##### 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, 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 Road 
Suite 100
Southfield, Michigan
(Address of Principal Executive Offices)
    
    48034
(Zip Code)
  þ o
  o o þ
 o þ




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##### 



TABLE OF CONTENTS
 Item
    
    
    
    PagePART I  FINANCIAL INFORMAITON1.
    
    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 INFORMATION6.
    
    Exhibits
    
    
    32Certification of Chief Executive Officer, pursuant to Rule 13a-14(a)Certification of Chief Financial Officer, pursuant to Rule 13a-14(a)Certification of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350Certification of Chief Financial Officer, pursuant to 18 U.S.C. Section 1350
  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 31,2007
    
    
    2006(Unaudited)(Dollars in thousands,except share data)ASSETSInvestmentsDebt securities
    
    $
    369,203
    
    
    $
    260,323Equity securities and other
    
    
    4,228
    
    
    
    3,184Short-term
    
    
    55,643
    
    
    
    34,334Total Investments
    
    
    429,074
    
    
    
    297,841Cash and cash equivalents
    
    
    30,242
    
    
    
    14,335Premiums and reinsurance balances receivable
    
    
    35,629
    
    
    
    46,090Accrued investment income
    
    
    4,116
    
    
    
    2,931Accrued profit sharing commissions
    
    
    10,803
    
    
    
    7,735Reinsurance recoverable on paid and unpaid losses
    
    
    88,726
    
    
    
    69,437Prepaid reinsurance premiums
    
    
    52,221
    
    
    
    10,377Deferred acquisition costs
    
    
    12,227
    
    
    
    18,452Deferred federal income taxes
    
    
    33
    
    
    
    Intangible assets, net of accumulated amortization
    
    
    36,958
    
    
    
    37,878Other assets
    
    
    11,248
    
    
    
    7,857Total Assets
    
    $
    711,277
    
    
    $
    512,933LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    256,002
    
    
    $
    191,013Unearned premium reserves
    
    
    120,725
    
    
    
    91,803Long-term debt
    
    
    67,013
    
    
    
    46,394Funds held under reinsurance treaties
    
    
    28,780
    
    
    
    Reinsurance payable on paid losses
    
    
    7,527
    
    
    
    2,877Premiums payable to insurance companies
    
    
    2,055
    
    
    
    728Deferred federal income taxes
    
    
    
    
    
    
    1,642Accounts payable, accrued expenses, and other liabilities
    
    
    11,268
    
    
    
    5,738Total Liabilities
    
    
    493,370
    
    
    
    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
    
    
    166,606
    
    
    
    153,600Accumulated other comprehensive loss
    
    
    (255
    )
    
    
    (761
    )Retained earnings
    
    
    51,973
    
    
    
    20,323Treasury stock; 92,500 shares
    
    
    (598
    )
    
    
    (598
    )Total Stockholders Equity
    
    
    217,907
    
    
    
    172,738Total Liabilities and Stockholders Equity
    
    $
    711,277
    
    
    $
    512,933
  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 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands, except share and per share data)Operating RevenueNet earned premiums
    
    $
    41,155
    
    
    $
    26,947
    
    
    $
    129,655
    
    
    $
    83,804Commissions and fees
    
    
    5,825
    
    
    
    3,716
    
    
    
    15,384
    
    
    
    12,479Net investment income
    
    
    4,359
    
    
    
    2,446
    
    
    
    11,523
    
    
    
    6,717Net realized gains (losses) on investments
    
    
    355
    
    
    
    467
    
    
    
    1,117
    
    
    
    (15
    )Total Operating Revenues
    
    
    51,694
    
    
    
    33,576
    
    
    
    157,679
    
    
    
    102,985Operating ExpensesLosses and loss adjustment expenses, net
    
    
    20,886
    
    
    
    13,224
    
    
    
    67,328
    
    
    
    43,186Amortization of deferred acquisition expenses
    
    
    7,570
    
    
    
    3,546
    
    
    
    23,866
    
    
    
    12,638Underwriting, agency and other expenses
    
    
    4,914
    
    
    
    2,493
    
    
    
    14,257
    
    
    
    9,872Amortization of intangible assets
    
    
    307
    
    
    
    292
    
    
    
    921
    
    
    
    875Total Operating Expenses
    
    
    33,677
    
    
    
    19,555
    
    
    
    106,372
    
    
    
    66,571Operating Income
    
    
    18,017
    
    
    
    14,021
    
    
    
    51,307
    
    
    
    36,414Interest Expense
    
    
    1,054
    
    
    
    2,840
    
    
    
    3,022
    
    
    
    8,235Change in Fair Value of Derivative Instruments
    
    
    295
    
    
    
    335
    
    
    
    275
    
    
    
    (51
    )Income Before Income Taxes
    
    
    16,668
    
    
    
    10,846
    
    
    
    48,010
    
    
    
    28,230Income Taxes
    
    
    5,622
    
    
    
    3,920
    
    
    
    16,493
    
    
    
    9,959Net Income
    
    $
    11,046
    
    
    $
    6,926
    
    
    $
    31,517
    
    
    $
    18,271Net Income Per Share:Basic
    
    $
    0.61
    
    
    $
    1.42
    
    
    $
    1.79
    
    
    $
    3.69Diluted
    
    $
    0.59
    
    
    $
    0.55
    
    
    $
    1.71
    
    
    $
    1.48Weighted Average Shares Outstanding:Basic
    
    
    18,036,168
    
    
    
    4,220,045
    
    
    
    17,601,271
    
    
    
    4,206,556Diluted
    
    
    18,867,107
    
    
    
    12,621,422
    
    
    
    18,440,128
    
    
    
    12,315,035
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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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    243Exercise of stock options
    
    
    3
    
    
    
    
    
    
    
    458
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    461Stock-based compensation expense
    
    
    
    
    
    
    
    
    
    
    53
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    53Common stock repurchased
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (598
    )
    
    
    (598
    )Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,271
    
    
    
    
    
    
    
    18,271Other comprehensive income, net of taxUnrealized holding gains on securities
arising during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    236
    
    
    
    
    
    
    
    
    
    
    
    236Less reclassification adjustment for
losses included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    460
    
    
    
    
    
    
    
    
    
    
    
    460Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    696Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,967Balance, September 30, 2006
    
    $
    45
    
    
    $
    
    
    
    $
    59,611
    
    
    $
    (588
    )
    
    $
    24,983
    
    
    $
    (598
    )
    
    $
    83,453Balance, 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
    
    
    
    
    
    
    
    
    
    
    764
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    764Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,517
    
    
    
    
    
    
    
    31,517Other comprehensive income, net of taxUnrealized holding gains on securities
arising during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,234
    
    
    
    
    
    
    
    
    
    
    
    1,234Less reclassification adjustment for
gains included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (427
    )
    
    
    
    
    
    
    
    
    
    
    (427
    )Change in fair value of interest rate swap
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168
    )
    
    
    
    
    
    
    
    
    
    
    (168
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    639Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    32,156Balance, September 30, 2007
    
    $
    181
    
    
    $
    
    
    
    $
    166,606
    
    
    $
    (255
    )
    
    $
    51,973
    
    
    $
    (598
    )
    
    $
    217,907
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
 (Unaudited)
 Nine Months EndedSeptember 30,2007
    
    
    2006(Dollars in thousands)Cash Flows from Operating ActivitiesNet Income
    
    $
    31,517
    
    
    $
    18,271Adjustments to reconcile net income to net cash provided by
operating activitiesDepreciation and amortization
    
    
    1,511
    
    
    
    1,823Realized (gains) losses on investments
    
    
    (1,117
    )
    
    
    15Deferrals of acquisition costs, net
    
    
    6,225
    
    
    
    4,267Deferred income taxes
    
    
    (1,675
    )
    
    
    (1,777
    )Stock-based compensation expense
    
    
    764
    
    
    
    53Increase (decrease) in cash resulting from changes in assets
and liabilitiesPremiums and reinsurance balances receivable
    
    
    10,461
    
    
    
    3,489Accrued investment income
    
    
    (1,185
    )
    
    
    (486
    )Receivable from related entity
    
    
    (15
    )
    
    
    1,878Accrued profit sharing commissions
    
    
    (3,068
    )
    
    
    13Reinsurance recoverable on paid and unpaid losses
    
    
    (19,289
    )
    
    
    (34,769
    )Prepaid reinsurance premiums
    
    
    (41,844
    )
    
    
    (12,638
    )Loss and loss adjustment expense reserves
    
    
    64,989
    
    
    
    58,205Unearned premium reserves
    
    
    28,922
    
    
    
    7,741Funds held under reinsurance treaties
    
    
    28,780
    
    
    
    Reinsurance payable on paid losses
    
    
    4,650
    
    
    
    (1,858
    )Premiums payable to insurance companies
    
    
    1,327
    
    
    
    (2,920
    )Other
    
    
    (1,763
    )
    
    
    1,521Net Cash Provided By Operating Activities
    
    
    109,190
    
    
    
    42,828Cash Flows From Investing ActivitiesCost of short-term investments acquired
    
    
    (325,766
    )
    
    
    (154,291
    )Proceeds from disposals of short-term investments
    
    
    304,457
    
    
    
    154,105Cost of debt and equity securities acquired
    
    
    (149,750
    )
    
    
    (100,629
    )Proceeds from debt and equity securities
    
    
    48,072
    
    
    
    63,654Change in receivable from stockholders
    
    
    
    
    
    
    322Acquisition, net of cash acquired
    
    
    
    
    
    
    (6,351
    )Cost of fixed asset purchases
    
    
    (3,164
    )
    
    
    (450
    )Net Cash Used In Investing Activities
    
    
    (126,151
    )
    
    
    (43,640
    )Cash Flows From Financing ActivitiesStock issued on stock options exercised
    
    
    
    
    
    
    461Issuance of common stock, net of issuance costs
    
    
    12,249
    
    
    
    243Repurchase of common stock
    
    
    
    
    
    
    (598
    )Issuance of long-term debt
    
    
    20,619
    
    
    
    Net Cash Provided By Financing Activities
    
    
    32,868
    
    
    
    106Net Increase (Decrease) In Cash and Cash Equivalents
    
    
    15,907
    
    
    
    (706
    )Cash and Cash Equivalents, beginning of period
    
    
    14,335
    
    
    
    8,400Cash and Cash Equivalents, end of period
    
    $
    30,242
    
    
    $
    7,694Supplemental Disclosure of Cash Flow Information:Cash paid during the period for:Interest
    
    $
    2,899
    
    
    $
    7,703Income taxes
    
    $
    18,415
    
    
    $
    9,273
  6




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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
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands,except share and per share data)Net Income
    
    $
    11,046
    
    
    $
    6,926
    
    
    $
    31,517
    
    
    $
    18,271Less: Dividends in arrears
    
    
    
    
    
    
    (951
    )
    
    
    
    
    
    
    (2,766
    )Net income available to common
    
    
    11,046
    
    
    
    5,975
    
    
    
    31,517
    
    
    
    15,505Weighted-average number of common and common equivalent shares
outstanding:Basic number of common shares outstanding
    
    
    18,036,168
    
    
    
    4,220,045
    
    
    
    17,601,271
    
    
    
    4,206,556Dilutive effect of stock options
    
    
    830,939
    
    
    
    821,591
    
    
    
    832,844
    
    
    
    820,676Dilutive effect of unvested restricted stock
    
    
    
    
    
    
    
    
    
    
    6,013
    
    
    
    Dilutive effect of convertible preferred stock
    
    
    
    
    
    
    6,434,782
    
    
    
    
    
    
    
    6,434,782Dilutive effect of cumulative dividends on preferred stock
    
    
    
    
    
    
    1,145,004
    
    
    
    
    
    
    
    853,021Dilutive number of common and common equivalent shares outstanding
    
    
    18,867,107
    
    
    
    12,621,422
    
    
    
    18,440,128
    
    
    
    12,315,035Basic Net Income Per Common Share
    
    $
    0.61
    
    
    $
    1.42
    
    
    $
    1.79
    
    
    $
    3.69Diluted Net Income Per Common Share
    
    $
    0.59
    
    
    $
    0.55
    
    
    $
    1.71
    
    
    $
    1.48Anti-dilutive shares excluded from diluted net income per common share
    
    
    75,633
    
    
    
    
    
    
    
    52,444
    
    
    
    
 3. INCOME TAXES
 Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109 Accounting for Income Taxes.
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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
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands)Balance,beginning of period
    
    $
    235,862
    
    
    $
    150,940
    
    
    $
    191,013
    
    
    $
    113,864Less reinsurance recoverables
    
    
    77,385
    
    
    
    42,350
    
    
    
    66,926
    
    
    
    21,869Net Balance,beginning of period
    
    
    158,477
    
    
    
    108,590
    
    
    
    124,087
    
    
    
    91,995Incurred Related ToCurrent year
    
    
    22,314
    
    
    
    13,240
    
    
    
    69,608
    
    
    
    42,145Prior years
    
    
    (1,428
    )
    
    
    (16
    )
    
    
    (2,280
    )
    
    
    1,041Total Incurred
    
    
    20,886
    
    
    
    13,224
    
    
    
    67,328
    
    
    
    43,186Paid Related ToCurrent year
    
    
    1,230
    
    
    
    605
    
    
    
    2,384
    
    
    
    1,396Prior years
    
    
    7,719
    
    
    
    4,000
    
    
    
    18,617
    
    
    
    16,576Total Paid
    
    
    8,949
    
    
    
    4,605
    
    
    
    21,001
    
    
    
    17,972Net Balance
    
    
    170,414
    
    
    
    117,209
    
    
    
    170,414
    
    
    
    117,209Plus reinsurance recoverables
    
    
    85,588
    
    
    
    54,860
    
    
    
    85,588
    
    
    
    54,860Balance,end of period
    
    $
    256,002
    
    
    $
    172,069
    
    
    $
    256,002
    
    
    $
    172,069
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 5. REINSURANCE
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006(Dollars in thousands)Written PremiumsDirect
    
    $
    62,039
    
    
    $
    49,472
    
    
    $
    195,590
    
    
    $
    160,452Assumed
    
    
    4,235
    
    
    
    1,033
    
    
    
    8,602
    
    
    
    3,295Ceded
    
    
    (30,796
    )
    
    
    (26,518
    )
    
    
    (90,177
    )
    
    
    (85,823
    )Net Written Premiums
    
    $
    35,478
    
    
    $
    23,987
    
    
    $
    114,015
    
    
    $
    77,924Earned PremiumsDirect
    
    $
    60,218
    
    
    $
    52,627
    
    
    $
    170,410
    
    
    $
    152,999Assumed
    
    
    535
    
    
    
    1,036
    
    
    
    4,372
    
    
    
    2,651Ceded
    
    
    (19,845
    )
    
    
    (26,951
    )
    
    
    (48,319
    )
    
    
    (72,828
    )Earned but unbilled premiums
    
    
    247
    
    
    
    235
    
    
    
    3,192
    
    
    
    982Net Earned Premiums
    
    $
    41,155
    
    
    $
    26,947
    
    
    $
    129,655
    
    
    $
    83,804
    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 PriceOustanding at January 1, 2006
    
    
    1,119,528
    
    
    $
    1.85
    
    
    
    
    
    
    $
    Granted during the period
    
    
    91,575
    
    
    
    6.49
    
    
    
    
    
    
    
    Forfeited during the period
    
    
    15,541
    
    
    
    6.49
    
    
    
    
    
    
    
    Exercised during the period
    
    
    268,065
    
    
    
    1.72
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at September 30, 2006
    
    
    927,497
    
    
    $
    2.27
    
    
    
    
    
    
    $
    Oustanding 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 September 30, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    476,188
    
    
    $
    18.78Exercisable at:September 30, 2006
    
    
    851,185
    
    
    $
    1.89
    
    
    
    
    
    
    
    September 30, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    
    
    
    
    
   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, 2007
    
    Contractual Life
    
    Share
    
    September 30, 2007
    
    Share1998 Plan$1.51  $2.14
    
    
    810,762
        
    3.48
    Years
    
    $
    1.71
    
    
    
    810,762
    
    
    $
    1.71$4.86  $6.49
    
    
    117,013
    
    

    6.27
        
    
    
    5.92
    
    
    
    117,013
    
    
    
    5.92Total
    
    
    927,775
    
    

    3.83
        
    

    $
    2.24
    
    
    
    927,775
    
    
    $
    2.24Omnibus Plan$17.00  $20.75
    
    
    476,188
    
    
    7.66
    Years
    
    $
    18.78
    
    
    
    
    
    
    $
    Total
    
    
    476,188
    
    

    7.66
        
    
    $
    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)
  Nine Months EndedSeptember 30,2007
    
    20061998 PlanExpected term
    
    
    
    
    
    
    2.5Expected stock price volatility
    
    
    
    
    
    
    26.50
    %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. JUNIOR SUBORDINATED DEBENTURES
    13




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 9. JUNIOR SUBORDINATED DEBENTURES  (Concluded)
  10. STOCKHOLDERS EQUITY
  11. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
  September 30,2007
    
    
    2006(Dollars in thousands)Unrealized holding losses on securities, net of tax
    
    $
    (79
    )
    
    $
    (588
    )Fair value of interest rate swap, net of tax
    
    
    (176
    )
    
    
    Total accumulated other comprehensive loss
    
    $
    (255
    )
    
    $
    (588
    )
 14




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##### Table of Contents



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




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##### 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.
    September 30,
    
    
    December 31,2007
    
    
    2006(Dollars in thousands)GrossCase reserves
    
    $
    62,921
    
    
    $
    47,004IBNR and ULAE reserves
    
    
    193,081
    
    
    
    144,009Total reserves
    
    $
    256,002
    
    
    $
    191,013Net of reinsuranceCase reserves
    
    $
    48,046
    
    
    $
    37,376IBNR and ULAE reserves
    
    
    122,368
    
    
    
    86,711Total
    
    $
    170,414
    
    
    $
    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 September 30, 2007 Compared to Three Months Ended September 30, 2006
  Three Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    41,155
    
    
    $
    26,947
    
    
    
    53
    %Commissions and fees
    
    
    5,825
    
    
    
    3,716
    
    
    
    57Net investment income
    
    
    4,359
    
    
    
    2,446
    
    
    
    78Net realized gains on investments
    
    
    355
    
    
    
    467
    
    
    
    24Total Operating Revenues
    
    
    51,694
    
    
    
    33,576
    
    
    
    54Operating ExpensesLosses and loss adjustment expenses, net
    
    
    20,886
    
    
    
    13,224
    
    
    
    58Amortization of intangible assets
    
    
    307
    
    
    
    292
    
    
    
    5Other operating expenses
    
    
    12,484
    
    
    
    6,039
    
    
    
    107Total Operating Expenses
    
    
    33,677
    
    
    
    19,555
    
    
    
    72Operating Income
    
    
    18,017
    
    
    
    14,021
    
    
    
    29Interest Expense
    
    
    1,349
    
    
    
    3,175
    
    
    
    (58
    )Income Before Income Taxes
    
    
    16,668
    
    
    
    10,846
    
    
    
    54Income Taxes
    
    
    5,622
    
    
    
    3,920
    
    
    
    43Net Income
    
    $
    11,046
    
    
    $
    6,926
    
    
    
    59
    %Loss Ratio
    
    
    50.7
    %
    
    
    49.1
    %
    
    1.6 pointsUnderwriting Expense Ratio
    
    
    21.8
    %
    
    
    16.2
    %
    
    5.6 pointsCombined Ratio
    
    
    72.5
    %
    
    
    65.3
    %
    
    7.2 points
 Premiums Produced
  19




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Three Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Written PremiumsDirect
    
    $
    62,039
    
    
    $
    49,472
    
    
    
    25
    %Assumed
    
    
    4,235
    
    
    
    1,033
    
    
    
    310Ceded
    
    
    (30,796
    )
    
    
    (26,518
    )
    
    
    16Net Written Premiums
    
    $
    35,478
    
    
    $
    23,987
    
    
    
    48
    %Earned PremiumsDirect
    
    $
    60,218
    
    
    $
    52,627
    
    
    
    14
    %Assumed
    
    
    535
    
    
    
    1,036
    
    
    
    (48
    )Ceded
    
    
    (19,845
    )
    
    
    (26,951
    )
    
    
    (26
    )Earned but unbilled premiums
    
    
    247
    
    
    
    235
    
    
    
    5Net Earned Premiums
    
    $
    41,155
    
    
    $
    26,947
    
    
    
    53
    %
     20




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##### Table of Contents



Commissions and Fees
 Three Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    2,226
    
    
    $
    320
    
    
    
    596
    %Insurance services commissions and fees
    
    
    3,599
    
    
    
    3,396
    
    
    
    6Total commissions and fees
    
    $
    5,825
    
    
    $
    3,716
    
    
    
    57
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Three Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    7,570
    
    
    $
    3,546
    
    
    
    113
    %Ceded reinsurance commissions
    
    
    (9,057
    )
    
    
    (9,504
    )
    
    
    (5
    )Other underwriting and operating expenses
    
    
    13,971
    
    
    
    11,997
    
    
    
    16Other operating expenses
    
    $
    12,484
    
    
    $
    6,039
    
    
    
    107
    %
  21




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##### Table of Contents



Interest Expense
 Three Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Senior notes
    
    $
    
    
    
    $
    2,208
    
    
    
    (100
    )%Junior subordinated debentures
    
    
    1,349
    
    
    
    484
    
    
    
    179Other
    
    
    
    
    
    
    483
    
    
    
    (100
    )Total interest expense
    
    $
    1,349
    
    
    $
    3,175
    
    
    
    (58
    )%
  Income taxes
 22




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##### Table of Contents



Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30, 2006
  Nine Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    129,655
    
    
    $
    83,804
    
    
    
    55
    %Commissions and fees
    
    
    15,384
    
    
    
    12,479
    
    
    
    23Net investment income
    
    
    11,523
    
    
    
    6,717
    
    
    
    72Net realized gains (losses) on investments
    
    
    1,117
    
    
    
    (15
    )
    
    
    7,547Total Operating Revenues
    
    
    157,679
    
    
    
    102,985
    
    
    
    53Operating ExpensesLosses and loss adjustment expenses, net
    
    
    67,328
    
    
    
    43,186
    
    
    
    56Amortization of intangible assets
    
    
    921
    
    
    
    875
    
    
    
    5Other operating expenses
    
    
    38,123
    
    
    
    22,510
    
    
    
    69Total Operating Expenses
    
    
    106,372
    
    
    
    66,571
    
    
    
    60Operating Income
    
    
    51,307
    
    
    
    36,414
    
    
    
    41Interest Expense
    
    
    3,297
    
    
    
    8,184
    
    
    
    (60
    )Income Before Income Taxes
    
    
    48,010
    
    
    
    28,230
    
    
    
    70Income Taxes
    
    
    16,493
    
    
    
    9,959
    
    
    
    66Net Income
    
    $
    31,517
    
    
    $
    18,271
    
    
    
    72
    %Loss Ratio
    
    
    51.9
    %
    
    
    51.5
    %
    
    0.4 pointsUnderwriting Expense Ratio
    
    
    21.5
    %
    
    
    18.2
    %
    
    3.3 pointsCombined Ratio
    
    
    73.4
    %
    
    
    69.7
    %
    
    3.7 points
 Premiums Produced
  23




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Nine Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    195,590
    
    
    $
    160,452
    
    
    
    22
    %Assumed
    
    
    8,602
    
    
    
    3,295
    
    
    
    161Ceded
    
    
    (90,177
    )
    
    
    (85,823
    )
    
    
    5Net written premiums
    
    $
    114,015
    
    
    $
    77,924
    
    
    
    46
    %Earned premiumsDirect
    
    $
    170,410
    
    
    $
    152,999
    
    
    
    11
    %Assumed
    
    
    4,372
    
    
    
    2,651
    
    
    
    65Ceded
    
    
    (48,319
    )
    
    
    (72,828
    )
    
    
    (34
    )Earned but unbilled premiums
    
    
    3,192
    
    
    
    982
    
    
    
    225Net earned premiums
    
    $
    129,655
    
    
    $
    83,804
    
    
    
    55
    %
     24




---



##### Table of Contents



Commissions and Fees
 Nine Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    6,161
    
    
    $
    3,363
    
    
    
    83
    %Insurance services commissions and fees
    
    
    9,223
    
    
    
    9,116
    
    
    
    1Total commissions and fees
    
    $
    15,384
    
    
    $
    12,479
    
    
    
    23
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Nine Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    23,866
    
    
    $
    12,638
    
    
    
    89
    %Ceded reinsurance commissions
    
    
    (27,155
    )
    
    
    (27,466
    )
    
    
    (1
    )Other underwriting and operating expenses
    
    
    41,412
    
    
    
    37,338
    
    
    
    11Other operating expenses
    
    $
    38,123
    
    
    $
    22,510
    
    
    
    69
    %
 25




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##### Table of Contents



Interest Expense
 Nine Months EndedSeptember 30,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Senior notes
    
    $
    
    
    
    $
    6,377
    
    
    
    (100
    )%Junior subordinated debentures
    
    
    3,297
    
    
    
    1,381
    
    
    
    139Other
    
    
    
    
    
    
    426
    
    
    
    (100
    )Total interest expense
    
    $
    3,297
    
    
    $
    8,184
    
    
    
    (60
    )%
  Income taxes
 Liquidity and Capital Resources
 Sources and Uses of Funds
 FMFC
 Insurance Subsidiaries
  Non-insurance Subsidiaries
 26




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##### Table of Contents



Cash Flows
  Nine Months EndedSeptember 30,2007
    
    
    2006(Dollars in thousands)Cash and cash equivalents provided by (used in):Operating activities
    
    $
    109,190
    
    
    $
    42,828Investing activities
    
    
    (126,151
    )
    
    
    (43,640
    )Financing activities
    
    
    32,868
    
    
    
    106Change in cash and cash equivalents
    
    $
    15,907
    
    
    $
    (706
    )
     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
  September 30, 2007Market Value
    
    
    % of Portfolio(Dollars in thousands)Money Market Funds
    
    $
    55,632
    
    
    
    13.0
    %Treasury Securities
    
    
    8,484
    
    
    
    2.0
    %Agency Securities
    
    
    2,665
    
    
    
    0.6
    %Corp / Preferred
    
    
    47,252
    
    
    
    11.0
    %Municipal Bonds
    
    
    189,418
    
    
    
    44.1
    %Asset backed Securities
    
    
    38,918
    
    
    
    9.1
    %Mortgages
    
    
    55,081
    
    
    
    12.8
    %Convertible Securities
    
    
    31,613
    
    
    
    7.4
    %Other
    
    
    11
    
    
    
    0.0
    %Total
    
    $
    429,074
    
    
    
    100.0
    %
  28




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##### Table of Contents



Average Life
    
    % of Total InvestmentLess than one year
    
    
    25.2
    %One to two years
    
    
    8.7
    %Two to three years
    
    
    13.0
    %Three to four years
    
    
    16.5
    %Four to five years
    
    
    14.3
    %Five to seven years
    
    
    10.3
    %More than seven years
    
    
    12.0
    %Total
    
    
    100.0
    %
   % of TotalS&P Rating
    
    InvestmentsAAA
    
    
    77.1
    %AA
    
    
    8.1
    %A
    
    
    8.3
    %BBB
    
    
    5.3
    %BB
    
    
    0.8
    %B
    
    
    0.3
    %CCC
    
    
    0.1
    %NR
    
    
    0.0
    %Total
    
    
    100.0
    %
     Deferred Policy Acquisition Costs
  29




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##### Table of Contents



Reinsurance
  Nine Months EndedSeptember 30,2007
    
    
    2006(Dollars in thousands)Direct written premiums
    
    $
    195,590
    
    
    $
    160,452Ceded written premiums
    
    
    90,177
    
    
    
    85,823Net written premiums
    
    $
    105,413
    
    
    $
    74,629Ceded written premiums as percentage of direct written premiums
    
    
    46.1
    %
    
    
    53.5
    %
  Nine Months EndedSeptember 30,2007
    
    2006(Dollars in thousands)Ceded written premiums
    
    $
    90,177
    
    
    $
    85,823Ceded premiums earned
    
    
    48,319
    
    
    
    72,828Losses and loss adjustment expenses ceded
    
    
    25,531
    
    
    
    38,103Ceding commissions
    
    
    15,119
    
    
    
    23,464
   30




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##### Table of Contents



Recent Accounting Pronouncements
 Fair Value Measurements (SFAS 157)
 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 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. MarazzaDate: November 13, 2007
    
    Executive Vice President, Chief Financial Officer
and Treasurer 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