||
Exercisable at: |
||||||||||||||||
September 30, 2008 |
620,112 | $ | 2.49 | 152,566 | $ | 18.80 | ||||||||||
September 30, 2009 |
425,962 | 2.83 | 447,793 | 18.27 |
The aggregate intrinsic value of fully vested options outstanding and exercisable under the
1998 Plan was $4.5 million at September 30, 2009. There was $0.1 million of aggregate intrinsic
value of options expected to vest under the Omnibus Plan at September 30, 2009.
The total intrinsic value of stock options exercised was $0.1 million for the nine months
ended September 30, 2009.
The number of stock option awards outstanding and exercisable at September 30, 2009 by range
of exercise prices was as follows:
Options Outstanding | Options Exercisable | |||||||||||||||||||
Weighted-Average | Weighted-Average | Weighted-Average | ||||||||||||||||||
Range of | Outstanding as of | Remaining | Exercise Price Per | Exercisable as of | Exercise Price Per | |||||||||||||||
Exercisable Price | September 30, 2009 | Contractual Life | Share | September 30, 2009 | Share | |||||||||||||||
1998 Plan |
||||||||||||||||||||
$1.51 - $1.95 |
314,037 | 3.37 Years | $ | 1.71 | 314,037 | $ | 1.71 | |||||||||||||
$4.86 - $6.49 |
111,925 | 1.05 | 5.97 | 111,925 | 5.97 | |||||||||||||||
Total |
425,962 | 2.76 | 2.83 | 425,962 | 2.83 | |||||||||||||||
Omnibus Plan |
||||||||||||||||||||
$10.98 - $14.93 |
361,000 | 9.07 Years | $ | 13.69 | 45,829 | $ | 14.93 | |||||||||||||
$17.00 - $20.75 |
751,688 | 6.77 | 18.59 | 401,964 | 18.65 | |||||||||||||||
Total |
1,112,688 | 7.52 | 17.00 | 447,793 | 18.27 | |||||||||||||||
As of September 30, 2009, there was approximately $4.2 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 2.0 years.
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
10. STOCK COMPENSATION PLANS (Concluded)
The fair value of stock options granted during the nine months ended September 30, 2009 and
2008 were determined on the dates of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions:
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
Omnibus Plan |
||||||||
Expected term |
6.0 | 6.0 | ||||||
Expected stock price volatility |
41.64 | % | 29.78 | % | ||||
Risk-free interest rate |
2.22 | % | 3.12 | % | ||||
Expected dividend yield |
0.08 | % | | |||||
Estimated fair value per option |
$ | 5.57 | $ | 5.79 |
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 Companys peer group with consideration given
to the Companys 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 Companys historical experience and future
expectations. The calculated fair value is recognized as compensation cost in the Companys
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 Companys 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 $0.7 million and $2.3 million for the three and nine months ended September
30, 2009, respectively. The Company recognized stock-based compensation expense of $0.6 million
and $1.6 million for the three and nine months ended September 30, 2008, respectively.
11. FAIR VALUE MEASUREMENTS
Our available-for-sale investment portfolio consists of fixed maturity and equity securities
and short-term investments, and is recorded at fair value in the accompanying Condensed
Consolidated Balance Sheets in accordance with FASB accounting guidance for investments in debt and
equity securities. The change in the fair value of these investments is recorded as a component of
Other comprehensive income (loss).
We adopted the FASB guidance for the fair value option related to financial instruments
effective January 1, 2008. Under this standard, we are permitted to elect to measure financial
instruments and certain other items at fair value, with the change in fair value recorded in
earnings. On January 1, 2008, we elected not to measure any eligible items using the fair value
option in accordance with the FASB guidance. We believe the current accounting is appropriate for
our available-for-sale investments as we have the intent and ability to hold our investments,
therefore, this standard did not have any impact on our consolidated financial condition or results
of operations on the adoption date.
We also adopted the FASB guidance on fair value measurements and disclosures effective January
1, 2008. This standard defines fair value as the price that would be received to sell an asset or
would be paid to transfer a liability (i.e., the exit price) in an orderly transaction between
market participants at the measurement date, and establishes a framework to make the measurement of
fair value more consistent and comparable. In determining fair value, we primarily use prices and
other relevant information generated by market transactions involving identical or comparable
assets, or market approach as defined by the FASB guidance. The implementation of this standard
did not have any impact on our consolidated financial condition or results of operations; however,
it resulted in expanded disclosures about securities measured at fair value, as discussed below.
The FASB guidance established a three-level hierarchy for fair value measurements that
distinguishes between market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and the reporting entitys own
assumptions about market participant assumptions developed based on the best information available
in the circumstances (unobservable inputs). The estimated fair values of the Companys fixed
income securities, convertible bonds, and equity securities are based on prices provided by an
independent, nationally recognized pricing service. Approximately 95.0% of the
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Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
11. FAIR VALUE MEASUREMENTS (Continued)
Companys fixed income security prices are obtained from the independent 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 Companys 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 securitys hierarchy level is based upon the lowest level of input that is significant
to the fair value measurement. A number of our investment grade corporate bonds are frequently
traded in active markets and traded market prices for these securities existed at September 30,
2009. These securities were classified as Level 2 at September 30, 2009 because our third party
pricing service uses valuation models which use observable market inputs in addition to traded
prices.
The following table presents our investments measured at fair value on a recurring basis as of
September 30, 2009 classified by the fair value measurements standard valuation hierarchy (as
discussed above):
Fair Value Measurements Using | ||||||||||||||||
Total | Level 1 | Level 2 | Level 3 | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Available for sale
investments: |
||||||||||||||||
Fixed maturity securities |
$ | 573,011 | $ | 3,922 | $ | 569,089 | $ | | ||||||||
Short-term investments |
10,754 | 10,754 | | | ||||||||||||
Hybrid securities |
66,131 | | 66,131 | | ||||||||||||
Alternative investments |
24,115 | | 11,814 | 12,301 | ||||||||||||
Total |
$ | 674,011 | $ | 14,676 | $ | 647,034 | $ | 12,301 | ||||||||
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
11. FAIR VALUE MEASUREMENTS (Concluded)
Level 3 assets above include a $12.3 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 securitys 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 September 30, 2009, 9.2% of the reported market value
of this limited partnership was valued by a good faith judgment of the General Partner and the
balance by observable market inputs.
Three Months Ended | Nine Months Ended | |||||||
September 30, 2009 | September 30, 2009 | |||||||
Level 3 investments, beginning of period |
$ | 10,633 | $ | 6,282 | ||||
Purchases |
| 2,000 | ||||||
Transfer to Level 2 |
(660 | ) | (660 | ) | ||||
Increase in market value |
2,328 | 4,679 | ||||||
Level 3 investments as of September 30, 2009 |
$ | 12,301 | $ | 12,301 | ||||
The Company uses derivatives to hedge its exposure to interest rate fluctuations. For these
derivatives, the Company uses quoted market prices to estimate fair value and includes the estimate
as a Level 2 measurement.
The Companys financial instruments include investments, cash and cash equivalents, premiums
and reinsurance balances receivable, reinsurance recoverable on paid losses and long-term debt. At
September 30, 2009, the carrying amounts of the Companys financial instruments, including its
derivative financial instruments, approximated fair value, except for the $67.0 million of the
Companys junior subordinated debentures. The fair value of these junior subordinated debentures
is estimated to be $29.3 million at September 30, 2009. The estimate of fair value for the
Companys 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
10.5%, which was based on yields of comparable securities. The fair values of the Companys
investments, as determined by quoted market prices, are disclosed in Note 5.
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Notes to Condensed Consolidated Financial Statements
(Unaudited)
12. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The Companys accumulated other comprehensive income (loss) included the following:
September 30, | ||||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Unrealized holding losses on securities having
credit losses recognized in the condensed consolidated
statements of income, net of tax |
$ | (1,782 | ) | $ | | |||
Unrealized holding gains (losses) on securities having no
credit losses recognized in the condensed consolidated
statements of income, net of tax |
20,163 | (6,559 | ) | |||||
Fair value of interest rate swaps, net of tax |
(2,075 | ) | (684 | ) | ||||
Total accumulated other comprehensive income (loss) |
$ | 16,306 | $ | (7,243 | ) | |||
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 CoverXs 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 CoverXs and Emeralds 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.
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ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements that relate to future
periods and includes statements regarding our anticipated performance. Generally, the words
anticipates, believes, expects, intends, estimates, projects, plans and similar
expressions identify forward-looking statements. These forward-looking statements involve known
and unknown risks, uncertainties and other important factors that could cause our actual results,
performance or achievements or industry results to differ materially from any future results,
performance or achievements expressed or implied by these forward-looking statements. These risks,
uncertainties and other important factors include, among others: recent and future events and
circumstances impacting financial, stock, and capital markets, and the responses to such events by
governments and financial communities; the impact of catastrophic events and the occurrence of
significant severe weather conditions on our operating results; our ability to maintain or the
lowering or loss of one of our financial or claims-paying ratings; our actual incurred losses
exceeding our loss and loss adjustment expense reserves; the failure of reinsurers to meet their
obligations; our 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 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. FMFCs principal operating
subsidiaries are CoverX Corporation (CoverX), First Mercury Insurance Company (FMIC), First
Mercury Casualty Company (FMCC), First Mercury Emerald Insurance Services, Inc. (FM Emerald),
and American Management Corporation (AMC).
CoverX produces and underwrites insurance policies for which we retain risk and receive
premiums. As a wholesale insurance broker, CoverX markets our insurance policies through a
nationwide network of wholesale and retail insurance brokers who then distribute these policies
through retail insurance brokers. CoverX also provides underwriting services with respect to the
insurance policies it markets in that it reviews the applications submitted for insurance coverage,
decides whether to accept all or part of the coverage requested and determines applicable premiums,
all in a manner consistent with and within parameters defined by underwriting or binding authority
guidelines established by FMIC or other non-affiliated insurers on whose behalf CoverX is producing
business. 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 produces commercial lines business on primarily an excess and surplus lines basis
for CoverX via a producer agreement. 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
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FMCC in accordance with fixed percentages. FMIC also provides claims handling and adjustment services for
policies produced by CoverX and directly written by third parties.
On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk
Pooling Consultants, Inc. (ARPCO). The results of ARPCOs operations are presented as
Discontinued Operations in the Condensed Consolidated Statements of Income. ARPCO provided third
party administrative services for risk sharing pools of governmental entity risks, including
underwriting, claims, loss control and reinsurance services. ARPCO was solely a fee-based business
and received fees for these services and commissions on excess per occurrence insurance placed in
the commercial market with third party companies on behalf of the pools.
On February 1, 2008, we acquired 100% of the issued and outstanding common stock of American
Management Corporation. AMC is a managing general agency writing primarily commercial lines
package policies focused primarily on the niche fuel-related marketplace. AMC distributes these
insurance policies through a nationwide distribution system of independent general agencies. AMC
underwrites these policies for third party insurance carriers and receives commission income for
its services. AMC also provides claims handling and adjustment services for policies produced by
AMC and directly written for third parties. In addition, AMC owns and operates American
Underwriters Insurance Company (AUIC), a single state, non-standard auto insurance company
domiciled in the state of Arkansas, and AMC Re, Inc. (AMC Re), a captive reinsurer incorporated
under the provisions of the laws of Arkansas. Effective July 1, 2008, FMIC and AUIC entered into
an intercompany reinsurance agreement wherein all premiums and losses of AUIC, including all past
liabilities, are 100% assumed by FMIC.
GAAP and Non-GAAP Financial Performance Metrics
Throughout this report, we present our operations in the way we believe will be most
meaningful, useful, and transparent to anyone using this financial information to evaluate our
performance. In addition to the GAAP (generally accepted accounting principles in the United
States of America) presentation of net income and certain statutory reporting information, we show
certain non-GAAP financial 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 premiums earned is the related GAAP measure used in the
statements of earnings, gross written premiums is the component of net premiums earned that
measures insurance business produced before the impact of ceding reinsurance premiums, but without
respect to when those premiums will be recognized as actual revenue. We use this measure as an
overall gauge of gross business volume in our insurance underwriting operations with some
indication of profit potential subject to the levels of our retentions, expenses, and loss costs.
Net written premiums. While net premiums earned is the related GAAP measure used in the
statements of earnings, net written premiums is the component of net premiums earned that measures
the difference between gross written premiums and the impact of ceding reinsurance premiums, but
without respect to when those premiums will be recognized as actual revenue. We use this measure
as an indication of retained or net business volume in our insurance underwriting operations. It
is an indicator of future earnings potential subject to our expenses and loss costs.
Combined ratio. This ratio is a common industry measure of profitability for any underwriting
operation, and is calculated in two components. First, the loss ratio is losses and settlement
expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum
of policy acquisition costs and insurance operating expenses, net of insurance underwriting
commissions and fees, divided by net premiums earned. The sum of the loss and expense ratios is the
combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of
underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of
premium we earn, we record $15 of pre-tax underwriting income.
Critical Accounting Policies
The critical accounting policies discussed below are important to the portrayal of our
financial condition and results of operations and require us to exercise significant judgment. We
use significant judgments concerning future results and developments in making these critical
accounting estimates and in preparing our consolidated financial statements. These judgments and
estimates affect the reported amounts of assets, liabilities, revenues and expenses and the
disclosure of material contingent assets and liabilities. We evaluate our estimates on a continual
basis using information that we believe to be relevant. Actual results may differ materially from
the estimates and assumptions used in preparing the consolidated financial statements.
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Readers are also urged to review Managements Discussion and Analysis of Financial Condition
and Results of Operations Critical Accounting Policies and Note 1 to the audited consolidated
financial statements thereto included in the Annual Report on Form 10-K for the year ended December 31, 2008 on file with the Securities and Exchange
Commission for a more complete description of our critical accounting policies and estimates.
Use of Estimates
In preparing our consolidated financial statements, management is required to make estimates
and assumptions that affect the reported amounts of assets and liabilities and the disclosures of
contingent assets and liabilities as of the date of the consolidated financial statements, and
revenues and expenses reported for the periods then ended. Actual results may differ from those
estimates. Material estimates that are susceptible to significant change in the near term relate
primarily to the determination of the reserves for losses and loss adjustment expenses and
valuation of intangible assets and goodwill.
Loss and Loss Adjustment Expense Reserves
The reserves for losses and loss adjustment expenses represent our estimated ultimate costs of
all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance
sheet date. Our reserves reflect our estimates at a given time of amounts that we expect to pay
for losses that have been reported, which are referred to as Case reserves, and losses that have
been incurred but not reported and the expected development of losses and allocated loss adjustment
expenses on reported cases, which are referred to as IBNR reserves. We do not discount the
reserves for losses and loss adjustment expenses.
We allocate the applicable portion of our estimated loss and loss adjustment expense reserves
to amounts recoverable from reinsurers under ceded reinsurance contracts and report those amounts
separately from our loss and loss adjustment expense reserves as an asset on our balance sheet.
The estimation of ultimate liability for losses and loss adjustment expenses is an inherently
uncertain process, requiring the use of informed estimates and judgments. Our loss and loss
adjustment expense reserves do not represent an exact measurement of liability, but are our
estimates based upon various factors, including:
| actuarial projections of what we, at a given time, expect to be the cost of the ultimate settlement and administration of claims reflecting facts and circumstances then known; | ||
| estimates of future trends in claims severity and frequency; | ||
| assessment of asserted theories of liability; and | ||
| analysis of other factors, such as variables in claims handling procedures, economic factors, and judicial and legislative trends and actions. |
Most or all of these factors are not directly or precisely quantifiable, particularly on a
prospective basis, and are subject to a significant degree of variability over time. In addition,
the establishment of loss and loss adjustment expense reserves makes no provision for the
broadening of coverage by legislative action or judicial interpretation or for the extraordinary
future emergence of new types of losses not sufficiently represented in our historical experience
or which cannot yet be quantified. Accordingly, the ultimate liability may be more or less than
the current estimate. The effects of changes in the estimated reserves are included in the results
of operations in the period in which the estimate is revised.
Our reserves consist of reserves for property and liability losses, consistent with the
coverages provided for in the insurance policies directly written or assumed by the Company under
reinsurance contracts. In many cases, several years may elapse between the occurrence of an
insured loss, the reporting of the loss to us and our payment of the loss. Although we believe
that our reserve estimates are reasonable, it is possible that our actual loss experience may not
conform to our assumptions and may, in fact, vary significantly from our assumptions. Accordingly,
the ultimate settlement of losses and the related loss adjustment expenses may vary significantly
from the estimates included in our financial statements. We continually review our estimates and
adjust them as we believe appropriate as our experience develops or new information becomes known
to us.
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Our reserves for losses and loss adjustment expenses at September 30, 2009 and December 31,
2008, gross and net of ceded reinsurance were as follows:
September 30, | December 31, | |||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Gross |
||||||||
Case reserves |
$ | 107,137 | $ | 91,057 | ||||
IBNR and ULAE reserves |
341,128 | 281,664 | ||||||
Total reserves |
$ | 448,265 | $ | 372,721 | ||||
Net of reinsurance |
||||||||
Case reserves |
$ | 73,651 | $ | 62,497 | ||||
IBNR and ULAE reserves |
217,718 | 181,672 | ||||||
Total |
$ | 291,369 | $ | 244,169 | ||||
Revenue Recognition
Premiums. Premiums are recognized as earned using the daily pro rata method over the terms of
the policies. When premium rates change, the effect of those changes will not immediately affect
earned premium. Rather, those changes will be recognized ratably over the period of coverage.
Unearned premiums represent the portion of premiums written that relate to the unexpired terms of
policies-in-force. As policies expire, we audit those policies comparing the estimated premium
rating units that were used to set the initial premium to the actual premiums rating units for the
period and adjust the premiums accordingly. Premium adjustments identified as a result of these
audits are recognized as earned when identified.
Commissions and Fees. Wholesale agency commissions and fee income from unaffiliated companies
are earned at the effective date of the related insurance policies produced or as services are
provided under the terms of the administrative and service provider contracts. Related commissions
to retail agencies are concurrently expensed at the effective date of the related insurance
policies produced. Profit sharing commissions due from certain insurance and reinsurance
companies, based on losses and loss adjustment expense experience, are earned when determined in
accordance with the applicable contract.
Investments
Our marketable investment securities, including money market accounts held in our investment
portfolio, are classified as available-for-sale and, as a result, are reported at market value.
Effective January 1, 2008, we adopted the accounting guidance for fair value measurements and
disclosures which resulted in no material changes in valuation techniques we previously used to
measure fair values. See Note 11 to the Condensed Consolidated Financial Statements for a more
complete description. Convertible securities were accounted for under the accounting guidance for
hybrid securities for the three and nine months ended September 30, 2009 and 2008. Alternative
investments consist of our investments in limited partnerships, which invest in high yield
convertible securities and distressed structured finance products. These alternative investments
are accounted for in accordance with FASB guidance for the fair value option of financial
instruments for the three and nine months ended September 30, 2009 and 2008.
Premiums and discounts are amortized or accreted over the life of the related debt security as
an adjustment to yield using the effective-interest method. Dividend and interest income are
recognized when earned. Realized gains and losses are included in earnings and are derived using
the specific identification method for determining the cost of securities sold.
Impairment of Investment Securities
Impairment of investment securities results 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
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when evaluating investments for impairment losses could result in a change in impairment
losses reported in the consolidated financial statements.
As mentioned above, the Company considers its intent and ability to hold a security until the
value recovers as part of the process of evaluating whether a securitys unrealized loss represents
an other-than-temporary decline. The Companys ability to hold such securities is supported by
sufficient cash flow from its operations and from maturities within its investment portfolio in
order to meet its claims payment and other disbursement obligations arising from its underwriting
operations without selling such investments. With respect to securities where the decline in value
is determined to be temporary and the securitys 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 Companys 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
Companys 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 securitys 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.
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 managements 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.
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Results of Operations
Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008
The following table summarizes our results for the three months ended September 30, 2009 and
2008:
Three Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Operating Revenue |
||||||||||||
Net earned premiums |
$ | 51,512 | $ | 49,092 | 5 | % | ||||||
Commissions and fees |
7,445 | 4,757 | 57 | |||||||||
Net investment income |
7,540 | 5,571 | 35 | |||||||||
Net realized gains (losses) on investments |
13,766 | (7,128 | ) | 293 | ||||||||
Other-than-temporary impairment losses on
investments |
(292 | ) | (3,476 | ) | 92 | |||||||
Total Operating Revenues |
79,971 | 48,816 | 64 | |||||||||
Operating Expenses |
||||||||||||
Losses and loss adjustment expenses, net |
30,345 | 27,537 | 10 | |||||||||
Amortization of intangible assets |
559 | 553 | 1 | |||||||||
Other operating expenses |
24,129 | 19,797 | 22 | |||||||||
Total Operating Expenses |
55,033 | 47,887 | 15 | |||||||||
Operating Income |
24,938 | 929 | 2,584 | |||||||||
Interest Expense |
1,275 | 1,376 | (7 | ) | ||||||||
Income
(Loss) From Continuing Operations Before Income Taxes |
23,663 | (447 | ) | 5,394 | ||||||||
Income Taxes |
8,018 | (948 | ) | 946 | ||||||||
Income From Continuing Operations |
15,645 | 501 | 3,023 | |||||||||
Income
(Loss) From Discontinued Operations, Net of Income Taxes |
| (447 | ) | n/m | ||||||||
Net Income |
$ | 15,645 | $ | 54 | 28,872 | % | ||||||
Loss Ratio |
58.9 | % | 56.1 | % | 2.8 points | |||||||
Underwriting Expense Ratio |
33.6 | % | 30.2 | % | 3.4 points | |||||||
Combined Ratio |
92.5 | % | 86.3 | % | 6.2 points | |||||||
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Operating Revenue
Net Earned Premiums
Three Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Written premiums |
||||||||||||
Direct |
$ | 77,607 | $ | 72,746 | 7 | % | ||||||
Assumed |
4,201 | 4,253 | (1 | ) | ||||||||
Ceded |
(35,483 | ) | (27,453 | ) | 29 | |||||||
Net written premiums |
$ | 46,325 | $ | 49,546 | (7 | )% | ||||||
Earned premiums |
||||||||||||
Direct |
$ | 77,907 | $ | 70,985 | 10 | % | ||||||
Assumed |
4,529 | 4,422 | 2 | |||||||||
Ceded |
(29,907 | ) | (26,566 | ) | 13 | |||||||
Earned but
unbilled premiums |
(1,017 | ) | 251 | (505 | ) | |||||||
Net earned premiums |
$ | 51,512 | $ | 49,092 | 5 | % | ||||||
Direct written premiums increased $4.9 million, or 7%, primarily due to increases in premium
production from the Companys Professional Liability and FM Emerald platforms partially offset by
decreases in production from the Companys Security and Specialty underwriting platforms during the
three months ended September 30, 2009. Direct earned premiums increased $6.9 million in the three
months ended September 30, 2009, or 10%, compared to the three months ended September 30, 2008.
Assumed written and assumed earned premiums were approximately flat.
Ceded written premiums increased $8.0 million, or 29%, and ceded earned premiums increased
$3.3 million, or 13%, for the three months ended September 30, 2009 compared to the three months
ended September 30, 2008. Ceded written premiums increased to 43.4% of direct and assumed written
premiums during the third quarter of 2009 compared to 35.7% of direct and assumed written premiums
during the third quarter of 2008 principally due to purchasing more quota share reinsurance during
the third quarter of 2009 for the Companys primary casualty business compared to the third quarter
of 2008. The increase in quota share cessions was partially offset by lower cessions under our
excess of loss treaties during the third quarter of 2009 and the elimination of a 50% quota share
on a contract underwriting class of business during the fourth quarter of 2008, which impacted the
third quarter of 2009.
Earned but unbilled premiums decreased $1.3 million, or 505%, primarily due to the net earned
premiums subject to audit during the three months ended September 30, 2009 decreasing compared to
the net premiums earned subject to audit during the three months ended September 30, 2008.
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Commissions and Fees
Three Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Insurance underwriting commissions and fees |
$ | 1,272 | $ | (619 | ) | 305 | % | |||||
Insurance services commissions and fees |
6,173 | 5,376 | 15 | |||||||||
Total commissions and fees |
$ | 7,445 | $ | 4,757 | 57 | % | ||||||
Insurance underwriting commissions and fees increased 305% from the three months ended
September 30, 2008 to the three months ended September 30, 2009, principally due to a non-recurring
$1.8 million negative profit sharing commission on a fronted program recorded during the three
months ended September 30, 2008. 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 $0.5 million during the third quarter of 2009 compared
to the third quarter of 2008. In addition, commission income related to our workers compensation
service program increased $0.3 million.
Net Investment Income and Realized Gains (Losses) on Investments. During the three months
ended September 30, 2009, net investment income was $7.5 million, a $2.0 million, or 35%, increase
from $5.6 million reported for the three months ended September 30, 2008 primarily due to the
increase in invested assets over the period and an increase in the book yield of the portfolio. At
September 30, 2009, invested assets were $674.0 million, a $139.8 million, or 26%, increase over
$534.2 million of invested assets at September 30, 2008. 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 5.0% and 4.0% at September 30, 2009 and 2008, respectively. The annualized taxable
equivalent yield on total investments (net of investment expenses) was 5.5% and 4.8% at September
30, 2009 and 2008, respectively.
During the three months ended September 30, 2009, net realized gains were $13.8 million
compared to net realized losses of $7.1 million during the three months ended September 30, 2008.
The third quarter 2009 net realized gains were due to the mark to market increase in securities
carried at market of approximately $12.4 million and gains on the sale of certain securities of
$2.3 million, partially offset by the losses on the sale of certain securities. 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 change 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 these positions. The value of
these components in the limited partnership change 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
September 30, 2009 other-than-temporary impairment losses on investments were $0.3 million compared
to other-than-temporary impairment losses on investments of $3.5 million during the three months
ended September 30, 2008. The decrease in other-than-temporary impairment losses on investments is
primarily attributable to the stabilization of the capital markets.
Operating Expenses
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred increased
$2.8 million, or 10%, in the three months ended September 30, 2009 compared to the three months
ended September 30, 2008. This increase was primarily due to the increase in net earned exposures
reflected in the 5% increase in net earned premiums and an increase in the accident year loss and
loss adjustment expense ratio from decreased premium rates, partially offset by favorable claims
trends for the current and prior accident years. Losses and loss adjustment expenses for the three
months ended September 30, 2009 included approximately $1.3 million of favorable development of
December 31, 2008 prior years loss and loss adjustment expense reserves in our Specialty general
liability classes in the 2007 accident year due to lower than expected claim frequency along with
lower than expected severity. Losses and loss adjustment expenses for the three months ended
September 30, 2008 included approximately $4.8 million in favorable development of December 31,
2007 prior years loss and loss adjustment expense reserves and $2.9 million from the impact of
Hurricane Ike. The $4.8 million in net favorable development included $6.0 million in our
Specialty general liability classes in the 2007 accident year due to favorable claims trends,
unfavorable development of $1.4 million in our Contract Underwriting liability classes in accident
years 2005 through 2007 due to higher than expected severity in the 2006 and 2007 accident years reduced
by lower than expected severity in the 2005 accident year and net favorable development of $0.2
million in unallocated loss and loss adjustment expenses for the 2005 through 2007 accident years.
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Other Operating Expenses
Three Months Ended | ||||||||||||
September 30 | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Amortization of deferred acquisition expenses |
$ | 13,960 | $ | 10,798 | 29 | % | ||||||
Ceded reinsurance commissions |
(8,340 | ) | (7,164 | ) | 16 | |||||||
Other underwriting and operating expenses |
18,509 | 16,163 | 15 | |||||||||
Other operating expenses |
$ | 24,129 | $ | 19,797 | 22 | % | ||||||
During the three months ended September 30, 2009, other operating expenses increased $4.3
million, or 22%, from the three months ended September 30, 2008. Amortization of deferred
acquisition expenses increased by $3.2 million, or 29% due to increased acquisition expenses on new
underwriting initiatives and the impact of purchasing less quota share reinsurance in 2008,
partially offset by purchasing more quota share reinsurance in 2009. Ceded reinsurance commissions
increased $1.2 million, or 16%, principally due to the effect of purchasing more quota share
reinsurance during the third quarter of 2009 compared to the third quarter of 2008. Other
underwriting and operating expenses, which consist of commissions, other acquisition costs, and
general and underwriting expenses, net of acquisition cost deferrals increased by $2.3 million, or
15%. The increase was principally due to higher commissions and other
acquisition costs of $1.1 million, higher corporate expenses of $1.0 million, and an
increase of $0.2 million in general and underwriting expenses related to our insurance services
operations, which are unrelated to premiums.
Interest Expense. Interest expense decreased 7% from the three months ended September 30,
2008 compared to the three months ended September 30, 2009. 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 33.9% for the three months ended
September 30, 2009 and -212.1% for the three months ended September 30, 2008 and differed from the
federal statutory rate primarily due to state income taxes, non-deductible expenses, and the
nontaxable portion of dividends received and tax-exempt interest. The increase in the effective
tax rate is primarily due to the nontaxable portion of dividends received and tax-exempt interest
constituting a lower portion of overall pretax income for the three months ended September 30, 2009
compared to the same period of 2008.
Discontinued Operations. On June 27, 2008, the Company sold all of the outstanding capital
stock of American Risk Pooling Consultants, Inc. (ARPCO). The results of ARPCOs operations are
presented as Discontinued Operations in the Condensed Consolidated Statements of Income. For the
three months ended September 30, 2008, income from discontinued operations consisted of state
income tax expense of $0.4 million, net of federal taxes, on the sale of ARPCO.
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Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
The following table summarizes our results for the nine months ended September 30, 2009 and
2008:
Nine Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Operating Revenue |
||||||||||||
Net earned premiums |
$ | 155,539 | $ | 139,222 | 12 | % | ||||||
Commissions and fees |
23,916 | 15,896 | 50 | |||||||||
Net investment income |
21,105 | 15,635 | 35 | |||||||||
Net realized gains (losses) on investments |
25,204 | (8,714 | ) | 389 | ||||||||
Other-than-temporary impairment losses on investments |
(426 | ) | (3,701 | ) | 88 | |||||||
Total Operating Revenues |
225,338 | 158,338 | 42 | |||||||||
Operating Expenses |
||||||||||||
Losses and loss adjustment expenses, net |
96,301 | 76,713 | 26 | |||||||||
Amortization of intangible assets |
1,709 | 1,466 | 17 | |||||||||
Other operating expenses |
69,808 | 54,706 | 28 | |||||||||
Total Operating Expenses |
167,818 | 132,885 | 26 | |||||||||
Operating Income |
57,520 | 25,453 | 126 | |||||||||
Interest Expense |
3,877 | 4,490 | (14 | ) | ||||||||
Income
From Continuing Operations Before Income Taxes |
53,643 | 20,963 | 156 | |||||||||
Income Taxes |
17,707 | 5,592 | 217 | |||||||||
Income From Continuing Operations |
35,936 | 15,371 | 134 | |||||||||
Income
From Discontinued Operations, Net of Income Taxes |
| 23,106 | n/m | |||||||||
Net Income |
$ | 35,936 | $ | 38,477 | (7 | )% | ||||||
Loss Ratio |
61.9 | % | 55.1 | % | 6.8 points | |||||||
Underwriting Expense Ratio |
31.6 | % | 26.9 | % | 4.7 points | |||||||
Combined Ratio |
93.5 | % | 82.0 | % | 11.5 points | |||||||
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Operating Revenue
Net Earned Premiums
Nine Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Written premiums |
||||||||||||
Direct |
$ | 228,619 | $ | 224,720 | 2 | % | ||||||
Assumed |
13,588 | 13,399 | 1 | |||||||||
Ceded |
(92,615 | ) | (77,828 | ) | 19 | |||||||
Net written premiums |
$ | 149,592 | $ | 160,291 | (7 | )% | ||||||
Earned premiums |
||||||||||||
Direct |
$ | 226,125 | $ | 209,208 | 8 | % | ||||||
Assumed |
13,276 | 12,405 | 7 | |||||||||
Ceded |
(81,752 | ) | (82,063 | ) | (0 | ) | ||||||
Earned but unbilled premiums |
(2,110 | ) | (328 | ) | 543 | |||||||
Net earned premiums |
$ | 155,539 | $ | 139,222 | 12 | % | ||||||
Direct written premiums increased $3.9 million, or 2%, primarily due to increases in
production from the Companys FM Emerald, Professional Liability and Contract Underwriting
platforms offset by decreases in premium production from the Companys Security and Specialty
underwriting platforms during the nine months ended September 30, 2009. Direct earned premiums
increased $16.9 million in the nine months ended September 30, 2009, or 8%, compared to the nine
months ended September 30, 2008.
Assumed written premiums were approximately flat and assumed earned premiums increased $0.9
million, or 7%.
Ceded written premiums increased $14.8 million, or 19%, and ceded earned premiums decreased
$0.3 million, or less than 1%, for the nine months ended September 30, 2009 compared to the nine
months ended September 30, 2008. Ceded written premiums increased to 38.2% of direct and assumed
written premiums during the nine months ended September 30, 2009 compared to 32.7% of direct and
assumed written premiums during the nine months ended September 30, 2008 principally due to
purchasing more quota share reinsurance during the nine months ended September 30, 2009 for the
Companys primary casualty business compared to the same period of 2008. The increase in quota
share cessions was partially offset by lower cessions under our excess of loss treaties during the
nine months ended September 30, 2009 and the elimination of a 50% quota share on a contract
underwriting class of business during the fourth quarter of 2008, which impacted the nine months
ended September 30, 2009.
Earned but unbilled premiums decreased $1.8 million, or 543%, primarily due to the net earned
premiums subject to audit during the nine months ended September 30, 2009 decreasing compared to
the net premiums earned subject to audit during the nine months ended September 30, 2008.
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Commissions and Fees
Nine Months Ended | ||||||||||||
September 30, | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Insurance underwriting commissions and
fees |
$ | 3,989 | $ | 2,136 | 87 | % | ||||||
Insurance services commissions and fees |
19,927 | 13,760 | 45 | |||||||||
Total commissions and fees |
$ | 23,916 | $ | 15,896 | 50 | % | ||||||
Insurance underwriting commissions and fees increased $1.9 million, or 87%, in the nine months
ended September 30, 2008 compared to the nine months ended September 30, 2009. This increase was
primarily due to a non-recurring $1.8 million negative profit sharing commission on a fronted
program recorded during the nine months ended September 30, 2008. Insurance services commissions
and fees, which were principally AMC commission and fee income and not related to premiums,
increased $6.2 million, as the result of nine months of commission and fee income during the period
ended September 30, 2009 compared to eight months during the period ended September 30, 2008, the
favorable settlement of a contingent adjustment due to an unaffiliated carrier for $1.3 million,
and $1.3 million increase in commission income related to our workers compensation service
program.
Net Investment Income and Realized Gains (Losses) on Investments. During the nine months
ended September 30, 2009, net investment income was $21.1 million, a $5.5 million, or 35%, increase
from $15.6 million reported for the nine months ended September 30, 2008 primarily due to the
increase in invested assets over the period and an increase in the book yield of the portfolio. At
September 30, 2009, invested assets were $674.0 million, a $139.8 million, or 26%, increase over
$534.2 million of invested assets at September 30, 2008. 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 5.0% and 4.0% at September 30, 2009 and 2008, respectively. The annualized taxable
equivalent yield on total investments (net of investment expenses) was 5.5% and 4.8% at September
30, 2009 and 2008, respectively.
During the nine months ended September 30, 2009, net realized gains were $25.2 million
compared to net realized losses of $8.7 million during the nine months ended September 30, 2008.
The nine months ended September 30, 2009 net realized gains were principally due to the mark to
market increase in securities carried at market of approximately $21.1 million and gains on the
sale of certain securities of $5.9 million, partially offset by the losses on the sale of certain
securities. 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 change 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 change 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 nine months ended September
30, 2009, other-than-temporary impairment losses on investments were $0.4 million compared to
other-than-temporary impairment losses on investments of $3.7 million during the nine months ended
September 30, 2008. The decrease in other-than-temporary impairment losses on investments is
primarily attributable to the stabilization of the capital markets.
Operating Expenses
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred increased
$19.6 million, or 26%, in the nine months ended September 30, 2009 compared to the nine months
ended September 30, 2008. This increase was primarily due to the increase in net earned exposures
reflected in the 12% increase in net earned premiums, an increase in the accident year loss and
loss adjustment expense ratio from decreased premium rates, $2.4 million of storm-related losses
experienced during the second
quarter of 2009, and $5.2 million of higher than anticipated 2009 commercial property fire and
other losses and loss adjustment expenses during the second quarter of 2009, partially offset by
favorable claims trends in the current and prior accident years. Losses and loss adjustment
expenses for the nine months ended September 30, 2009 included approximately $5.7 million of
favorable development of December 31, 2008 prior years loss and loss adjustment expense reserves.
Favorable development of $1.9 million in our Security general
liability classes in 2006 through 2007
accident years and $3.6 million in our Specialty general
liability classes in the 2006 through 2007
accident years was due to lower than expected claim frequency and lower than expected severity.
Net favorable
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development of $0.2 million in unallocated loss and loss adjustment expenses was
recorded for the 2006 through 2007 accident years. Losses and loss adjustment expenses for the nine months
ended September 30, 2008 included approximately $4.8 million in favorable development of December
31, 2007 prior years loss and loss adjustment expense reserves and $2.9 million from the impact of
Hurricane Ike. The $4.8 million in net favorable development included $6.0 million in our
Specialty general liability classes in the 2007 accident year due to favorable claims trends,
unfavorable development of $1.4 million in our Contract Underwriting liability classes in accident
years 2005 through 2007 due to higher than expected severity in the 2006 and 2007 accident years reduced
by lower than expected severity in the 2005 accident year and net favorable development of $0.2
million in unallocated loss and loss adjustment expenses for the 2005 through 2007 accident years.
Other Operating Expenses
Nine Months Ended | ||||||||||||
September 30 | ||||||||||||
2009 | 2008 | Change | ||||||||||
(Dollars in thousands) | ||||||||||||
Amortization of deferred acquisition
expenses |
$ | 40,889 | $ | 28,107 | 45 | % | ||||||
Ceded reinsurance commissions |
(24,767 | ) | (23,959 | ) | 3 | |||||||
Other underwriting and operating expenses |
53,686 | 50,558 | 6 | |||||||||
Other operating expenses |
$ | 69,808 | $ | 54,706 | 28 | % | ||||||
During the nine months ended September 30, 2009, other operating expenses increased $15.1
million, or 28%, from the nine months ended September 30, 2008. Amortization of deferred
acquisition expenses increased by $12.8 million, or 45% due to increased acquisition expenses on
new underwriting initiatives and the impact of purchasing less quota share reinsurance in 2008,
partially offset by purchasing more quota share reinsurance in 2009. Ceded reinsurance commissions
decreased $0.8 million, or 3%, principally due to the effect of purchasing more quota share
reinsurance during the nine months ended September 30, 2009 compared to the nine months ended
September 30, 2008 and lower ceding commissions related to profit sharing on ceded written
premiums. Other underwriting and operating expenses, which consist of commissions, other
acquisition costs, and general and underwriting expenses, net of acquisition cost deferrals,
increased by $3.1 million, or 6%. The increase was principally
due to higher commissions and other acquisition costs of
$2.4 million, lower corporate expenses of $1.0 million and an increase of $1.7 million
in general and underwriting expenses related to our insurance services operations, which are
unrelated to premiums, principally due to having nine months of AMC results compared to eight
months during the period ended September 30, 2008 due to the closing of the AMC acquisition on
February 1, 2008 and increased premium production for unaffiliated carriers by our services
operations.
Interest Expense. Interest expense decreased 14% from the nine months ended September 30,
2008 compared to the nine months ended September 30, 2009. This decrease was primarily due to a
$0.5 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 33.0% for the nine months ended
September 30, 2009 and 26.7% for the nine months ended September 30, 2008 and differed from the
federal statutory rate primarily due to state income taxes, non-deductible expenses, and the
nontaxable portion of dividends received and tax-exempt interest. The increase in the effective
tax rate is primarily due to the nontaxable portion of dividends received and tax-exempt interest
constituting a lower portion of overall pretax income for the nine months ended September 30, 2009
compared to the same period of 2008.
Discontinued Operations. On June 27, 2008, the Company sold all of the outstanding capital
stock of American Risk Pooling Consultants, Inc. (ARPCO). The results of ARPCOs operations are
presented as Discontinued Operations in the Condensed
Consolidated Statements of Income. For the nine months ended September 30, 2008, income from
discontinued operations consisted principally of ARPCOs operating income, net of taxes, and the
gain on the sale of ARPCO of $20.9 million.
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 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.
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Table of Contents
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 and taxes and making investments. 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 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 and for purchasing
investments. A summary of our cash flows is as follows:
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Cash and cash equivalents provided by (used in): |
||||||||
Operating activities continuing operations |
$ | 66,606 | $ | 91,712 | ||||
Operating activities discontinued operations |
| 1,928 | ||||||
Investing activities continuing operations |
(72,513 | ) | (128,185 | ) | ||||
Investing activities discontinued operations |
| 41,830 | ||||||
Financing activities |
(9,721 | ) | (3,122 | ) | ||||
Change in cash and cash equivalents |
$ | (15,628 | ) | $ | 4,163 | |||
Net cash provided by operating activities from continuing operations for the nine months ended
September 30, 2009 and 2008 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 nine months ended September 30, 2009 and 2008 was retained on a funds
withheld basis in accordance with the quota share reinsurance contracts.
Net cash provided by operating activities from discontinued operations for the nine months
ended September 30, 2008 was primarily from cash received on commissions and service fees less cash
disbursed for operating expenses.
Net cash used in investing activities from continuing operations for the nine months ended
September 30, 2009 primarily resulted from our net investment in short-term, debt and equity
securities. Net cash used in investing activities from continuing operations for the nine months
ended September 30, 2008 primarily resulted from our net investment in short-term, debt and equity
securities, and for the acquisition of AMC.
Net cash provided by investing activities from discontinued operations for the nine months
ended September 30, 2008 was from cash received on the sale of ARPCO less cash disbursed for
transaction costs.
Net cash used in financing activities for the nine months ended September 30, 2009 was
primarily from the purchase of common stock under the Companys Share Repurchase Plan (Note 9), the
payment of shareholders dividends, and the purchase of common stock by the Company to be held in a
rabbi trust for the benefit of the Companys Supplemental Executive Retirement Plan, partially
offset by net short-term borrowings of $3.0 million on the Companys $30.0 million revolving credit
facility.
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Net cash used in financing activities for the nine months ended September 30, 2008 resulted
from the issuance of common stock as a result of the exercise of stock options offset by the
purchase of common stock under the Companys Share Repurchase Plan and the purchase of common stock
by the Company to be held in a rabbi trust for the benefit of the Companys Supplemental Executive
Retirement Plan.
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 $307.5 million, or $17.90 per outstanding share, as of
September 30, 2009 compared to $261.6 million, or $14.67 per outstanding share, as of December 31,
2008. Our tangible stockholders equity attributable to common shareholders was $257.1 million, or
$14.97 per outstanding share, as of September 30, 2009 compared to $210.2 million, or $11.79 per
outstanding share as of December 31, 2008. Below is a reconciliation of our total stockholders
equity to our tangible stockholders equity attributable to common shareholders:
September 30, | December 31, | |||||||
2009 | 2008 | |||||||
(Dollars in thousands, except share and per share data) | ||||||||
Total stockholders equity |
$ | 307,472 | $ | 261,637 | ||||
Intangible assets, net |
(37,642 | ) | (39,351 | ) | ||||
Deferred tax liability intangible assets, net |
12,801 | 13,399 | ||||||
Goodwill |
(25,483 | ) | (25,483 | ) | ||||
Tangible stockholders equity attributable to common shareholders |
$ | 257,148 | $ | 210,202 | ||||
Common shares outstanding |
17,174,906 | 17,836,337 | ||||||
Book value per share |
$ | 17.90 | $ | 14.67 | ||||
Tangible book value per share |
$ | 14.97 | $ | 11.79 | ||||
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 September 30, 2009, 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 Facility. In October 2006, we entered into a credit facility which provided for
borrowings of up to $30.0 million. Borrowings under the credit facility bear interest at our
election as follows: (i) at a rate per annum equal to the greater of the lenders prime rate and
the federal funds rate less 0.5%, each minus 0.75%; or, (ii) a rate per annum equal to LIBOR plus
an applicable margin
39
Table of Contents
based on our leverage ratio, which is currently 0.75%. The obligations under
the credit facility are guaranteed by our material non-insurance subsidiaries. The maturity date of
borrowings made under the credit facility is September 2011. The credit facility contains
covenants which, among other things, restrict our ability to incur indebtedness, grant liens, make
investments and sell assets. The credit facility also has certain financial covenants. At
September 30, 2009, there were $3.0 million of borrowings under the facility. At September 30,
2009, the Company was in compliance with all of the covenants related to the credit facility.
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 other 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 September 30,
2009, 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 September 30, 2009, our investments had a
market value of $674.0 million and consisted of the following investments:
Market Value | % of Portfolio | |||||||
(Dollars in thousands) | ||||||||
Short Term Investments |
$ | 10,754 | 1.6 | % | ||||
U.S. Treasuries |
3,922 | 0.6 | % | |||||
U.S. Agencies |
1,028 | 0.2 | % | |||||
Municipal Bonds |
197,257 | 29.2 | % | |||||
Taxable Municipal Bonds |
3,445 | 0.5 | % | |||||
Corporate Bonds |
129,254 | 19.2 | % | |||||
High Yield Bonds |
19,275 | 2.9 | % | |||||
MBS Passthroughs |
61,532 | 9.1 | % | |||||
CMOs |
74,226 | 11.0 | % | |||||
Asset Backed Securities |
22,875 | 3.4 | % | |||||
Commercial MBS |
58,924 | 8.7 | % | |||||
Convertible Securities |
66,131 | 9.8 | % | |||||
High Yield Convertible Fund |
12,301 | 1.8 | % | |||||
Structured Finance Fund |
11,814 | 1.8 | % | |||||
Preferred Stocks |
1,273 | 0.2 | % | |||||
Common Stocks |
| 0.0 | % | |||||
Total |
$ | 674,011 | 100.0 | % | ||||
The following table shows the composition of the investment portfolio by remaining time to
maturity at September 30, 2009. 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.
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% of Total | ||||
Average Life | Investment | |||
Less than one year |
15.2 | % | ||
One to two years |
13.5 | % | ||
Two to three years |
15.6 | % | ||
Three to four years |
15.5 | % | ||
Four to five years |
13.6 | % | ||
Five to seven years |
11.1 | % | ||
More than seven years |
15.5 | % | ||
Total |
100.0 | % | ||
The effective duration of the portfolio as of September 30, 2009 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 3.6 years and
3.3 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 5.0% at September 30, 2009 and 4.0% at September 30, 2008. The
annualized taxable equivalent yield on total investments (net of investment expenses) was 5.5% at
September 30, 2009 and 4.8% at September 30, 2008.
The majority of our portfolio consists of AAA or AA rated securities with a Standard and
Poors weighted average credit quality of AA- at September 30, 2009. The fixed income portfolio
had a weighted average credit quality of AA at September 30, 2009. 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 September 30, 2009 as a percentage of total
market value.
% of Total | ||||
S&P Rating | Investments | |||
AAA |
47.6 | % | ||
AA |
14.6 | % | ||
A |
14.8 | % | ||
BBB |
12.9 | % | ||
BB |
5.7 | % | ||
B |
1.7 | % | ||
CCC |
2.7 | % | ||
C |
0.0 | % | ||
NR |
0.0 | % | ||
Total |
100.0 | % | ||
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 Companys 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 CMOs.
At September 30, 2009, the Company held CMOs classified as available-for-sale with a fair
value of $74.2 million. Approximately 60.4% 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 September 30, 2009, the
Company held $60.8 million of mortgage-backed pass-through securities issued by one of the GSEs
and classified as available-for-sale.
The Company held commercial mortgage-backed securities (CMBS) of $58.9 million, of which
83.5% are pre-2006 vintage, at September 30, 2009. The weighted average credit support (adjusted
for defeasance) of our CMBS portfolio was 40.6% and comprised mainly of super senior structures.
The weighted average loan to value at origination was 67.3%. The average credit rating of these
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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 Companys 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 $9.2 million and $3.5 million at September
30, 2009, respectively. Included in these securities is a recent allocation made during the
quarter 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 September 30, 2009 was BB-.
The Companys fixed maturity investment portfolio at September 30, 2009 included securities
issued by numerous municipalities with a total carrying value of $200.7 million. Approximately
$21.5 million, or 10.7%, were pre-refunded (escrowed with Treasuries). Approximately $95.9
million, or 47.8%, 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, results 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 $95.9 million of insured municipal securities in the Companys investment portfolio
at September 30, 2009, 98.9% were rated at A- or above, and approximately 73.5% were rated AA- or
above, without the benefit of insurance. The average underlying credit rating of the entire
municipal bond portfolio was AA at September 30, 2009. The Company believes that a loss of the
benefit of insurance would not result in a material adverse impact on the Companys results of
operations, financial position or liquidity, due to the underlying credit strength of the issuers
of the securities, as well as the Companys ability and intent to hold the securities.
The Companys investment portfolio does not contain any exposure to Collateralized Debt
Obligations (CDO) or investments collateralized by CDOs. In addition, the Companys investment
portfolio does not contain any exposure to auction-rate securities.
Cash and cash equivalents consisted of cash on hand of $16.2 million at September 30, 2009.
The amortized cost, gross unrealized gains and losses, and market value of marketable
investment securities classified as available-for-sale at September 30, 2009 by major security type
were as follows:
Gross Unrealized | ||||||||||||||||
Amortized Cost | Gains | Losses | Market Value | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | 3,776 | $ | 146 | $ | | $ | 3,922 | ||||||||
Government agency mortgage-backed securities |
101,160 | 4,491 | (8 | ) | 105,643 | |||||||||||
Government agency obligations |
989 | 39 | | 1,028 | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
109,734 | 5,176 | (2,996 | ) | 111,914 | |||||||||||
Obligations of states and political subdivisions |
189,101 | 11,661 | (60 | ) | 200,702 | |||||||||||
Corporate bonds |
137,912 | 11,317 | (700 | ) | 148,529 | |||||||||||
Total Debt Securities |
542,672 | 32,830 | (3,764 | ) | 571,738 | |||||||||||
Preferred stocks |
1,416 | 50 | (193 | ) | 1,273 | |||||||||||
Short-term investments |
10,754 | | | 10,754 | ||||||||||||
Total |
$ | 554,842 | $ | 32,880 | $ | (3,957 | ) | $ | 583,765 | |||||||
At September 30, 2009, there were 108 unrealized loss positions with a total unrealized loss
of $4.0 million. This represents approximately 0.7% of quarter end available-for-sale assets of
$583.8 million. This unrealized loss position is a function of the purchase of specific securities
in a lower interest rate or spread environment than what prevails as of September 30, 2009. Some
of these losses are due to the increase in spreads of select corporate bonds or structured
securities. We have viewed these market value declines as being temporary in nature. Our
portfolio is relatively short as the duration of the core fixed income portfolio excluding cash,
convertible securities, and equity is approximately 3.6 years. We do not intend to sell and it is
not expected we will need to sell these temporarily impaired securities. In light of our growth
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
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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 fair value and amount of unrealized losses segregated by the time period the investment
had been in an unrealized loss position is as follows at September 30, 2009:
Less than 12 Months | Greater than 12 Months | |||||||||||||||
Fair Value | Fair Value | |||||||||||||||
of | of | |||||||||||||||
Investments | Investments | |||||||||||||||
With | Gross | With | Gross | |||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||
Losses | Losses | Losses | Losses | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | | $ | | $ | | $ | | ||||||||
Government agency mortgage-backed securities |
1,680 | (1 | ) | 194 | (7 | ) | ||||||||||
Government agency obligations |
| | | | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
6,351 | (262 | ) | 14,157 | (2,734 | ) | ||||||||||
Obligations of states and political
subdivisions |
| | 3,645 | (60 | ) | |||||||||||
Corporate bonds |
1,252 | (1 | ) | 8,542 | (699 | ) | ||||||||||
Total Debt Securities |
9,283 | (264 | ) | 26,538 | (3,500 | ) | ||||||||||
Preferred Stocks |
| | 313 | (193 | ) | |||||||||||
Total |
$ | 9,283 | $ | (264 | ) | $ | 26,851 | $ | (3,693 | ) | ||||||
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, 2008:
Less than 12 Months | Greater than 12 Months | |||||||||||||||
Fair Value | Fair Value | |||||||||||||||
of | of | |||||||||||||||
Investments | Investments | |||||||||||||||
With | Gross | With | Gross | |||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||
Losses | Losses | Losses | Losses | |||||||||||||
(Dollars in thousands) | ||||||||||||||||
Debt Securities |
||||||||||||||||
U.S. government securities |
$ | | $ | | $ | | $ | | ||||||||
Government agency mortgage-backed securities |
3,902 | (37 | ) | 326 | (2 | ) | ||||||||||
Government agency obligations |
| | | | ||||||||||||
Collateralized mortgage obligations and other
asset-backed securities |
48,125 | (5,143 | ) | 5,963 | (1,944 | ) | ||||||||||
Obligations of states and political
subdivisions |
14,063 | (427 | ) | 8,809 | (267 | ) | ||||||||||
Corporate bonds |
42,402 | (2,549 | ) | 12,824 | (1,325 | ) | ||||||||||
Total Debt Securities |
108,492 | (8,156 | ) | 27,922 | (3,538 | ) | ||||||||||
Preferred Stocks |
832 | (78 | ) | 216 | (289 | ) | ||||||||||
Total |
$ | 109,324 | $ | (8,234 | ) | $ | 28,138 | $ | (3,827 | ) | ||||||
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 nine
months ended September 30, 2009. 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.
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Amount of | ||||
Unrealized Loss at | ||||
Sector | September 30, 2009 | |||
(Dollars in thousands) | ||||
Short Term Investments |
$ | | ||
U.S. Treasuries |
| |||
U.S. Agencies |
| |||
Municipal Bonds |
(60 | ) | ||
Taxable Municipal Bonds |
| |||
Corporate Bonds |
(700 | ) | ||
High Yield Bonds |
| |||
MBS Passthroughs |
(23 | ) | ||
CMOs |
(1,339 | ) | ||
Asset Backed Securities |
(631 | ) | ||
Commercial MBS |
(1,011 | ) | ||
Convertible Securities |
| |||
High Yield Convertible Fund |
| |||
Structured Finance Fund |
| |||
Preferred Stocks |
(193 | ) | ||
Common Stocks |
| |||
$ | (3,957 | ) | ||
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 vast majority of our unrealized impairment losses are rated investment
grade, with the majority rated AA or better. 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 9.9% as of September
30, 2009.
% of Total | Total | Total | Average Unrealized Loss | % of Loss | ||||||||||||||||
Amortized Cost | Amortized Cost | Unrealized Losses | as % of Amortized Cost | > 12 Months | ||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||
Non Investment Grade |
19.0 | % | $ | 7,615 | $ | 1,859 | 24.4 | % | 98.7 | % | ||||||||||
Investment Grade |
81.0 | 32,477 | 2,098 | 6.5 | 88.5 | |||||||||||||||
Total |
100.0 | % | $ | 40,092 | $ | 3,957 | 9.9 | % | 93.3 | % | ||||||||||
The majority of these securities are AAA or AA rated. Of the $1.9 million of unrealized
loss within non-investment grade, CMOs accounted for 43.0% of this
loss. Within CMOs 80.2% 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 33.9% of the loss. The remaining portion of the loss, or 23.1% within non-investment grade was
a financial corporate issue rated BB+ by Standard and Poors. 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 33.8% of the total
loss. Within CMOs 72.4% are rated AAA including the 60.4% 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 Commercial MBS at approximately 25.5%
of the total loss. These securities are all AAA rated and have been affected primarily by the
widening of spreads within this sector and/or the general level of interest rates. The next
largest concentration of temporarily impaired securities is Corporate Bonds at
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approximately 17.7% of the total loss. Within Corporate Bonds 98.6% are rated investment grade or better, and their
temporary impairment results primarily from the widening of credit spreads.
For the nine months ended September 30, 2009, we sold approximately $4.8 million of market
value of fixed income securities excluding convertibles, which were trading below amortized cost
while recording a realized loss of $0.2 million. This loss represented 3.3% 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. This
position is further supported by the insignificant losses as a percentage of amortized cost for the
respective periods.
During the nine months ended September 30, 2009, net realized gains were $25.2 million
compared to net realized losses of $8.7 million during the nine months ended September 30, 2008.
The nine months ended September 30, 2009 net realized gains were principally due to the mark to
market increase in securities carried at market of approximately $21.1 million and gains on the
sale of certain securities of $5.9 million, partially offset by the losses on the sale of certain
securities. 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 change 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 change 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 nine months ended September 30, 2009, $41.4 million of
the costs were deferred. Deferred policy acquisition costs totaled $26.3 million, or 29.0% of
unearned premiums (net of reinsurance), at September 30, 2009.
Reinsurance
The following table illustrates our direct written premiums and premiums ceded for the nine
months ended September 30, 2009 and 2008:
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Direct written premiums |
$ | 228,619 | $ | 224,720 | ||||
Ceded written premiums |
92,615 | 77,828 | ||||||
Net written premiums |
$ | 136,004 | $ | 146,892 | ||||
Ceded written premiums as percentage of
direct written premiums |
40.5 | % | 34.6 | % | ||||
The following table illustrates the effect of our reinsurance ceded strategies on our results
of operations:
Nine Months Ended | ||||||||
September 30, | ||||||||
2009 | 2008 | |||||||
(Dollars in thousands) | ||||||||
Ceded written premiums |
$ | 92,615 | $ | 77,828 | ||||
Ceded premiums earned |
81,752 | 82,063 | ||||||
Losses and loss adjustment expenses ceded |
59,604 | 46,536 | ||||||
Ceding commissions |
21,897 | 27,470 |
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Our net cash flows relating to ceded reinsurance activities (premiums paid less losses
recovered and ceding commissions received) were approximately $24.9 million net cash paid for the
nine months ended September 30, 2009 compared to net cash paid of $35.9 million for the nine months
ended September 30, 2008.
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 before entering into a contract and monitor the financial strength of
the reinsurer. On September 30, 2009, 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 September 30, 2009, there was no allowance for uncollectible reinsurance, as all
reinsurance balances were current and there were no disputes with reinsurers.
On September 30, 2009 and December 31, 2008, FMFC had a net amount of recoverables from
reinsurers of $223.7 million and $181.2 million, respectively, on a consolidated basis.
Recent Accounting Pronouncements
On July 1, 2009, the FASB issued Topic 105, Generally Accepted Accounting Principles which
establishes the Accounting Standards Codification (ASC) as the single official source of
authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to
guidance issued by the Securities and Exchange Commission (SEC). All other nongrandfathered,
non-SEC accounting literature not included in the ASC is deemed nonauthoritative. The ASC
supersedes all existing, non-SEC accounting and reporting standards applied by nongovernmental
entities in the preparation of financial statements in conformity with generally accepted
accounting principles (GAAP). The ASC is effective for interim and annual reporting periods ending
after September 15, 2009. As the ASC reorganizes GAAP literature but does not change GAAP, the
implementation of the ASC did not have a material impact on the Companys financial statements.
In May 2009, the FASB issued new accounting guidance related to subsequent events. This new
guidance establishes general standards of accounting for and disclosures of events that occur after
the balance sheet date but before the financial statements are issued or are available to be
issued. It provides direction for the period after the balance sheet date during which management
of a reporting entity should evaluate events or transactions that may occur for potential
recognition or disclosure in the financial statements, the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date in its financial
statements and the disclosures that an entity should make about events or transactions that
occurred after the balance sheet date. We adopted the new guidance during the second quarter of
2009, and its application had no impact on our condensed consolidated financial statements. We
evaluate subsequent events through the date the accompanying financial statements were issued,
which was November 9, 2009.
In April 2009, the FASB issued new accounting guidance for the recognition and presentation of
other-than-temporary-impairments on investments. The new guidance modifies the existing
other-than-temporary impairment guidance to require the recognition of an other-than-temporary
impairment when an entity has the intent to sell a debt security or when it is more likely than not
an entity will be required to sell the debt security before its anticipated recovery. Additionally,
the new guidance changes the presentation and amount of other-than-temporary losses recognized in
the income statement for instances when the Company determines that there is a credit loss on a
debt security but it is more likely than not that the entity will not be required to sell the
security prior to the anticipated recovery of its remaining cost basis. For these debt securities,
the amount representing the credit loss will be reported as an impairment loss in the Condensed
Consolidated Statements of Income and the amount related to all other factors will be reported in
accumulated other comprehensive income. It also requires the presentation of other-than-temporary
impairments separately from realized gains and losses on the face of the income statement. In
addition to the changes in measurement and presentation, the new guidance is intended to enhance
the existing disclosure requirements for other-than-temporary impairment and requires all
disclosures related to other-than-temporary impairments in both interim and annual periods. The
adoption of the new guidance in the second quarter of 2009 resulted in a $1.0 million increase in
retained earnings, which was offset by a corresponding decrease in accumulated other comprehensive
income (loss) of the same amount.
In April 2009, the FASB issued new accounting guidance pertaining to the determination of fair
value of assets and liabilities when volume and activity level have significantly decreased and for
transactions that are not orderly. Under the new guidance, if an
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entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in
relation to the normal market activity for the asset or liability (or similar assets or
liabilities), then transactions or quoted prices may not accurately reflect fair value. In
addition, if there is evidence that the transaction for the asset or liability is not orderly; the
entity shall place little, if any weight on that transaction price as an indicator of fair value.
The adoption of this guidance in the second quarter of 2009 did not have a material effect on the
Companys results of operations, financial position, or liquidity.
In April 2009, the FASB issued new accounting guidance that requires disclosures about the
fair value of financial instruments in interim and annual financial statements. The adoption of
this guidance in the second quarter of 2009 is included in Note 11, Fair Value Measurements to
the condensed consolidated financial statements.
During the first quarter of 2009, the Company adopted various accounting standards related to
business combinations, noncontrolling interests in consolidated financial statements, disclosures
about derivative instruments and hedging activities, participating securities and undistributed
earnings and fair value measurements and disclosures. The adoption of the new standards did not
have a material effect on the Companys results of operations, financial position, or liquidity.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Refer to the Companys Annual Report on Form 10-K for the year ended December 31, 2008 for a
complete discussion of the Companys market risk. There have been no material changes to the
market risk information included in the Companys Annual Report on Form 10-K.
Item 4. Controls and Procedures
The Companys 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 Companys 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
Commissions 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 Companys
internal control over financial reporting that occurred during the quarter ended September 30, 2009
that has materially affected or is reasonably likely to materially affect, the Companys internal
control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
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 CoverXs 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 CoverXs and Emeralds 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 these 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.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
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 September 30, 2009, the Company did not repurchase any shares
of common stock under this new share repurchase program. Shares purchased under the program are
retired and returned to the status of authorized but unissued shares.
The Companys prior share repurchase program, announced in August 2008, originally authorized
the repurchase of up to 1.5 million shares of the Companys outstanding common stock. As of August
7, 2009, the Company had repurchased 100 percent, or 1.5 million, of the total shares authorized
for repurchase for approximately $19.0 million.
Maximum Number (or | ||||||||||||||||
Total Number of | Approximate Dollar | |||||||||||||||
Shares (or Units) | Value) of Shares | |||||||||||||||
Purchased as Part | (or Units) that May | |||||||||||||||
Total Number of | Average Price as | of Publicly | Yet Be Purchased | |||||||||||||
Shares (or Units) | Paid per Share (or | Announced Plans or | Under the Plan or | |||||||||||||
Month | Purchased | Unit) | Programs | Programs | ||||||||||||
July |
118,740 | $ | 13.86 | 118,740 | 294,925 | |||||||||||
August |
294,925 | 12.74 | 294,925 | | ||||||||||||
September |
| | | | ||||||||||||
Total |
413,665 | $ | 13.06 | 413,665 | | |||||||||||
= |
Item 6. Exhibits
See Index of Exhibits following the signature page, which is incorporated herein by reference.
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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.
FIRST MERCURY FINANCIAL CORPORATION |
||||
By: | /s/ RICHARD H. SMITH | |||
Richard H. Smith | ||||
Chairman, President and Chief Executive Officer | ||||
By: | /s/ JOHN A. MARAZZA | |||
John A. Marazza | ||||
Executive Vice President and Chief Financial Officer |
Date: November 9, 2009
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INDEX OF EXHIBITS
Exhibit | ||||||
Number | Note | Description | ||||
10.34*
|
(1 | ) | Employment Letter from First Mercury Financial Corporation to Terrance A. Fleckenstein dated June 27, 2008 | |||
31 (a)
|
(1 | ) | Certification of Chief Executive Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 | |||
31 (b)
|
(1 | ) | Certification of Chief Financial Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 | |||
32 (a)
|
(1 | ) | Certification of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act of 1934 | |||
32 (b)
|
(1 | ) | Certification of Chief Financial Officer, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act of 1934 |
(1) | Filed herewith | |
* | Management contract or compensation plan or arrangement. |
50