##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the quarterly period ended June 30, 2007
 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
  Delaware
    
    38-3164336(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)29110 Inkster RoadSuite 100
    
    48034Southfield, Michigan
    
    (Zip Code)(Address of Principal Executive Offices)
  þ o
  o o þ
 o þ




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##### 



TABLE OF CONTENTS
 Item
    
    
    
    PagePART I  FINANCIAL INFORMATION1.
    
    Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets
    
    
    3Condensed Consolidated Statements of Income
    
    
    4Condensed Consolidated Statements of Stockholders Equity
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements (Unaudited)
    
    
    72.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    153.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    314.
    
    Controls and Procedures
    
    
    31PART II  OTHER INFORMATION4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    326.
    
    Exhibits
    
    
    32Certification of Chief Executive OfficerCertification of Chief Financial Officer1350 Certification of Chief Executive Officer1350 Certification of Chief Financial Officer
  2




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 PART I.  FINANCIAL INFORMATION
 
 ITEM 1. Condensed Consolidated Financial Statements
 
 Condensed Consolidated Balance Sheets
 June 30,
    
    
    December 31,2007
    
    
    2006(Unaudited)(Dollars in thousands,except share data)ASSETSInvestmentsDebt securities
    
    $
    327,208
    
    
    $
    260,323Equity securities and other
    
    
    4,135
    
    
    
    3,184Short-term
    
    
    64,511
    
    
    
    34,334Total Investments
    
    
    395,854
    
    
    
    297,841Cash and cash equivalents
    
    
    7,071
    
    
    
    14,335Premiums and reinsurance balances receivable
    
    
    32,751
    
    
    
    46,090Accrued investment income
    
    
    3,831
    
    
    
    2,931Accrued profit sharing commissions
    
    
    9,538
    
    
    
    7,735Reinsurance recoverable on paid and unpaid losses
    
    
    79,495
    
    
    
    69,437Prepaid reinsurance premiums
    
    
    42,770
    
    
    
    10,377Deferred acquisition costs
    
    
    12,489
    
    
    
    18,452Deferred federal income taxes
    
    
    1,869
    
    
    
    Intangible assets, net of accumulated amortization
    
    
    37,264
    
    
    
    37,878Other assets
    
    
    9,663
    
    
    
    7,857Total Assets
    
    $
    632,595
    
    
    $
    512,933LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    235,862
    
    
    $
    191,013Unearned premium reserves
    
    
    116,702
    
    
    
    91,803Long-term debt
    
    
    46,394
    
    
    
    46,394Funds held under reinsurance treaties
    
    
    19,268
    
    
    
    Reinsurance payable on paid losses
    
    
    4,827
    
    
    
    2,877Premiums payable to insurance companies
    
    
    1,782
    
    
    
    728Deferred federal income taxes
    
    
    
    
    
    
    1,642Accounts payable, accrued expenses, and other liabilities
    
    
    3,367
    
    
    
    5,738Total Liabilities
    
    
    428,202
    
    
    
    340,195Stockholders EquityCommon stock, $0.01 par value; authorized 100,000,000 shares; issued
and outstanding 18,036,168 and 17,330,831 shares
    
    
    181
    
    
    
    174Paid-in-capital
    
    
    166,353
    
    
    
    153,600Accumulated other comprehensive loss
    
    
    (2,469
    )
    
    
    (761
    )Retained earnings
    
    
    40,926
    
    
    
    20,323Treasury stock; 92,500 shares
    
    
    (598
    )
    
    
    (598
    )Total Stockholders Equity
    
    
    204,393
    
    
    
    172,738Total Liabilities and Stockholders Equity
    
    $
    632,595
    
    
    $
    512,933
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Income
(Unaudited)
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands, except share and per share data)Operating RevenueNet earned premiums
    
    $
    43,571
    
    
    $
    28,328
    
    
    $
    88,500
    
    
    $
    56,857Commissions and fees
    
    
    4,902
    
    
    
    4,319
    
    
    
    9,559
    
    
    
    8,763Net investment income
    
    
    3,870
    
    
    
    2,121
    
    
    
    7,164
    
    
    
    4,271Net realized gains (losses) on investments
    
    
    627
    
    
    
    (329
    )
    
    
    762
    
    
    
    (482
    )Total Operating Revenues
    
    
    52,970
    
    
    
    34,439
    
    
    
    105,985
    
    
    
    69,409Operating ExpensesLosses and loss adjustment expenses, net
    
    
    22,488
    
    
    
    15,055
    
    
    
    46,442
    
    
    
    29,962Amortization of deferred acquisition expenses
    
    
    7,557
    
    
    
    4,198
    
    
    
    16,296
    
    
    
    9,092Underwriting, agency and other expenses
    
    
    5,613
    
    
    
    3,169
    
    
    
    9,344
    
    
    
    7,379Amortization of intangible assets
    
    
    307
    
    
    
    291
    
    
    
    613
    
    
    
    583Total Operating Expenses
    
    
    35,965
    
    
    
    22,713
    
    
    
    72,695
    
    
    
    47,016Operating Income
    
    
    17,005
    
    
    
    11,726
    
    
    
    33,290
    
    
    
    22,393Interest Expense
    
    
    986
    
    
    
    2,747
    
    
    
    1,968
    
    
    
    5,395Change in Fair Value of Derivative Instruments
    
    
    (127
    )
    
    
    (157
    )
    
    
    (19
    )
    
    
    (386
    )Income Before Income Taxes
    
    
    16,146
    
    
    
    9,136
    
    
    
    31,341
    
    
    
    17,384Income Taxes
    
    
    5,642
    
    
    
    3,170
    
    
    
    10,871
    
    
    
    6,039Net Income
    
    $
    10,504
    
    
    $
    5,966
    
    
    $
    20,470
    
    
    $
    11,345Net Income Per Share:Basic
    
    $
    0.60
    
    
    $
    1.20
    
    
    $
    1.18
    
    
    $
    2.26Diluted
    
    $
    0.58
    
    
    $
    0.48
    
    
    $
    1.12
    
    
    $
    0.92Weighted Average Shares Outstanding:Basic
    
    
    17,428,006
    
    
    
    4,216,144
    
    
    
    17,380,219
    
    
    
    4,216,144Diluted
    
    
    18,254,015
    
    
    
    12,467,938
    
    
    
    18,220,558
    
    
    
    12,324,179
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Stockholders Equity
(Unaudited)
 AccumulatedConvertible
    
    
    
    
    
    
    OtherCommon
    
    
    Preferred
    
    
    Paid-in
    
    
    Comprehensive
    
    
    Retained
    
    
    TreasuryStock
    
    
    Stock
    
    
    Capital
    
    
    Income (Loss)
    
    
    Earnings
    
    
    Stock
    
    
    Total(Dollars in thousands, except share data)Balance, January 1, 2006
    
    $
    42
    
    
    $
    
    
    
    $
    58,857
    
    
    $
    (1,284
    )
    
    $
    6,712
    
    
    $
    
    
    
    $
    64,327Issuance of stock
    
    
    
    
    
    
    
    
    
    
    243
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    243Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,345
    
    
    
    
    
    
    
    11,345Other comprehensive loss, net of taxUnrealized holding losses on securities
arising during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,956
    )
    
    
    
    
    
    
    
    
    
    
    (1,956
    )Less reclassification adjustment for
losses included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    492
    
    
    
    
    
    
    
    
    
    
    
    492Total other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,464
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,881Balance, June 30, 2006
    
    $
    42
    
    
    $
    
    
    
    $
    59,100
    
    
    $
    (2,748
    )
    
    $
    18,057
    
    
    $
    
    
    
    $
    74,451Balance, January 1, 2007
    
    $
    174
    
    
    $
    
    
    
    $
    153,600
    
    
    $
    (761
    )
    
    $
    20,323
    
    
    $
    (598
    )
    
    $
    172,738Common stock issued, net of issuance costs
    
    
    7
    
    
    
    
    
    
    
    12,242
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,249Cumulative effect adjustment upon
adoption of SFAS 155
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (133
    )
    
    
    133
    
    
    
    
    
    
    
    Stock-based compensation expense
    
    
    
    
    
    
    
    
    
    
    511
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    511Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    20,470
    
    
    
    
    
    
    
    20,470Other comprehensive income, net of taxUnrealized holding losses on securities
arising during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,389
    )
    
    
    
    
    
    
    
    
    
    
    (1,389
    )Less reclassification adjustment for
gains included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (416
    )
    
    
    
    
    
    
    
    
    
    
    (416
    )Change in fair value of interest rate swap
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    230
    
    
    
    
    
    
    
    
    
    
    
    230Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,575
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,895Balance, June 30, 2007
    
    $
    181
    
    
    $
    
    
    
    $
    166,353
    
    
    $
    (2,469
    )
    
    $
    40,926
    
    
    $
    (598
    )
    
    $
    204,393
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
(Unaudited)
 Six Months EndedJune 30,2007
    
    
    2006(Dollars in thousands)Cash Flows from Operating ActivitiesNet Income
    
    $
    20,470
    
    
    $
    11,345Adjustments to reconcile net income to net cash provided by
operating activitiesDepreciation and amortization
    
    
    974
    
    
    
    1,218Realized (gains) losses on investments
    
    
    (762
    )
    
    
    482Deferrals of acquisition costs, net
    
    
    5,963
    
    
    
    3,585Deferred income taxes
    
    
    (3,511
    )
    
    
    (2,428
    )Stock-based compensation expense
    
    
    511
    
    
    
    Increase (decrease) in cash resulting from changes in assets
and liabilitiesPremiums and reinsurance balances receivable
    
    
    13,339
    
    
    
    2,068Accrued investment income
    
    
    (900
    )
    
    
    (274
    )Receivable from related entity
    
    
    (50
    )
    
    
    1,814Accrued profit sharing commissions
    
    
    (1,803
    )
    
    
    1,345Reinsurance recoverable on paid and unpaid losses
    
    
    (10,058
    )
    
    
    (22,369
    )Prepaid reinsurance premiums
    
    
    (32,393
    )
    
    
    (13,066
    )Loss and loss adjustment expense reserves
    
    
    44,849
    
    
    
    37,077Unearned premium reserves
    
    
    24,899
    
    
    
    10,892Funds held under reinsurance treaties
    
    
    19,268
    
    
    
    Reinsurance payable on paid losses
    
    
    1,950
    
    
    
    83Premiums payable to insurance companies
    
    
    1,054
    
    
    
    (2,210
    )Other
    
    
    (2,089
    )
    
    
    2,496Net Cash Provided By Operating Activities
    
    
    81,711
    
    
    
    32,058Cash Flows From Investing ActivitiesCost of short-term investments acquired
    
    
    (224,301
    )
    
    
    (99,507
    )Proceeds from disposals of short-term investments
    
    
    194,124
    
    
    
    117,614Cost of debt and equity securities acquired
    
    
    (99,662
    )
    
    
    (84,349
    )Proceeds from debt and equity securities
    
    
    30,733
    
    
    
    51,769Change in receivable from stockholders
    
    
    
    
    
    
    222Acquisition, net of cash acquired
    
    
    
    
    
    
    (6,351
    )Cost of fixed asset purchases
    
    
    (2,118
    )
    
    
    (55
    )Net Cash Used In Investing Activities
    
    
    (101,224
    )
    
    
    (20,657
    )Cash Flows From Financing ActivitiesIssuance of common stock, net of issuance costs
    
    
    12,249
    
    
    
    243Net Cash Provided By Financing Activities
    
    
    12,249
    
    
    
    243Net (Decrease) Increase In Cash and Cash Equivalents
    
    
    (7,264
    )
    
    
    11,644Cash and Cash Equivalents, beginning of period
    
    
    14,335
    
    
    
    8,400Cash and Cash Equivalents, end of period
    
    $
    7,071
    
    
    $
    20,044
  
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 Basis of Presentation
    Use of Estimates
  Recently Issued Accounting Standards
 Fair Value Measurements
 The Fair Value Option for Financial Assets
and Financial Liabilities (SFAS 159),
 7




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Concluded)
 Stock Split
  2. NET INCOME PER SHARE
   Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands,except share and per share data)Net Income
    
    $
    10,504
    
    
    $
    5,966
    
    
    $
    20,470
    
    
    $
    11,345Less: Dividends in arrears
    
    
    
    
    
    
    (921
    )
    
    
    
    
    
    
    (1,815
    )Net income available to common
    
    
    10,504
    
    
    
    5,045
    
    
    
    20,470
    
    
    
    9,530Weighted-average number of common and common equivalent shares outstanding:Basic number of common shares outstanding
    
    
    17,428,006
    
    
    
    4,216,144
    
    
    
    17,380,219
    
    
    
    4,216,144Dilutive effect of stock options
    
    
    823,432
    
    
    
    820,232
    
    
    
    831,270
    
    
    
    820,232Dilutive effect of unvested restricted stock
    
    
    2,577
    
    
    
    
    
    
    
    9,069
    
    
    
    Dilutive effect of convertible preferred stock
    
    
    
    
    
    
    6,434,783
    
    
    
    
    
    
    
    6,434,783Dilutive effect of cumulative dividends on preferred stock
    
    
    
    
    
    
    996,779
    
    
    
    
    
    
    
    853,020Dilutive number of common and common equivalent shares outstanding
    
    
    18,254,015
    
    
    
    12,467,938
    
    
    
    18,220,558
    
    
    
    12,324,179Basic Net Income Per Common Share
    
    $
    0.60
    
    
    $
    1.20
    
    
    $
    1.18
    
    
    $
    2.26Diluted Net Income Per Common Share
    
    $
    0.58
    
    
    $
    0.48
    
    
    $
    1.12
    
    
    $
    0.92Anti-dilutive shares excluded from diluted net income per common share
    
    
    95,292
    
    
    
    
    
    
    
    49,273
    
    
    
    
 3. INCOME TAXES
 Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109 Accounting for Income Taxes.
 8




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 3. INCOME TAXES  (Concluded)
   4. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands)Balance,beginning of period
    
    $
    211,271
    
    
    $
    132,949
    
    
    $
    191,013
    
    
    $
    113,864Less reinsurance recoverables
    
    
    69,126
    
    
    
    31,736
    
    
    
    66,926
    
    
    
    21,869Net Balance,beginning of period
    
    
    142,145
    
    
    
    101,213
    
    
    
    124,087
    
    
    
    91,995Incurred Related ToCurrent year
    
    
    23,225
    
    
    
    14,503
    
    
    
    47,294
    
    
    
    28,904Prior years
    
    
    (737
    )
    
    
    552
    
    
    
    (852
    )
    
    
    1,058Total Incurred
    
    
    22,488
    
    
    
    15,055
    
    
    
    46,442
    
    
    
    29,962Paid Related ToCurrent year
    
    
    977
    
    
    
    687
    
    
    
    1,154
    
    
    
    791Prior years
    
    
    5,179
    
    
    
    6,991
    
    
    
    10,898
    
    
    
    12,576Total Paid
    
    
    6,156
    
    
    
    7,678
    
    
    
    12,052
    
    
    
    13,367Net Balance
    
    
    158,477
    
    
    
    108,590
    
    
    
    158,477
    
    
    
    108,590Plus reinsurance recoverables
    
    
    77,385
    
    
    
    42,350
    
    
    
    77,385
    
    
    
    42,350Balance,end of period
    
    $
    235,862
    
    
    $
    150,940
    
    
    $
    235,862
    
    
    $
    150,940
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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 5. REINSURANCE
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands)Written PremiumsDirect
    
    $
    74,217
    
    
    $
    55,443
    
    
    $
    133,551
    
    
    $
    110,980Assumed
    
    
    3,101
    
    
    
    923
    
    
    
    4,367
    
    
    
    2,262Ceded
    
    
    (33,241
    )
    
    
    (29,537
    )
    
    
    (59,381
    )
    
    
    (59,305
    )Net Written Premiums
    
    $
    44,077
    
    
    $
    26,829
    
    
    $
    78,537
    
    
    $
    53,937Earned PremiumsDirect
    
    $
    56,818
    
    
    $
    51,511
    
    
    $
    110,192
    
    
    $
    100,372Assumed
    
    
    2,751
    
    
    
    850
    
    
    
    3,837
    
    
    
    1,615Ceded
    
    
    (17,410
    )
    
    
    (24,598
    )
    
    
    (28,474
    )
    
    
    (45,876
    )Earned but unbilled premiums
    
    
    1,412
    
    
    
    565
    
    
    
    2,945
    
    
    
    746Net Earned Premiums
    
    $
    43,571
    
    
    $
    28,328
    
    
    $
    88,500
    
    
    $
    56,857
    6. RELATED PARTY TRANSACTIONS
    10




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 7. HYBRID INSTRUMENTS
 Accounting for Certain Hybrid Financial Instruments Accounting for Derivative Instruments and Hedging Activities
  8. STOCK COMPENSATION PLANS
    11




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 8. STOCK COMPENSATION PLANS  (Continued)
  1998 Plan
    
    
    Omnibus PlanNumber of
    
    
    Weighted Average
    
    
    Number of
    
    
    Weighted AverageOptions
    
    
    Exercise Price
    
    
    Options
    
    
    Exercise PriceOutstanding at January 1, 2006
    
    
    1,119,528
    
    
    $
    1.85
    
    
    
    
    
    
    $
    Granted during the period
    
    
    76,312
    
    
    
    6.49
    
    
    
    
    
    
    
    Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercised during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at June 30, 2006
    
    
    1,195,840
    
    
    $
    2.12
    
    
    
    
    
    
    $
    Outstanding at January 1, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    250,000
    
    
    $
    17.00Granted during the period
    
    
    
    
    
    
    
    
    
    
    226,188
    
    
    
    20.74Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercised during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at June 30, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    476,188
    
    
    $
    18.78Exercisable at:June 30, 2006
    
    
    1,119,528
    
    
    $
    1.85
    
    
    
    
    
    
    
    June 30, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    
    
    
    
    
   Options Outstanding
    
    Options ExercisableWeighted-Average
    
    Weighted-Average
    
    
    
    
    
    Weighted-AverageRange of
    
    Outstanding as of June
    
    Remaining
    
    Exercise Price Per
    
    Exercisable as of
    
    Exercise Price PerExercisable Price
    
    30, 2007
    
    Contractual Life
    
    Share
    
    June 30, 2007
    
    Share1998 Plan$1.51 - $2.14
    
    
    810,762
    
    
    3.73
    Years
    
    $
    1.71
    
    
    
    810,762
    
    
    $
    1.71$4.86 - $6.49
    
    
    117,013
    
    
    
    6.52
    
    
    
    5.92
    
    
    
    117,013
    
    
    
    5.92Total
    
    
    927,775
    
    
    
    4.08
    
    
    
    2.24
    
    
    
    927,775
    
    
    
    2.24Omnibus Plan$17.00 - $20.55
    
    
    476,188
    
    
    7.91
    Years
    
    $
    18.78
    
    
    
    
    
    
    $
    Total
    
    
    476,188
    
    
    
    7.91
    
    
    $
    18.78
    
    
    
    
    
    
    $
    
  
 12




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 8. STOCK COMPENSATION PLANS  (Concluded)
  Six Months EndedJune 30,2007
    
    20061998 PlanExpected term
    
    
    
    
    
    
    2.5Expected stock price volatility
    
    
    
    
    
    
    26.51
    %Risk-free interest rate
    
    
    
    
    
    
    4.72
    %Expected dividend yield
    
    
    
    
    
    
    Estimated fair value per option
    
    
    
    
    
    $
    1.39Omnibus PlanExpected term
    
    
    5.0
    
    
    
    Expected stock price volatility
    
    
    26.50
    %
    
    
    Risk-free interest rate
    
    
    4.50
    %
    
    
    Expected dividend yield
    
    
    
    
    
    
    Estimated fair value per option
    
    $
    6.71
    
    
    
    
 Share-Based Payment (SAB 107) Share-Based Payment (SFAS
123(R))
   9. STOCKHOLDERS EQUITY
  10. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
  13




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 June 30,2007
    
    
    2006(Dollars in thousands)Unrealized holding losses on securities, net of tax
    
    
    (2,691
    )
    
    
    (2,748
    )Fair value of interest rate swap, net of tax
    
    
    222
    
    
    
    Total accumulated other comprehensive loss
    
    $
    (2,469
    )
    
    $
    (2,748
    )
 14




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
   Overview
 ®
     15




---



##### Table of Contents



Premiums Produced
  Critical Accounting Policies
   Use of Estimates
  Loss and Loss Adjustment Expense Reserves
   16




---



##### Table of Contents




    
    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.
    June 30,
    
    
    December 31,2007
    
    
    2006(Dollars in thousands)GrossCase reserves
    
    $
    54,509
    
    
    $
    47,004IBNR and ULAE reserves
    
    
    181,353
    
    
    
    144,009Total reserves
    
    $
    235,862
    
    
    $
    191,013Net of reinsuranceCase reserves
    
    $
    42,657
    
    
    $
    37,376IBNR and ULAE reserves
    
    
    115,820
    
    
    
    86,711Total
    
    $
    158,477
    
    
    $
    124,087
 Revenue Recognition
 Premiums
 17




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##### Table of Contents



Commissions and Fees
 Investments
 Accounting for Certain Hybrid Financial Instruments (SFAS 155) Accounting for Derivative Instruments and Hedging
Activities (SFAS 133)
  Deferred Policy Acquisition Costs
  Intangible Assets
 Goodwill and Other Intangible Assets,
 Accounting for the Impairment or Disposal of Long-lived
Assets,
 18




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##### Table of Contents



Results of Operations
 Three Months Ended June 30, 2007 Compared to Three Months Ended June 30, 2006
  Three Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    43,571
    
    
    $
    28,328
    
    
    
    54
    %Commissions and fees
    
    
    4,902
    
    
    
    4,319
    
    
    
    13Net investment income
    
    
    3,870
    
    
    
    2,121
    
    
    
    82Net realized gains (losses) on investments
    
    
    627
    
    
    
    (329
    )
    
    
    291Total Operating Revenues
    
    
    52,970
    
    
    
    34,439
    
    
    
    54Operating ExpensesLosses and loss adjustment expenses, net
    
    
    22,488
    
    
    
    15,055
    
    
    
    49Amortization of intangible assets
    
    
    307
    
    
    
    291
    
    
    
    5Other operating expenses
    
    
    13,170
    
    
    
    7,367
    
    
    
    79Total Operating Expenses
    
    
    35,965
    
    
    
    22,713
    
    
    
    58Operating Income
    
    
    17,005
    
    
    
    11,726
    
    
    
    45Interest Expense
    
    
    859
    
    
    
    2,590
    
    
    
    (67
    )Income Before Income Taxes
    
    
    16,146
    
    
    
    9,136
    
    
    
    77Income Taxes
    
    
    5,642
    
    
    
    3,170
    
    
    
    78Net Income
    
    $
    10,504
    
    
    $
    5,966
    
    
    
    76
    %Loss Ratio
    
    
    51.6
    %
    
    
    53.1
    %
    
    (1.5 points
    )Underwriting Expense Ratio
    
    
    22.4
    %
    
    
    15.6
    %
    
    6.8 pointsCombined Ratio
    
    
    74.0
    %
    
    
    68.7
    %
    
    5.3 points
 Premiums Produced
  19




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Three Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    74,217
    
    
    $
    55,443
    
    
    
    34
    %Assumed
    
    
    3,101
    
    
    
    923
    
    
    
    236Ceded
    
    
    (33,241
    )
    
    
    (29,537
    )
    
    
    13Net written premiums
    
    $
    44,077
    
    
    $
    26,829
    
    
    
    64
    %Earned premiumsDirect
    
    $
    56,818
    
    
    $
    51,511
    
    
    
    10
    %Assumed
    
    
    2,751
    
    
    
    850
    
    
    
    224Ceded
    
    
    (17,410
    )
    
    
    (24,598
    )
    
    
    (29
    )Earned but unbilled premiums
    
    
    1,412
    
    
    
    565
    
    
    
    150Net earned premiums
    
    $
    43,571
    
    
    $
    28,328
    
    
    
    54
    %
     20




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##### Table of Contents



Commissions and Fees
 Three Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    2,063
    
    
    $
    1,613
    
    
    
    28
    %Insurance services commissions and fees
    
    
    2,839
    
    
    
    2,706
    
    
    
    5Total commissions and fees
    
    $
    4,902
    
    
    $
    4,319
    
    
    
    13
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Three Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    7,557
    
    
    $
    4,198
    
    
    
    80
    %Ceded reinsurance commissions
    
    
    (9,840
    )
    
    
    (8,899
    )
    
    
    11Other underwriting and operating expenses
    
    
    15,453
    
    
    
    12,068
    
    
    
    28Other operating expenses
    
    $
    13,170
    
    
    $
    7,367
    
    
    
    79
    %
  21




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##### Table of Contents



Interest Expense
 Three Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Senior notes
    
    $
    
    
    
    $
    1,959
    
    
    
    (100
    )%Junior subordinated debentures
    
    
    859
    
    
    
    304
    
    
    
    183Other
    
    
    
    
    
    
    327
    
    
    
    (100
    )Total interest expense
    
    $
    859
    
    
    $
    2,590
    
    
    
    (67)
    %
  Income taxes
 22




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##### Table of Contents



Six Months Ended June 30, 2007 Compared to Six Months Ended June 30, 2006
  Six Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    88,500
    
    
    $
    56,857
    
    
    
    56
    %Commissions and fees
    
    
    9,559
    
    
    
    8,763
    
    
    
    9Net investment income
    
    
    7,164
    
    
    
    4,271
    
    
    
    68Net realized gains (losses) on investments
    
    
    762
    
    
    
    (482
    )
    
    
    258Total Operating Revenues
    
    
    105,985
    
    
    
    69,409
    
    
    
    53Operating ExpensesLosses and loss adjustment expenses, net
    
    
    46,442
    
    
    
    29,962
    
    
    
    55Amortization of intangible assets
    
    
    613
    
    
    
    583
    
    
    
    5Other operating expenses
    
    
    25,640
    
    
    
    16,471
    
    
    
    56Total Operating Expenses
    
    
    72,695
    
    
    
    47,016
    
    
    
    55Operating Income
    
    
    33,290
    
    
    
    22,393
    
    
    
    49Interest Expense
    
    
    1,949
    
    
    
    5,009
    
    
    
    (61
    )Income Before Income Taxes
    
    
    31,341
    
    
    
    17,384
    
    
    
    80Income Taxes
    
    
    10,871
    
    
    
    6,039
    
    
    
    80Net Income
    
    $
    20,470
    
    
    $
    11,345
    
    
    
    80
    %Loss Ratio
    
    
    52.5
    %
    
    
    52.7
    %
    
    (0.2 points
    )Underwriting Expense Ratio
    
    
    21.4
    %
    
    
    19.1
    %
    
    2.3 pointsCombined Ratio
    
    
    73.9
    %
    
    
    71.8
    %
    
    2.1 points
 Premiums Produced
  23




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Six Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    133,551
    
    
    $
    110,980
    
    
    
    20
    %Assumed
    
    
    4,367
    
    
    
    2,262
    
    
    
    93Ceded
    
    
    (59,381
    )
    
    
    (59,305
    )
    
    
    0Net written premiums
    
    $
    78,537
    
    
    $
    53,937
    
    
    
    46
    %Earned premiumsDirect
    
    $
    110,192
    
    
    $
    100,372
    
    
    
    10
    %Assumed
    
    
    3,837
    
    
    
    1,615
    
    
    
    138Ceded
    
    
    (28,474
    )
    
    
    (45,876
    )
    
    
    (38
    )Earned but unbilled premiums
    
    
    2,945
    
    
    
    746
    
    
    
    295Net earned premiums
    
    $
    88,500
    
    
    $
    56,857
    
    
    
    56
    %
     24




---



##### Table of Contents



Commissions and Fees
 Six Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    3,935
    
    
    $
    3,044
    
    
    
    29
    %Insurance services commissions and fees
    
    
    5,624
    
    
    
    5,719
    
    
    
    (2
    )Total commissions and fees
    
    $
    9,559
    
    
    $
    8,763
    
    
    
    9
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Six Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    16,296
    
    
    $
    9,092
    
    
    
    79
    %Ceded reinsurance commissions
    
    
    (18,098
    )
    
    
    (17,962
    )
    
    
    1Other underwriting and operating expenses
    
    
    27,442
    
    
    
    25,341
    
    
    
    8Other operating expenses
    
    $
    25,640
    
    
    $
    16,471
    
    
    
    56
    %
 25




---



##### Table of Contents



Interest Expense
 Six Months EndedJune 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Senior notes
    
    $
    
    
    
    $
    4,169
    
    
    
    (100
    )%Junior subordinated debentures
    
    
    1,949
    
    
    
    510
    
    
    
    282Other
    
    
    
    
    
    
    330
    
    
    
    (100
    )Total interest expense
    
    $
    1,949
    
    
    $
    5,009
    
    
    
    (61
    )%
  Income taxes
 Liquidity and Capital Resources
 Sources and Uses of Funds
 FMFC
 Insurance Subsidiaries
  Non-insurance Subsidiaries
 26




---



##### Table of Contents



Cash Flows
  Six Months EndedJune 30,2007
    
    
    2006(Dollars in thousands)Cash and cash equivalents provided by (used in):Operating activities
    
    $
    81,711
    
    
    $
    32,058Investing activities
    
    
    (101,224
    )
    
    
    (20,657
    )Financing activities
    
    
    12,249
    
    
    
    243Change in cash and cash equivalents
    
    $
    (7,264
    )
    
    $
    11,644
     Follow-on stock offering
  Long-term debt
 Junior Subordinated Debentures
 27




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##### Table of Contents



Credit Facility
 Derivative Financial Instruments
 Cash and Invested Assets
  June 30, 2007Market Value
    
    
    % of Portfolio(Dollars in thousands)Money Market Funds
    
    $
    64,500
    
    
    
    16.3
    %Treasury Securities
    
    
    8,345
    
    
    
    2.1
    %Agency Securities
    
    
    719
    
    
    
    0.2
    %Corp / Preferred
    
    
    38,542
    
    
    
    9.7
    %Municipal Bonds
    
    
    171,952
    
    
    
    43.4
    %Asset backed Securities
    
    
    42,794
    
    
    
    10.8
    %Mortgages
    
    
    39,263
    
    
    
    9.9
    %Convertible Securities
    
    
    29,728
    
    
    
    7.5
    %Other
    
    
    11
    
    
    
    0.1
    %Total
    
    $
    395,854
    
    
    
    100.0
    %
  % of TotalAverage Life
    
    InvestmentLess than one year
    
    
    26.6
    %One to two years
    
    
    9.5
    %Two to three years
    
    
    12.0
    %Three to four years
    
    
    18.5
    %Four to five years
    
    
    13.9
    %Five to seven years
    
    
    10.3
    %More than seven years
    
    
    9.2
    %Total
    
    
    100.0
    %
 28




---



##### Table of Contents



% of TotalS&P Rating
    
    InvestmentsAAA
    
    
    77.3
    %AA
    
    
    8.1
    %A
    
    
    8.3
    %BBB
    
    
    5.1
    %BB
    
    
    0.9
    %B
    
    
    0.2
    %CCC
    
    
    0.1
    %NR
    
    
    0.0
    %Total
    
    
    100.0
    %
    Deferred Policy Acquisition Costs
   29




---



##### Table of Contents



Reinsurance
  Six Months EndedJune 30,2007
    
    
    2006(Dollars in thousands)Direct written premiums
    
    $
    133,551
    
    
    $
    110,980Ceded written premiums
    
    
    59,381
    
    
    
    59,305Net written premiums
    
    $
    74,170
    
    
    $
    51,675Ceded written premiums as percentage of direct written premiums
    
    
    44.5
    %
    
    
    53.4
    %
  Six Months EndedJune 30,2007
    
    2006(Dollars in thousands)Ceded written premiums
    
    $
    59,381
    
    
    $
    59,305Ceded premiums earned
    
    
    28,474
    
    
    
    45,876Losses and loss adjustment expenses ceded
    
    
    14,282
    
    
    
    23,979Ceding commissions
    
    
    8,365
    
    
    
    14,350
    Recent Accounting Pronouncements
 Fair Value Measurements (SFAS 157)
 30




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##### Table of Contents



The Fair Value Option for Financial Assets
and Financial Liabilities (SFAS 159),
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
  31




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##### Table of Contents



PART II.  OTHER INFORMATION
 
 Item 4. Submission of Matters to a Vote of Security Holders
  (i)
    
    elected to the Board of Directors of First Mercury Financial Corporation seven directors;
and(ii)
    
    ratified the appointment of BDO Seidman, LLP as independent registered public accounting
firm for the Company for the year ending December 31, 2007.
   Director Nominee
    
    Votes For
    
    Votes WithheldSteven A. Shapiro
    
    
    15,878,794
    
    
    
    699,793Jerome M. Shaw
    
    
    11,327,775
    
    
    
    5,250,812Richard H. Smith
    
    
    15,706,013
    
    
    
    872,574Thomas Kearney
    
    
    15,879,094
    
    
    
    699,493William C. Tyler
    
    
    15,879,094
    
    
    
    699,493Louis J. Manetti
    
    
    11,185,175
    
    
    
    5,393,412Hollis W. Rademacher
    
    
    16,315,574
    
    
    
    263,013
  For
    
    Against
    
    AbstainRatification of appointment of BDO Seidman, LLP
    
    
    16,521,237
    
    
    
    53,422
    
    
    
    3,928
 
 Item 6. Exhibits
  32




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##### Table of Contents



SIGNATURES
  FIRST MERCURY FINANCIAL CORPORATIONBy:
    /s/ RICHARD  H. SMITHRichard H. SmithChairman, President and Chief Executive OfficerBy:
    /s/ JOHN A. MARAZZAJohn A. MarazzaExecutive Vice President, Chief Financial Officer and TreasurerDate:
    August 8, 2007 33




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##### Table of Contents



INDEX OF EXHIBITS
 ExhibitNumber
    
    Note
    
    Description31 (a)
    
    
    (1
    )
    
    Certification of Chief Executive Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 193431 (b)
    
    
    (1
    )
    
    Certification of Chief Financial Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 193432 (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 193432 (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 34