##### 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 September 30, 2010
 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 100Southfield, Michigan
    
    48034(Address of Principal Executive Offices)
    
    (Zip Code)
  þ o
 o o
  Large accelerated filer o
Accelerated filer þ
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company o o þ




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##### 



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 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
    
    
    243.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    454.
    
    Controls and Procedures
    
    
    45PART II  OTHER INFORMATION1.
    
    Legal Proceedings
    
    
    461A.
    
    Risk Factors
    
    
    466.
    
    Exhibits
    
    
    47EX-31.AEX-31.BEX-32.AEX-32.B
  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
 September 30,
    
    
    December 31,2010
    
    
    2009(Unaudited)(Dollars in thousands,except share and per share data)ASSETSInvestmentsDebt securities
    
    $
    688,556
    
    
    $
    648,522Equity securities and other
    
    
    42,328
    
    
    
    38,752Short-term
    
    
    40,710
    
    
    
    12,216Total Investments
    
    
    771,594
    
    
    
    699,490Cash and cash equivalents
    
    
    13,771
    
    
    
    14,275Premiums and reinsurance balances receivable
    
    
    48,576
    
    
    
    78,544Accrued investment income
    
    
    6,220
    
    
    
    6,248Accrued profit sharing commissions
    
    
    8,903
    
    
    
    14,661Reinsurance recoverable on paid and unpaid losses
    
    
    216,003
    
    
    
    172,711Prepaid reinsurance premiums
    
    
    63,072
    
    
    
    57,374Deferred acquisition costs
    
    
    24,197
    
    
    
    25,654Intangible assets, net of accumulated amortization
    
    
    35,590
    
    
    
    37,104Goodwill
    
    
    25,483
    
    
    
    25,483Other assets
    
    
    44,421
    
    
    
    26,049Total Assets
    
    $
    1,257,830
    
    
    $
    1,157,593LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    566,886
    
    
    $
    488,444Unearned premium reserves
    
    
    149,491
    
    
    
    146,773Long-term debt
    
    
    67,013
    
    
    
    67,013Line of credit
    
    
    30,000
    
    
    
    4,000Funds held under reinsurance treaties
    
    
    80,409
    
    
    
    71,661Premiums payable to insurance companies
    
    
    29,767
    
    
    
    31,167Reinsurance payable on paid losses
    
    
    1,221
    
    
    
    958Deferred federal income taxes
    
    
    17,821
    
    
    
    13,844Accounts payable, accrued expenses, and other liabilities
    
    
    13,523
    
    
    
    17,649Total Liabilities
    
    
    956,131
    
    
    
    841,509Stockholders EquityCommon stock, $0.01 par value; authorized 100,000,000 shares; issued
and outstanding 17,752,360 and 17,181,106 shares
    
    
    178
    
    
    
    172Paid-in-capital
    
    
    157,535
    
    
    
    154,417Accumulated other comprehensive income
    
    
    28,020
    
    
    
    16,256Retained earnings
    
    
    117,814
    
    
    
    147,087Treasury stock; 134,500 shares
    
    
    (1,848
    )
    
    
    (1,848
    )Total Stockholders Equity
    
    
    301,699
    
    
    
    316,084Total Liabilities and Stockholders Equity
    
    $
    1,257,830
    
    
    $
    1,157,593
  3




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##### Table of Contents



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




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Stockholders Equity
(Unaudited)
 AccumulatedOtherCommon
    
    
    Paid-in
    
    
    Comprehensive
    
    
    Retained
    
    
    TreasuryStock
    
    
    Capital
    
    
    Income (Loss)
    
    
    Earnings
    
    
    Stock
    
    
    Total(Dollars in thousands)Balance, January 1, 2009
    
    $
    178
    
    
    $
    161,957
    
    
    $
    (3,027
    )
    
    $
    103,028
    
    
    $
    (499
    )
    
    $
    261,637Issuance of restricted stock
    
    
    1
    
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercise of stock options
    
    
    1
    
    
    
    8
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9Stock-based compensation expense
    
    
    
    
    
    
    2,288
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,288Stock-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
    
    
    
    
    
    
    
    35,936Cumulative effect of adoption of FASB ASC 320-10 at April 1, 2009
    
    
    
    
    
    
    
    
    
    
    (999
    )
    
    
    999
    
    
    
    
    
    
    
    Other comprehensive income, net of taxUnrealized holding losses on securities arising during the
period having credit losses recognized in the condensed
consolidated statements of income, net of tax of $422
    
    
    
    
    
    
    
    
    
    
    (783
    )
    
    
    
    
    
    
    
    
    
    
    (783
    )Unrealized holding gains on securities arising during the
period having no credit losses recognized in the condensed
consolidated statements of income, net of tax of ($12,377)
    
    
    
    
    
    
    
    
    
    
    22,986
    
    
    
    
    
    
    
    
    
    
    
    22,986Change in fair value of interest rate swaps, net of tax of $268
    
    
    
    
    
    
    
    
    
    
    (498
    )
    
    
    
    
    
    
    
    
    
    
    (498
    )Less reclassification adjustment for gains included in net
income, net of tax of $739
    
    
    
    
    
    
    
    
    
    
    (1,373
    )
    
    
    
    
    
    
    
    
    
    
    (1,373
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    20,332
    
    
    
    
    
    
    
    
    
    
    
    20,332Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    20,332
    
    
    
    35,936
    
    
    
    
    
    
    
    56,268Balance, September 30, 2009
    
    $
    172
    
    
    $
    153,752
    
    
    $
    16,306
    
    
    $
    139,090
    
    
    $
    (1,848
    )
    
    $
    307,472Balance, January 1, 2010
    
    $
    172
    
    
    $
    154,417
    
    
    $
    16,256
    
    
    $
    147,087
    
    
    $
    (1,848
    )
    
    $
    316,084Issuance of restricted stock
    
    
    2
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercise of stock options
    
    
    4
    
    
    
    1,089
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,093Stock-based compensation expense
    
    
    
    
    
    
    2,053
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,053Stock-based compensation excess tax benefits
    
    
    
    
    
    
    (22
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22
    )Payment of shareholder dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36,599
    )
    
    
    
    
    
    
    (36,599
    )Comprehensive income:
    
    
    
    
    
    
    Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,326
    
    
    
    
    
    
    
    7,326Other comprehensive income, net of taxUnrealized holding gains on securities arising during
the period having credit losses recognized in the condensed
consolidated statements of income, net of tax ($378)
    
    
    
    
    
    
    
    
    
    
    702
    
    
    
    
    
    
    
    
    
    
    
    702Unrealized holding gains on securities arising during the
period having no credit losses recognized in the condensed
consolidated statements of income, net of tax ($8,325)
    
    
    
    
    
    
    
    
    
    
    15,460
    
    
    
    
    
    
    
    
    
    
    
    15,460Change in fair value of interest rate swaps, net of tax of
$272
    
    
    
    
    
    
    
    
    
    
    (506
    )
    
    
    
    
    
    
    
    
    
    
    (506
    )Less reclassification adjustment for
gains included in net income, net of tax of $2,095
    
    
    
    
    
    
    
    
    
    
    (3,892
    )
    
    
    
    
    
    
    
    
    
    
    (3,892
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    11,764
    
    
    
    
    
    
    
    
    
    
    
    11,764Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    11,764
    
    
    
    7,326
    
    
    
    
    
    
    
    19,090Balance, September 30, 2010
    
    $
    178
    
    
    $
    157,535
    
    
    $
    28,020
    
    
    $
    117,814
    
    
    $
    (1,848
    )
    
    $
    301,699
  5




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
(Unaudited)
 Nine Months EndedSeptember 30,2010
    
    
    2009(Dollars in thousands)Cash Flows from Operating ActivitiesNet Income
    
    $
    7,326
    
    
    $
    35,936Adjustments
to reconcile income to net cash provided by operating activitiesDepreciation and amortization
    
    
    3,006
    
    
    
    3,051Net investment income on alternative investments
    
    
    (1,880
    )
    
    
    (1,338
    )Realized gains on investments
    
    
    (10,354
    )
    
    
    (25,204
    )Other-than-temporary impairment losses on investments
    
    
    655
    
    
    
    426Deferrals of acquisition costs, net
    
    
    1,457
    
    
    
    1,060Deferred income taxes
    
    
    (2,358
    )
    
    
    5,716Stock-based compensation expense
    
    
    2,053
    
    
    
    2,288Increase
(decrease) in cash resulting from changes in assets and liabilitiesPremiums and reinsurance balances receivable
    
    
    29,968
    
    
    
    3,930Accrued investment income
    
    
    28
    
    
    
    (540
    )Accrued profit sharing commissions
    
    
    5,757
    
    
    
    (2,526
    )Reinsurance recoverable on paid and unpaid losses
    
    
    (43,292
    )
    
    
    (32,185
    )Prepaid reinsurance premiums
    
    
    (5,698
    )
    
    
    (10,863
    )Loss and loss adjustment expense reserves
    
    
    78,442
    
    
    
    75,544Unearned premium reserves
    
    
    2,718
    
    
    
    2,806Funds held under reinsurance treaties
    
    
    8,749
    
    
    
    17,674Reinsurance payable on paid losses
    
    
    263
    
    
    
    12Premiums payable to insurance companies
    
    
    (1,401
    )
    
    
    3,532Other
    
    
    (9,195
    )
    
    
    (14,051
    )Net Cash Provided By Operating Activities
    
    
    66,244
    
    
    
    65,268Cash Flows From Investing ActivitiesCost of short-term investments acquired
    
    
    (209,916
    )
    
    
    (238,579
    )Proceeds from disposals of short-term investments
    
    
    165,849
    
    
    
    259,966Cost of debt and equity securities acquired
    
    
    (179,557
    )
    
    
    (213,818
    )Proceeds from disposals of debt and equity securities
    
    
    166,404
    
    
    
    121,256Net Cash Used In Investing Activities
    
    
    (57,220
    )
    
    
    (71,175
    )Cash Flows From Financing ActivitiesStock issued on stock options exercised
    
    
    1,093
    
    
    
    9Purchase of common stock
    
    
    
    
    
    
    (10,487
    )Payment of shareholder dividends
    
    
    (36,599
    )
    
    
    (873
    )Cash retained on excess tax benefits
    
    
    (22
    )
    
    
    (21
    )Purchase of treasury stock
    
    
    
    
    
    
    (1,349
    )Net borrowings under credit facility
    
    
    26,000
    
    
    
    3,000Net Cash Used In Financing Activities
    
    
    (9,528
    )
    
    
    (9,721
    )Net Decrease In Cash and Cash Equivalents
    
    
    (504
    )
    
    
    (15,628
    )Cash and Cash Equivalents, beginning of period
    
    
    14,275
    
    
    
    31,833Cash and Cash Equivalents, end of period
    
    $
    13,771
    
    
    $
    16,205Supplemental Disclosure of Cash Flow Information:Cash paid during the period for:Interest
    
    $
    4,379
    
    
    $
    4,137Income taxes
    
    $
    10,150
    
    
    $
    8,100
  6




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 Basis of Presentation
   Use of Estimates
  Reclassifications
  Recently Issued Accounting Standards
 Accounting Standards Codification
  7




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Concluded)
 Prospective Accounting Standards
 Financial Services
 Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance
Contracts FASB Accounting Standards Codification Financial Services 
Insurance
   8




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 2. NET INCOME (LOSS) PER SHARE
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2010
    
    
    2009
    
    
    2010
    
    
    2009(Dollars in thousands, except share and per share data)Net income (loss) as reported
    
    $
    (2,031
    )
    
    $
    15,645
    
    
    $
    7,326
    
    
    $
    35,936Net income (loss) allocated to unvested restricted stock shares
    
    
    32
    
    
    
    (141
    )
    
    
    (116
    )
    
    
    (316
    )Net income (loss) available to common
    
    $
    (1,999
    )
    
    $
    15,504
    
    
    $
    7,210
    
    
    $
    35,620Weighted-average number of common and common equivalent shares
outstanding:Basic number of common shares outstanding
    
    
    17,469,803
    
    
    
    17,144,077
    
    
    
    17,343,255
    
    
    
    17,537,754Dilutive effect of stock options
    
    
    
    
    
    
    341,943
    
    
    
    92,289
    
    
    
    339,372Dilutive number of common and common equivalent shares
outstanding
    
    
    17,469,803
    
    
    
    17,486,020
    
    
    
    17,435,544
    
    
    
    17,877,126Net Income (Loss) Per Common Share:Basic
    
    $
    (0.11
    )
    
    $
    0.90
    
    
    $
    0.42
    
    
    $
    2.03Diluted
    
    $
    (0.11
    )
    
    $
    0.89
    
    
    $
    0.41
    
    
    $
    1.99Anti-dilutive shares excluded from diluted net income (loss)
per common share
    
    
    1,072,705
    
    
    
    1,112,688
    
    
    
    1,053,022
    
    
    
    1,112,688
  3. INVESTMENTS
  Gross UnrealizedAmortized Cost
    
    
    Gains
    
    
    Losses
    
    
    Market Value(Dollars in thousands)Debt SecuritiesU.S. government securities
    
    $
    3,675
    
    
    $
    170
    
    
    $
    
    
    
    $
    3,845Government agency mortgage-backed securities
    
    
    106,919
    
    
    
    6,223
    
    
    
    (9
    )
    
    
    113,133Government agency obligations
    
    
    1,009
    
    
    
    33
    
    
    
    
    
    
    
    1,042Collateralized mortgage obligations and other
asset-backed securities
    
    
    117,441
    
    
    
    12,476
    
    
    
    (549
    )
    
    
    129,368Obligations of states and political
subdivisions
    
    
    192,332
    
    
    
    13,299
    
    
    
    (62
    )
    
    
    205,569Corporate bonds
    
    
    152,653
    
    
    
    15,839
    
    
    
    (32
    )
    
    
    168,460Total Debt Securities
    
    
    574,029
    
    
    
    48,040
    
    
    
    (652
    )
    
    
    621,417Preferred stocks
    
    
    1,416
    
    
    
    162
    
    
    
    (129
    )
    
    
    1,449Short-term investments
    
    
    40,710
    
    
    
    
    
    
    
    
    
    
    
    40,710Total
    
    $
    616,155
    
    
    $
    48,202
    
    
    $
    (781
    )
    
    $
    663,576
 9




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 3. INVESTMENTS  (Continued)
  Gross UnrealizedAmortized Cost
    
    
    Gains
    
    
    Losses
    
    
    Market Value(Dollars in thousands)Debt SecuritiesU.S. government securities
    
    $
    4,014
    
    
    $
    110
    
    
    $
    (3
    )
    
    $
    4,121Government agency mortgage-backed securities
    
    
    98,278
    
    
    
    3,820
    
    
    
    (16
    )
    
    
    102,082Government agency obligations
    
    
    986
    
    
    
    30
    
    
    
    
    
    
    
    1,016Collateralized mortgage obligations and other
asset-backed securities
    
    
    120,505
    
    
    
    8,142
    
    
    
    (3,033
    )
    
    
    125,614Obligations of states and political subdivisions
    
    
    198,252
    
    
    
    9,310
    
    
    
    (293
    )
    
    
    207,269Corporate bonds
    
    
    135,549
    
    
    
    10,596
    
    
    
    (505
    )
    
    
    145,640Total Debt Securities
    
    
    557,584
    
    
    
    32,008
    
    
    
    (3,850
    )
    
    
    585,742Preferred stocks
    
    
    1,416
    
    
    
    121
    
    
    
    (131
    )
    
    
    1,406Short-term investments
    
    
    12,216
    
    
    
    
    
    
    
    
    
    
    
    12,216Total
    
    $
    571,216
    
    
    $
    32,129
    
    
    $
    (3,981
    )
    
    $
    599,364
  Amortized Cost
    
    
    Market Value(Dollars in thousands)Due in one year or less
    
    $
    73,841
    
    
    $
    74,750Due after one year through five years
    
    
    151,333
    
    
    
    163,448Due after five years through ten years
    
    
    139,243
    
    
    
    153,282Due after ten years
    
    
    27,378
    
    
    
    29,595391,795
    
    
    
    421,075Government agency mortgage-backed securities
    
    
    106,919
    
    
    
    113,133Collateralized mortgage obligations and
other asset-backed securities
    
    
    117,441
    
    
    
    129,368Total
    
    $
    616,155
    
    
    $
    663,576
  Alternative Investments
  10




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 3. INVESTMENTS  (Concluded)
  4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES
 Impairment of Investment Securities
     11




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES  (Continued)
  Additions forJanuary 1, 2010
    
    Additions for OTTI
    
    OTTI Securities
    
    Reductions Due to
    
    Adjustments to
    
    September 30,Cumulative OTTI
    
    Securities Where
    
    Where Credit
    
    Sales or
    
    Book Value of
    
    2010 CumulativeCredit Losses
    
    No Credit Losses
    
    Losses Have Been
    
    Intend/Required to
    
    Credit-Impaired
    
    OTTI Credit LossesRecognized for
    
    Were Recognized
    
    Recognized Prior
    
    Sell of Credit-
    
    Securities due to
    
    Recognized forSecurities Still
    
    Prior to
    
    to
    
    Impaired
    
    Changes in Cash
    
    Securities StillHeld
    
    Janaury 1, 2010
    
    January 1, 2010
    
    Securities
    
    Flows
    
    Held(Dollars in thousands)Debt securities:Mortgage-backed securities,
collateralized mortgage
obligations and passthrough
securities
    
    $
    796
    
    
    $
    
    
    
    $
    545
    
    
    $
    
    
    
    $
    
    
    
    $
    1,341All other corporate bonds
    
    
    569
    
    
    
    110
    
    
    
    
    
    
    
    (110
    )
    
    
    
    
    
    
    569Total debt securities
    
    $
    1,365
    
    
    $
    110
    
    
    $
    545
    
    
    $
    (110
    )
    
    $
    
    
    
    $
    1,910
   Less than 12 Months
    
    
    Greater than 12 MonthsFair Value
    
    
    
    
    
    
    Fair Valueof
    
    
    
    
    
    
    ofInvestments
    
    
    
    
    
    
    InvestmentsWith
    
    
    Gross
    
    
    With
    
    
    GrossUnrealized
    
    
    Unrealized
    
    
    Unrealized
    
    
    UnrealizedLosses
    
    
    Losses
    
    
    Losses
    
    
    Losses(Dollars in thousands)Debt SecuritiesU.S. government securities
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Government agency mortgage-backed securities
    
    
    3,052
    
    
    
    (9
    )
    
    
    
    
    
    
    Government agency obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Collateralized mortgage obligations and other
asset-backed securities
    
    
    8,548
    
    
    
    (105
    )
    
    
    6,219
    
    
    
    (444
    )Obligations of states and political
subdivisions
    
    
    
    
    
    
    
    
    
    
    1,216
    
    
    
    (62
    )Corporate bonds
    
    
    1,672
    
    
    
    (30
    )
    
    
    955
    
    
    
    (2
    )Total Debt Securities
    
    
    13,272
    
    
    
    (144
    )
    
    
    8,390
    
    
    
    (508
    )Preferred Stocks
    
    
    
    
    
    
    
    
    
    
    377
    
    
    
    (129
    )Total
    
    $
    13,272
    
    
    $
    (144
    )
    
    $
    8,767
    
    
    $
    (637
    )
 12




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES  (Continued)
  Less than 12 Months
    
    
    Greater than 12 MonthsFair Value
    
    
    
    
    
    
    Fair Valueof
    
    
    
    
    
    
    ofInvestments
    
    
    
    
    
    
    InvestmentsWith
    
    
    Gross
    
    
    With
    
    
    GrossUnrealized
    
    
    Unrealized
    
    
    Unrealized
    
    
    UnrealizedLosses
    
    
    Losses
    
    
    Losses
    
    
    Losses(Dollars in thousands)Debt SecuritiesU.S. government securities
    
    $
    359
    
    
    $
    (3
    )
    
    $
    
    
    
    $
    Government agency
mortgage-backed securities
    
    
    3,854
    
    
    
    (16
    )
    
    
    
    
    
    
    Government agency obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Collateralized mortgage
obligations and other
asset-backed securities
    
    
    8,438
    
    
    
    (1,291
    )
    
    
    9,635
    
    
    
    (1,742
    )Obligations of states and
political subdivisions
    
    
    14,044
    
    
    
    (237
    )
    
    
    1,179
    
    
    
    (56
    )Corporate bonds
    
    
    4,551
    
    
    
    (404
    )
    
    
    5,563
    
    
    
    (101
    )Total Debt Securities
    
    
    31,246
    
    
    
    (1,951
    )
    
    
    16,377
    
    
    
    (1,899
    )Preferred Stocks
    
    
    
    
    
    
    
    
    
    
    375
    
    
    
    (131
    )Total
    
    $
    31,246
    
    
    $
    (1,951
    )
    
    $
    16,752
    
    
    $
    (2,030
    )
  13




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES  (Continued)
 UnrealizedLoss atSeptember 30,Sector
    
    2010(Dollars in thousands)Debt SecuritiesU.S. Treasuries
    
    $
    U.S. Agencies
    
    
    U.S. government securities
    
    
    Government agency mortgage-backed securities
    
    
    (9
    )Government agency obligations
    
    
    MBS Passthroughs
    
    
    (4
    )CMOs
    
    
    (198
    )Asset Backed Securities
    
    
    (210
    )Commercial MBS
    
    
    (137
    )Collateralized mortgage
obligations and other
asset-backed securities
    
    
    (549
    )Obligations of states and
political subdivisions
    
    
    (62
    )Corporate Bonds
    
    
    (3
    )High Yield Bonds
    
    
    (29
    )Corporate Bonds
    
    
    (32
    )Total Debt Securities
    
    
    (652
    )Preferred Stocks
    
    
    (129
    )Short-term investments
    
    
    Total
    
    $
    (781
    )
    14




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 4. OTHER THAN TEMPORARY IMPAIRMENTS OF INVESTMENT SECURITIES  (Concluded)
 % of Total
    
    
    Total
    
    
    Total
    
    
    Average Unrealized Loss
    
    
    % of LossAmortized Cost
    
    
    Amortized Cost
    
    
    Unrealized Losses
    
    
    as % of Amortized Cost
    
    
    > 12 Months(Dollars in thousands)Non Investment Grade
    
    
    34.7
    %
    
    $
    7,929
    
    
    $
    384
    
    
    
    4.8
    %
    
    
    88.2
    %Investment Grade
    
    
    65.3
    
    
    
    14,891
    
    
    
    397
    
    
    
    2.7
    
    
    
    75.1Total
    
    
    100.0
    %
    
    $
    22,820
    
    
    $
    781
    
    
    
    3.4
    %
    
    
    81.6
    %
    5. FAIR VALUE MEASUREMENTS
   
    
    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.
 15




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 5. FAIR VALUE MEASUREMENTS  (Continued)
 
    
    Level 2   Valuations based on observable inputs (other than Level 1 prices), such as
quoted prices for similar assets at the measurement date; quoted prices in markets that are not
active; or other inputs that are observable, either directly or indirectly. The
fair value of fixed maturity and equity securities and short-term investments included in the Level
2 category were based on the market values obtained from an independent pricing service that were
evaluated using pricing models that vary by asset class and incorporate available trade, bid and
other market information and price quotes from well established independent broker-dealers. The
independent pricing service monitors market indicators, industry and economic events, and for
broker-quoted only securities, obtains
quotes from market makers or broker-dealers that it recognizes to be market participants. The
Level 2 category includes corporate bonds, municipal bonds, redeemable preferred stocks and certain
publicly traded common stocks with no trades on the measurement date.
    
    Level 3  Valuations based on inputs that are unobservable and significant to the overall
fair value measurement, and involve management judgment.
   Fair Value Measurements UsingTotal
    
    
    Level 1
    
    
    Level 2
    
    
    Level 3(Dollars in thousands)Available for sale
investments:Fixed maturity securities
    
    $
    622,866
    
    
    $
    3,845
    
    
    $
    619,021
    
    
    $
    Equity securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Short-term investments
    
    
    40,710
    
    
    
    40,710
    
    
    
    
    
    
    
    Hybrid securities
    
    
    73,351
    
    
    
    
    
    
    
    73,351
    
    
    
    Alternative investments
    
    
    34,667
    
    
    
    
    
    
    
    14,207
    
    
    
    20,460Total
    
    $
    771,594
    
    
    $
    44,555
    
    
    $
    706,579
    
    
    $
    20,460
  Fair Value Measurements UsingTotal
    
    
    Level 1
    
    
    Level 2
    
    
    Level 3(Dollars in thousands)Available for sale
investments:Fixed maturity securities
    
    $
    587,148
    
    
    $
    4,121
    
    
    $
    583,027
    
    
    $
    Equity securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Short-term investments
    
    
    12,216
    
    
    
    12,216
    
    
    
    
    
    
    
    Hybrid securities
    
    
    69,525
    
    
    
    
    
    
    
    69,525
    
    
    
    Alternative investments
    
    
    30,601
    
    
    
    
    
    
    
    12,427
    
    
    
    18,174Total
    
    $
    699,490
    
    
    $
    16,337
    
    
    $
    664,979
    
    
    $
    18,174
   16




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 5. FAIR VALUE MEASUREMENTS  (Concluded)
  Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2010
    
    
    September 30, 2010Level 3 investments, beginning of period
    
    $
    19,402
    
    
    $
    18,174Purchases
    
    
    
    
    
    
    Transfers to Level 2
    
    
    
    
    
    
    Transfers to Level 3
    
    
    
    
    
    
    Change in market value
    
    
    1,058
    
    
    
    2,286Level 3 investments as of September 30, 2010
    
    $
    20,460
    
    
    $
    20,460
   6. INCOME TAXES
    17




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 7. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2010
    
    
    2009
    
    
    2010
    
    
    2009(Dollars in thousands)Balance,beginning of period
    
    $
    527,042
    
    
    $
    426,908
    
    
    $
    488,444
    
    
    $
    372,721Less reinsurance recoverables
    
    
    182,616
    
    
    
    146,157
    
    
    
    164,488
    
    
    
    128,552Net Balance,beginning of period
    
    
    344,426
    
    
    
    280,751
    
    
    
    323,956
    
    
    
    244,169Incurred Related ToCurrent year
    
    
    31,175
    
    
    
    31,645
    
    
    
    96,758
    
    
    
    101,972Prior years
    
    
    11,356
    
    
    
    (1,300
    )
    
    
    11,356
    
    
    
    (5,671
    )Total Incurred
    
    
    42,531
    
    
    
    30,345
    
    
    
    108,114
    
    
    
    96,301Paid Related ToCurrent year
    
    
    797
    
    
    
    6,461
    
    
    
    5,024
    
    
    
    10,900Prior years
    
    
    24,099
    
    
    
    13,266
    
    
    
    64,985
    
    
    
    38,201Total Paid
    
    
    24,896
    
    
    
    19,727
    
    
    
    70,009
    
    
    
    49,101Net Balance
    
    
    362,061
    
    
    
    291,369
    
    
    
    362,061
    
    
    
    291,369Plus reinsurance recoverables
    
    
    204,825
    
    
    
    156,896
    
    
    
    204,825
    
    
    
    156,896Balance,end of period
    
    $
    566,886
    
    
    $
    448,265
    
    
    $
    566,886
    
    
    $
    448,265
 8. REINSURANCE
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2010
    
    
    2009
    
    
    2010
    
    
    2009(Dollars in thousands)Written PremiumsDirect
    
    $
    80,936
    
    
    $
    77,607
    
    
    $
    236,132
    
    
    $
    228,619Assumed
    
    
    2,913
    
    
    
    4,201
    
    
    
    15,584
    
    
    
    13,588Ceded
    
    
    (40,075
    )
    
    
    (35,483
    )
    
    
    (101,858
    )
    
    
    (92,615
    )Net Written Premiums
    
    $
    43,774
    
    
    $
    46,325
    
    
    $
    149,858
    
    
    $
    149,592Earned PremiumsDirect
    
    $
    79,092
    
    
    $
    77,907
    
    
    $
    231,936
    
    
    $
    226,125Assumed
    
    
    4,536
    
    
    
    4,529
    
    
    
    17,062
    
    
    
    13,276Ceded
    
    
    (33,934
    )
    
    
    (29,907
    )
    
    
    (96,160
    )
    
    
    (81,752
    )Earned but unbilled premiums
    
    
    (458
    )
    
    
    (1,017
    )
    
    
    (425
    )
    
    
    (2,110
    )Net Earned Premiums
    
    $
    49,236
    
    
    $
    51,512
    
    
    $
    152,413
    
    
    $
    155,539
   18




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 8. REINSURANCE  (Concluded)
   9. SHARE REPURCHASE PROGRAM
  10. SPECIAL DIVIDEND
  11. STOCK COMPENSATION PLANS
      19




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 11. STOCK COMPENSATION PLANS  (Continued)
 1998 Plan
    
    
    Omnibus PlanNumber of
    
    
    Weighted Average
    
    
    Number of
    
    
    Weighted AverageOptions
    
    
    Exercise Price
    
    
    Options
    
    
    Exercise PriceOustanding at January 1, 2009
    
    
    431,050
    
    
    $
    2.82
    
    
    
    932,188
    
    
    $
    17.93Granted during the period
    
    
    
    
    
    
    
    
    
    
    222,500
    
    
    
    13.04Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    (42,000
    )
    
    
    16.71Exercised during the period
    
    
    (5,088
    )
    
    
    1.62
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at September 30,
2009
    
    
    425,962
    
    
    $
    2.83
    
    
    
    1,112,688
    
    
    $
    17.00Oustanding at January 1, 2010
    
    
    419,762
    
    
    $
    2.83
    
    
    
    1,112,688
    
    
    $
    17.00Granted during the period
    
    
    
    
    
    
    
    
    
    
    140,500
    
    
    
    13.35Forfeited during the period
    
    
    (27,562
    )
    
    
    2.04
    
    
    
    (196,333
    )
    
    
    16.89Exercised during the period
    
    
    (371,850
    )
    
    
    2.78
    
    
    
    (4,500
    )
    
    
    13.01Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at September 30,
2010
    
    
    20,350
    
    
    $
    4.86
    
    
    
    1,052,355
    
    
    $
    16.55Exercisable at:September 30, 2009
    
    
    425,962
    
    
    $
    2.83
    
    
    
    447,793
    
    
    $
    18.27September 30, 2010
    
    
    20,350
    
    
    
    4.86
    
    
    
    708,467
    
    
    
    17.69
    Options Outstanding
    
    Options ExercisableWeighted-Average
    
    Weighted-Average
    
    
    
    
    
    Weighted-AverageRange of
    
    Outstanding as of
    
    Remaining
    
    Exercise Price Per
    
    Exercisable as of
    
    Exercise Price PerExercisable Price
    
    September 30, 2010
    
    Contractual Life
    
    Share
    
    September 30, 2010
    
    Share1998 Plan$4.86 - $6.49
    
    
    20,350
    
    
    4.14 Years
    
    $
    4.86
    
    
    
    20,350
    
    
    $
    4.86Omnibus Plan$10.98 - $14.93
    
    
    430,000
    
    
    8.49 Years
    
    $
    13.74
    
    
    
    143,166
    
    
    $
    14.23$17.00 - $20.75
    
    
    622,355
    
    
    5.44
    
    
    
    
    18.49
    
    
    
    565,301
    
    
    
    18.56Total
    
    
    1,052,355
    
    

    6.69
    
    
    
    
    16.55
    
    
    
    708,467
    
    
    
    17.69
 20




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 11. STOCK COMPENSATION PLANS  (Concluded)
  Number ofRestricted SharesOutstanding at January 1, 2009
    
    
    62,166Shares granted
    
    
    138,204Shares vested
    
    
    (41,571
    )Shares forfeited
    
    
    (3,300
    )Outstanding at September 30, 2009
    
    
    155,499Outstanding at January 1, 2010
    
    
    155,499Shares granted
    
    
    237,400Shares vested
    
    
    (73,068
    )Shares forfeited
    
    
    (41,836
    )Outstanding at September 30, 2010
    
    
    277,995
  Nine Months EndedSeptember 30,2010
    
    2009Omnibus PlanExpected term
    
    6 years
    
    6 yearsExpected stock price volatility
    
    
    43.20
    %
    
    
    41.64
    %Risk-free interest rate
    
    
    3.04
    %
    
    
    2.22
    %Expected dividend yield
    
    
    0.75
    %
    
    
    0.08
    %Estimated fair value per option
    
    $
    5.67
    
    
    $
    5.57
    21




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 12. ACCUMULATED OTHER COMPREHENSIVE INCOME
  September 30,2010
    
    
    2009(Dollars in thousands)Unrealized holding losses on securities having
credit losses recognized in the condensed consolidated
statements of income, net of tax
    
    $
    (438
    )
    
    $
    (1,782
    )Unrealized holding gains on securities having no
credit losses recognized in the condensed consolidated
statements of income, net of tax
    
    
    30,749
    
    
    
    20,163Fair value of interest rate swaps, net of tax
    
    
    (2,291
    )
    
    
    (2,075
    )Total accumulated other comprehensive income
    
    $
    28,020
    
    
    $
    16,306
 13. INSURANCE REGULATION
  14. RESTRUCTURING
  15. CREDIT AGREEMENT
  16. SUBSEQUENT EVENTS
  22




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 16. SUBSEQUENT EVENTS  (Concluded)
    23




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
   Overview
 ®
    24




---



##### Table of Contents



Recent Developments
   GAAP and Non-GAAP Financial Performance Metrics
   Gross written premiums.
 Net written premiums.
 Combined ratio.
 Critical Accounting Policies
  25




---



##### Table of Contents



Use of Estimates
  Loss and Loss Adjustment Expense Reserves
    
    
    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.
   26




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##### Table of Contents



September 30,
    
    
    December 31,2010
    
    
    2009(Dollars in thousands)GrossCase reserves
    
    $
    168,776
    
    
    $
    125,561IBNR and ULAE reserves
    
    
    398,110
    
    
    
    362,883Total reserves
    
    $
    566,886
    
    
    $
    488,444Net of reinsuranceCase reserves
    
    $
    112,783
    
    
    $
    83,911IBNR and ULAE reserves
    
    
    249,278
    
    
    
    240,045Total
    
    $
    362,061
    
    
    $
    323,956
 Revenue Recognition
 Premiums
  Commissions and Fees
 Investments
   27




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##### Table of Contents




    
    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.
    Impairment of Investment Securities
  28




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##### Table of Contents



Deferred Policy Acquisition Costs
  Goodwill and Intangible Assets
    29




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##### Table of Contents



Results of Operations
 Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009
  Three Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    49,236
    
    
    $
    51,512
    
    
    
    (4
    )%Commissions and fees
    
    
    40
    
    
    
    7,445
    
    
    
    (99
    )Net investment income
    
    
    8,349
    
    
    
    7,540
    
    
    
    11Net realized gains on investments
    
    
    7,671
    
    
    
    13,766
    
    
    
    (44
    )Other-than-temporary impairment losses
on investments
    
    
    (111
    )
    
    
    (292
    )
    
    
    (62
    )Total Operating Revenues
    
    
    65,185
    
    
    
    79,971
    
    
    
    (18
    )Operating ExpensesLosses and loss adjustment expenses, net
    
    
    42,531
    
    
    
    30,345
    
    
    
    40Amortization of intangible assets
    
    
    482
    
    
    
    559
    
    
    
    (14
    )Other operating expenses
    
    
    24,484
    
    
    
    24,129
    
    
    
    1Total Operating Expenses
    
    
    67,497
    
    
    
    55,033
    
    
    
    23Operating Income (Loss)
    
    
    (2,312
    )
    
    
    24,938
    
    
    
    (109
    )Interest Expense
    
    
    1,554
    
    
    
    1,275
    
    
    
    22Income (Loss) Before Income Taxes
    
    
    (3,866
    )
    
    
    23,663
    
    
    
    (116
    )Provision for (Benefit from) Income Taxes
    
    
    (1,835
    )
    
    
    8,018
    
    
    
    (123
    )Net Income (Loss)
    
    $
    (2,031
    )
    
    $
    15,645
    
    
    
    (113
    )%Loss Ratio
    
    
    86.4
    %
    
    
    58.9
    %
    
    27.5 pointsUnderwriting Expense Ratio
    
    
    50.8
    %
    
    
    33.6
    %
    
    17.2 pointsCombined Ratio
    
    
    137.2
    %
    
    
    92.5
    %
    
    44.7 points
 30




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Three Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    80,936
    
    
    $
    77,607
    
    
    
    4
    %Assumed
    
    
    2,913
    
    
    
    4,201
    
    
    
    (31
    )Ceded
    
    
    (40,075
    )
    
    
    (35,483
    )
    
    
    13Net written premiums
    
    $
    43,774
    
    
    $
    46,325
    
    
    
    (6
    )%Earned premiumsDirect
    
    $
    79,092
    
    
    $
    77,907
    
    
    
    2
    %Assumed
    
    
    4,536
    
    
    
    4,529
    
    
    
    Ceded
    
    
    (33,934
    )
    
    
    (29,907
    )
    
    
    13Earned but unbilled
premiums
    
    
    (458
    )
    
    
    (1,017
    )
    
    
    (55
    )Net earned premiums
    
    $
    49,236
    
    
    $
    51,512
    
    
    
    (4
    )%
     31




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##### Table of Contents



Commissions and Fees
 Three Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and
fees
    
    $
    (5,861
    )
    
    $
    1,272
    
    
    
    (561
    )%Insurance services commissions and fees
    
    
    5,901
    
    
    
    6,173
    
    
    
    (4
    )Total commissions and fees
    
    $
    40
    
    
    $
    7,445
    
    
    
    (99
    )%
  Net Investment Income and Realized Gains on Investments
  Other-Than-Temporary Impairment Losses on Investments.
 Operating Expenses
 Losses and Loss Adjustment Expenses
 32




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##### Table of Contents



Other Operating Expenses
 Three Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition
expenses
    
    $
    13,269
    
    
    $
    13,960
    
    
    
    (5
    )%Other underwriting and operating expenses
    
    
    11,215
    
    
    
    10,169
    
    
    
    10Other operating expenses
    
    $
    24,484
    
    
    $
    24,129
    
    
    
    1
    %
  Interest Expense
 Income Taxes
 33




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##### Table of Contents



Results of Operations
 Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009
  Nine Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    152,413
    
    
    $
    155,539
    
    
    
    (2
    )%Commissions and fees
    
    
    15,699
    
    
    
    23,916
    
    
    
    (34
    )Net investment income
    
    
    25,434
    
    
    
    21,105
    
    
    
    21Net realized gains on investments
    
    
    10,354
    
    
    
    25,204
    
    
    
    (59
    )Other-than-temporary impairment losses
on investments
    
    
    (655
    )
    
    
    (426
    )
    
    
    54Total Operating Revenues
    
    
    203,245
    
    
    
    225,338
    
    
    
    (10
    )Operating ExpensesLosses and loss adjustment expenses, net
    
    
    108,114
    
    
    
    96,301
    
    
    
    12Amortization of intangible assets
    
    
    1,515
    
    
    
    1,709
    
    
    
    (11
    )Other operating expenses
    
    
    75,095
    
    
    
    69,808
    
    
    
    8Restructuring
    
    
    5,018
    
    
    
    
    
    
    
    100Total Operating Expenses
    
    
    189,742
    
    
    
    167,818
    
    
    
    13Operating Income
    
    
    13,503
    
    
    
    57,520
    
    
    
    (77
    )Interest Expense
    
    
    4,483
    
    
    
    3,877
    
    
    
    16Income Before Income Taxes
    
    
    9,020
    
    
    
    53,643
    
    
    
    (83
    )Income Taxes
    
    
    1,694
    
    
    
    17,707
    
    
    
    (90
    )Net Income
    
    $
    7,326
    
    
    $
    35,936
    
    
    
    (80
    )%Loss Ratio
    
    
    70.9
    %
    
    
    61.9
    %
    
    9.0 pointsUnderwriting Expense Ratio
    
    
    43.0
    %
    
    
    31.6
    %
    
    11.4 pointsCombined Ratio
    
    
    113.9
    %
    
    
    93.5
    %
    
    20.4 points
 34




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Nine Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    236,132
    
    
    $
    228,619
    
    
    
    3
    %Assumed
    
    
    15,584
    
    
    
    13,588
    
    
    
    15Ceded
    
    
    (101,858
    )
    
    
    (92,615
    )
    
    
    10Net written premiums
    
    $
    149,858
    
    
    $
    149,592
    
    
    
    
    %Earned premiumsDirect
    
    $
    231,936
    
    
    $
    226,125
    
    
    
    3
    %Assumed
    
    
    17,062
    
    
    
    13,276
    
    
    
    29Ceded
    
    
    (96,160
    )
    
    
    (81,752
    )
    
    
    18Earned but unbilled premiums
    
    
    (425
    )
    
    
    (2,110
    )
    
    
    (80
    )Net earned premiums
    
    $
    152,413
    
    
    $
    155,539
    
    
    
    (2
    )%
     35




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##### Table of Contents



Commissions and Fees
 Nine Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    (3,072
    )
    
    $
    3,989
    
    
    
    (177
    )%Insurance services commissions and fees
    
    
    18,771
    
    
    
    19,927
    
    
    
    (6
    )Total commissions and fees
    
    $
    15,699
    
    
    $
    23,916
    
    
    
    (34
    )%
  Net Investment Income and Realized Gains on Investments
  Other-Than-Temporary Impairment Losses on Investments.
 Operating Expenses
 Losses and Loss Adjustment Expenses
 36




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##### Table of Contents



Other Operating Expenses
 Nine Months EndedSeptember 30,2010
    
    
    2009
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    40,024
    
    
    $
    40,889
    
    
    
    (2
    )%Other underwriting and operating expenses
    
    
    35,071
    
    
    
    28,919
    
    
    
    21Other operating expenses
    
    $
    75,095
    
    
    $
    69,808
    
    
    
    8
    %
  Restructuring .
 Interest Expense
 Income Taxes
 Liquidity and Capital Resources
 Sources and Uses of Funds
 FMFC
 Insurance Subsidiaries
  37




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##### Table of Contents



Non-insurance Subsidiaries
 Cash Flows
  Nine Months EndedSeptember 30,2010
    
    
    2009(Dollars in thousands)Cash and cash equivalents provided by (used in):Operating activities
    
    $
    66,244
    
    
    $
    65,268Investing activities
    
    
    (57,220
    )
    
    
    (71,175
    )Financing activities
    
    
    (9,528
    )
    
    
    (9,721
    )Change in cash and cash equivalents
    
    $
    (504
    )
    
    $
    (15,628
    )
     Stockholders Equity
  38




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##### Table of Contents



September 30,
    
    
    December 31,2010
    
    
    2009(Dollars in thousands, except share and per sharedata)Total stockholders equity
    
    $
    301,699
    
    
    $
    316,084Intangible assets, net
    
    
    (35,590
    )
    
    
    (37,104
    )Deferred tax liability  intangible assets, net
    
    
    12,083
    
    
    
    12,613Goodwill
    
    
    (25,483
    )
    
    
    (25,483
    )Tangible stockholders equity attributable to common shareholders
    
    $
    252,709
    
    
    $
    266,110Common shares outstanding
    
    
    17,752,360
    
    
    
    17,181,106Book value per share
    
    $
    16.99
    
    
    $
    18.40Tangible book value per share
    
    $
    14.24
    
    
    $
    15.49
  Long-term debt
 Junior Subordinated Debentures
 Credit Agreement
 Derivative Financial Instruments
 39




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##### Table of Contents



Cash and Invested Assets
  Market Value
    
    
    % of Portfolio(Dollars in thousands)Short Term Investments
    
    $
    40,710
    
    
    
    5.3
    %U.S. Treasuries
    
    
    3,845
    
    
    
    0.5
    %U.S. Agencies
    
    
    1,042
    
    
    
    0.1
    %Municipal Bonds
    
    
    195,590
    
    
    
    25.3
    %Taxable Municipal Bonds
    
    
    9,979
    
    
    
    1.3
    %Corporate Bonds
    
    
    135,988
    
    
    
    17.6
    %High Yield Bonds
    
    
    32,472
    
    
    
    4.2
    %MBS Passthroughs
    
    
    52,235
    
    
    
    6.8
    %CMOs
    
    
    100,232
    
    
    
    13.0
    %Asset Backed Securities
    
    
    28,168
    
    
    
    3.7
    %Commercial MBS
    
    
    61,865
    
    
    
    8.0
    %Convertible Securities
    
    
    73,352
    
    
    
    9.5
    %High Yield Convertible Fund
    
    
    20,460
    
    
    
    2.7
    %Structured Finance Fund
    
    
    14,207
    
    
    
    1.8
    %Preferred Stocks
    
    
    1,449
    
    
    
    0.2
    %Total
    
    $
    771,594
    
    
    
    100.0
    %
  % of TotalAverage Life
    
    InvestmentLess than one year
    
    
    20.6
    %One to two years
    
    
    16.1
    %Two to three years
    
    
    10.9
    %Three to four years
    
    
    16.5
    %Four to five years
    
    
    8.3
    %Five to seven years
    
    
    10.9
    %More than seven years
    
    
    16.7
    %Total
    
    
    100.0
    %
   40




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##### Table of Contents



% of TotalS&P Rating
    
    InvestmentsAAA
    
    
    45.5
    %AA
    
    
    13.5
    %A
    
    
    13.7
    %BBB
    
    
    10.9
    %BB
    
    
    7.9
    %B
    
    
    2.3
    %CCC
    
    
    5.8
    %CC
    
    
    0.3
    %D
    
    
    0.1
    %Total
    
    
    100.0
    %
      41




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##### Table of Contents



Deferred Policy Acquisition Costs
  Reinsurance
  Nine Months EndedSeptember 30,2010
    
    
    2009(Dollars in thousands)Direct written premiums
    
    $
    236,132
    
    
    $
    228,619Ceded written premiums
    
    
    101,858
    
    
    
    92,615Net written premiums
    
    $
    134,274
    
    
    $
    136,004Ceded written premiums as percentage of
direct written premiums
    
    
    43.1
    %
    
    
    40.5
    %
  Nine Months EndedSeptember 30,2010
    
    
    2009(Dollars in thousands)Ceded written premiums
    
    $
    101,858
    
    
    $
    92,615Ceded premiums earned
    
    
    96,160
    
    
    
    81,752Losses and loss adjustment expenses ceded
    
    
    68,288
    
    
    
    59,604Ceding commissions
    
    
    23,594
    
    
    
    21,897
   42




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##### Table of Contents



Recent Accounting Pronouncements
 Accounting Standards Codification
  Prospective Accounting Standards
 Financial
Services  Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing
Insurance Contracts FASB Accounting Standards Codification Financial
Services  Insurance
  43




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##### Table of Contents



44




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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
  45




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##### Table of Contents



PART II.  OTHER INFORMATION
 
 Item 1. Legal Proceedings
   
 Item 1A. Risk Factors
  Failure to complete the pending merger with Fairfax could materially and adversely affect our
results of operations and our stock price.
   
    
    the attention of our management and our employees may be diverted from
day-to-day operations as they focus on the Merger;
    
    our insureds, distribution partners and other business partners may cease or
delay conducting business with us as a result of the announcement of the Merger, which
could cause our revenues to materially decline or any anticipated increases in revenues to
be lower than expected;
    
    our ability to attract new employees and retain our existing employees may be
harmed by uncertainties associated with the Merger, and we may be required to incur
substantial costs to recruit replacements for lost personnel or consultants; and
    
    stockholder lawsuits could be filed against us challenging the Merger. If this
occurs, even if the lawsuits are groundless and we ultimately prevail, we may incur
substantial legal fees and expenses defending these lawsuits, and the Merger could be
prevented or delayed.
 46




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##### Table of Contents



Under the terms of the Merger Agreement, we are required to use commercially reasonable
efforts to sell our non-cash investments which could in the long-term adversely affect our
investment portfolio and business.
  
 Item 6. Exhibits
  47




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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 and Chief Financial OfficerDate:
    November 9, 2010 48




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##### Table of Contents



INDEX OF EXHIBITS
 2.1
    
    
    (1
    )
    
    Agreement and Plan of Merger, dated October 28, 2010, by and among Fairfax Holdings Limited, Fairfax
Investments III USA Corp. and the Company31 (a)
    
    
    (2
    )
    
    Certification of Chief Executive Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 193431 (b)
    
    
    (2
    )
    
    Certification of Chief Financial Officer, pursuant to Rule 13a-14(a) of the Securities Exchange Act
of 193432 (a)
    
    
    (2
    )
    
    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)
    
    
    (2
    )
    
    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)
    
     Incorporated by reference to Exhibit 2.1 of the Current Report on Form 8-K filed by the Company on November 1, 2010(2)
    
     Filed herewith 49