##### 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 March 31, 2008
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission File Number 001-33077
 FIRST MERCURY FINANCIAL CORPORATION
  Delaware
    
    38-3164336(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)29110 Inkster RoadSuite 100
    
    48034Southfield, Michigan
    
    (Zip Code)(Address of Principal Executive Offices)
  þ o
  Large accelerated filer o
    
    Accelerated filer þ
    
    Non-accelerated filer o
    
    Smaller reporting company o(Do not check if a smaller reporting company)
 o þ




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##### 



TABLE OF CONTENTS
 Item
    
    
    
    PagePART I  FINANCIAL INFORMATION1.
    
    Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets
    
    
    3Condensed Consolidated Statements of Income
    
    
    4Condensed Consolidated Statements of Stockholders Equity
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements (Unaudited)
    
    
    72.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    173.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    304.
    
    Controls and Procedures
    
    
    30PART II  OTHER INFORMATION6.
    
    Exhibits
    
    
    31Certification 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
 March 31,
    
    
    December 31,2008
    
    
    2007(Unaudited)(Dollars in thousands,except share and per share data)ASSETSInvestmentsDebt securities
    
    $
    420,426
    
    
    $
    402,418Equity securities and other
    
    
    18,431
    
    
    
    4,529Short-term
    
    
    35,065
    
    
    
    52,341Total Investments
    
    
    473,922
    
    
    
    459,288Cash and cash equivalents
    
    
    20,836
    
    
    
    18,432Premiums and reinsurance balances receivable
    
    
    59,295
    
    
    
    38,278Accrued investment income
    
    
    4,434
    
    
    
    4,481Accrued profit sharing commissions
    
    
    11,331
    
    
    
    14,220Reinsurance recoverable on paid and unpaid losses
    
    
    106,994
    
    
    
    96,995Prepaid reinsurance premiums
    
    
    47,743
    
    
    
    52,718Deferred acquisition costs
    
    
    19,315
    
    
    
    14,257Intangible assets, net of accumulated amortization
    
    
    47,912
    
    
    
    36,651Goodwill
    
    
    25,080
    
    
    
    Other assets
    
    
    14,800
    
    
    
    11,964Total Assets
    
    $
    831,662
    
    
    $
    747,284LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    301,314
    
    
    $
    272,365Unearned premium reserves
    
    
    134,005
    
    
    
    123,469Long-term debt
    
    
    67,013
    
    
    
    67,013Funds held under reinsurance treaties
    
    
    38,346
    
    
    
    35,799Premiums payable to insurance companies
    
    
    21,636
    
    
    
    2,163Reinsurance payable on paid losses
    
    
    4,800
    
    
    
    3,958Deferred federal income taxes
    
    
    3,913
    
    
    
    217Accounts payable, accrued expenses, and other liabilities
    
    
    21,148
    
    
    
    12,920Total Liabilities
    
    
    592,175
    
    
    
    517,904Stockholders EquityCommon stock, $0.01 par value; authorized 100,000,000 shares; issued
and outstanding 18,275,313 and 17,972,353 shares
    
    
    183
    
    
    
    180Paid-in-capital
    
    
    166,681
    
    
    
    165,836Accumulated other comprehensive income
    
    
    1,214
    
    
    
    1,177Retained earnings
    
    
    71,908
    
    
    
    62,187Treasury stock; 33,600 and 0 shares
    
    
    (499
    )
    
    
    Total Stockholders Equity
    
    
    239,487
    
    
    
    229,380Total Liabilities and Stockholders Equity
    
    $
    831,662
    
    
    $
    747,284
  3




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Income
(Unaudited)
 Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands, except share and per share data)Operating RevenueNet earned premiums
    
    $
    43,571
    
    
    $
    44,929Commissions and fees
    
    
    7,029
    
    
    
    4,657Net investment income
    
    
    4,853
    
    
    
    3,294Net realized gains on investments
    
    
    1
    
    
    
    135Total Operating Revenues
    
    
    55,454
    
    
    
    53,015Operating ExpensesLosses and loss adjustment expenses, net
    
    
    23,444
    
    
    
    23,954Amortization of deferred acquisition expenses
    
    
    8,213
    
    
    
    8,739Underwriting, agency and other expenses
    
    
    7,052
    
    
    
    3,730Amortization of intangible assets
    
    
    539
    
    
    
    307Total Operating Expenses
    
    
    39,248
    
    
    
    36,730Operating Income
    
    
    16,206
    
    
    
    16,285Interest Expense
    
    
    1,464
    
    
    
    982Change in Fair Value of Derivative Instruments
    
    
    435
    
    
    
    107Income Before Income Taxes
    
    
    14,307
    
    
    
    15,196Income Taxes
    
    
    4,586
    
    
    
    5,229Net Income
    
    $
    9,721
    
    
    $
    9,967Net Income Per Share:Basic
    
    $
    0.54
    
    
    $
    0.58Diluted
    
    $
    0.52
    
    
    $
    0.55Weighted Average Shares Outstanding:Basic
    
    
    18,106,063
    
    
    
    17,331,901Diluted
    
    
    18,793,264
    
    
    
    18,183,841
  4




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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, except share data)Balance, January 1, 2007
    
    $
    174
    
    
    $
    153,600
    
    
    $
    (761
    )
    
    $
    20,323
    
    
    $
    (598
    )
    
    $
    172,738Cumulative effect adjustment upon
adoption of SFAS 155
    
    
    
    
    
    
    
    
    
    
    (133
    )
    
    
    133
    
    
    
    
    
    
    
    Stock-based compensation expense
    
    
    
    
    
    
    30
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    30Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,967
    
    
    
    
    
    
    
    9,967Other comprehensive income, net of taxUnrealized holding gains on securities
arising during the period, net of tax of ($237)
    
    
    
    
    
    
    
    
    
    
    440
    
    
    
    
    
    
    
    
    
    
    
    440Change in fair value of interest rate swap, net of tax of $44
    
    
    
    
    
    
    
    
    
    
    (82
    )
    
    
    
    
    
    
    
    
    
    
    (82
    )Less reclassification adjustment for
gains included in net income, net of tax of $132
    
    
    
    
    
    
    
    
    
    
    (245
    )
    
    
    
    
    
    
    
    
    
    
    (245
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    113Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,080Balance, March 31, 2007
    
    $
    174
    
    
    $
    153,630
    
    
    $
    (781
    )
    
    $
    30,423
    
    
    $
    (598
    )
    
    $
    182,848Balance, January 1, 2008
    
    $
    180
    
    
    $
    165,836
    
    
    $
    1,177
    
    
    $
    62,187
    
    
    $
    
    
    
    $
    229,380Exercise of stock options
    
    
    3
    
    
    
    518
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    521Stock-based compensation expense
    
    
    
    
    
    
    327
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    327Common stock repurchased
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (499
    )
    
    
    (499
    )Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,721
    
    
    
    
    
    
    
    9,721Other comprehensive income, net of taxUnrealized holding gains on securities
arising during the period, net of tax of ($436)
    
    
    
    
    
    
    
    
    
    
    809
    
    
    
    
    
    
    
    
    
    
    
    809Change in fair value of interest rate swap, net of tax of $324
    
    
    
    
    
    
    
    
    
    
    (602
    )
    
    
    
    
    
    
    
    
    
    
    (602
    )Less reclassification adjustment for
gains included in net income, net of tax of $92
    
    
    
    
    
    
    
    
    
    
    (170
    )
    
    
    
    
    
    
    
    
    
    
    (170
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    37Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,758Balance, March 31, 2008
    
    $
    183
    
    
    $
    166,681
    
    
    $
    1,214
    
    
    $
    71,908
    
    
    $
    (499
    )
    
    $
    239,487
  5




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
(Unaudited)
 Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Cash Flows from Operating ActivitiesNet Income
    
    $
    9,721
    
    
    $
    9,967Adjustments to reconcile net income to net cash provided by
operating activitiesDepreciation and amortization
    
    
    893
    
    
    
    471Realized (gains) losses on investments
    
    
    (1
    )
    
    
    (135
    )Deferrals of acquisition costs, net
    
    
    (5,058
    )
    
    
    4,003Deferred income taxes
    
    
    (221
    )
    
    
    (1,371
    )Stock-based compensation expense
    
    
    327
    
    
    
    30Increase (decrease) in cash resulting from changes in assets
and liabilitiesPremiums and reinsurance balances receivable
    
    
    (1,447
    )
    
    
    17,935Accrued investment income
    
    
    47
    
    
    
    (512
    )Receivable from related entity
    
    
    75
    
    
    
    (180
    )Accrued profit sharing commissions
    
    
    2,889
    
    
    
    (1,055
    )Reinsurance recoverable on paid and unpaid losses
    
    
    (9,999
    )
    
    
    (1,791
    )Prepaid reinsurance premiums
    
    
    4,975
    
    
    
    (15,077
    )Loss and loss adjustment expense reserves
    
    
    24,459
    
    
    
    20,258Unearned premium reserves
    
    
    8,802
    
    
    
    6,140Funds held under reinsurance treaties
    
    
    2,547
    
    
    
    9,013Reinsurance payable on paid losses
    
    
    842
    
    
    
    (37
    )Premiums payable to insurance companies
    
    
    (3,745
    )
    
    
    1,048Other
    
    
    (8,944
    )
    
    
    2,921Net Cash Provided By Operating Activities
    
    
    26,162
    
    
    
    51,628Cash Flows From Investing ActivitiesCost of short-term investments acquired
    
    
    (135,182
    )
    
    
    (96,859
    )Proceeds from disposals of short-term investments
    
    
    155,618
    
    
    
    84,663Cost of debt and equity securities acquired
    
    
    (52,616
    )
    
    
    (59,587
    )Proceeds from debt and equity securities
    
    
    27,410
    
    
    
    16,035Change in receivable from stockholders
    
    
    
    
    
    
    Acquisition, net of cash acquired
    
    
    (18,466
    )
    
    
    Cost of fixed asset purchases
    
    
    (544
    )
    
    
    (648
    )Net Cash Used In Investing Activities
    
    
    (23,780
    )
    
    
    (56,396
    )Cash Flows From Financing ActivitiesStock issued on stock options exercised
    
    
    521
    
    
    
    Purchase of treasury stock
    
    
    (499
    )
    
    
    Net Cash Provided By Financing Activities
    
    
    22
    
    
    
    Net Decrease In Cash and Cash Equivalents
    
    
    2,404
    
    
    
    (4,768
    )Cash and Cash Equivalents, beginning of period
    
    
    18,432
    
    
    
    14,335Cash and Cash Equivalents, end of period
    
    $
    20,836
    
    
    $
    9,567Supplemental Disclosure of Cash Flow Information:Cash paid during the period for:Interest
    
    $
    1,787
    
    
    $
    965Income taxes
    
    $
    
    
    
    $
    915
  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 Effective Date of FASB Statement No. 157
 Business Combinations (SFAS 141(R))
 Noncontrolling Interests in Consolidated
Financial Statementsan amendment of Accounting Research Bulletin No. 51 (SFAS 160)
 Disclosures about Derivative Instruments and
Hedging Activities  an amendment of FASB Statement No. 133 (SFAS 161).
 7




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 2. MERGERS AND ACQUISITIONS
 American Management Corporation
     $ in thousandsAssets AcquiredInvestments
    
    $
    8,988Cash and cash equivalents
    
    
    20,012Premiums receivable
    
    
    19,570Other assets
    
    
    1,133Goodwill
    
    
    25,080Intangible assets:Agent relationships
    
    
    9,150Tradename
    
    
    2,130Customer relationships
    
    
    520Total Assets Acquired
    
    $
    86,583Liabilities AssumedPremiums payable to insurance companies
    
    $
    23,218Loss and loss adjustment expense reserves
    
    
    4,490Unearned premium reserves
    
    
    1,734Deferred federal income taxes
    
    
    3,917Accounts payable, accrued expenses, and other
liabilities
    
    
    14,745Total Liabilities Assumed
    
    
    48,104Net Assets Acquired
    
    $
    38,479
  8




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 2. MERGERS AND ACQUISITIONS  (Concluded)
   Pro Forma for theQuarter EndedMarch 31,2008
    
    2007(Dollars in thousands,except per share data)Revenues
    
    $
    58,649
    
    
    $
    61,531Net income
    
    
    9,748
    
    
    
    10,323Basic earnings per share
    
    
    0.54
    
    
    
    0.60Diluted earnings per share
    
    
    0.52
    
    
    
    0.57
 3. NET INCOME PER SHARE
   Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands,except share and per share data)Net income available to common
    
    $
    9,721
    
    
    $
    9,967Weighted-average number of common and common equivalent shares
outstanding:Basic number of common shares outstanding
    
    
    18,106,063
    
    
    
    17,331,901Dilutive effect of stock options
    
    
    686,122
    
    
    
    837,213Dilutive effect of unvested restricted stock
    
    
    1,079
    
    
    
    14,727Dilutive number of common and common equivalent shares outstanding
    
    
    18,793,264
    
    
    
    18,183,841Basic Net Income Per Common Share
    
    $
    0.54
    
    
    $
    0.58Diluted Net Income Per Common Share
    
    $
    0.52
    
    
    $
    0.55Anti-dilutive shares excluded from diluted net income per common share
    
    
    706,188
    
    
    
    16,181
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements   (Continued)
 (Unaudited)
 4. INCOME TAXES
 Accounting for
Uncertainty in Income Taxes, an Interpretation of SFAS No. 109 Accounting for Income Taxes,
   5. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
  Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Balance,beginning of period
    
    $
    272,365
    
    
    $
    191,013Less reinsurance recoverables
    
    
    91,444
    
    
    
    66,926Net Balance,beginning of period
    
    
    180,921
    
    
    
    124,087AUIC net reserves, date of
acquisition
    
    
    4,490
    
    
    
    Incurred Related ToCurrent year
    
    
    23,444
    
    
    
    24,069Prior years
    
    
    
    
    
    
    (115
    )Total Incurred
    
    
    23,444
    
    
    
    23,954Paid Related ToCurrent year
    
    
    334
    
    
    
    177Prior years
    
    
    10,275
    
    
    
    5,719Total Paid
    
    
    10,609
    
    
    
    5,896Net Balance
    
    
    198,246
    
    
    
    142,145Plus reinsurance recoverables
    
    
    103,068
    
    
    
    69,126Balance,end of period
    
    $
    301,314
    
    
    $
    211,271
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 6. REINSURANCE
  Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Written PremiumsDirect
    
    $
    76,214
    
    
    $
    59,334Assumed
    
    
    4,993
    
    
    
    1,266Ceded
    
    
    (22,704
    )
    
    
    (26,140
    )Net Written Premiums
    
    $
    58,503
    
    
    $
    34,460Earned PremiumsDirect
    
    $
    68,653
    
    
    $
    53,374Assumed
    
    
    3,752
    
    
    
    1,086Ceded
    
    
    (27,679
    )
    
    
    (11,064
    )Earned but unbilled premiums
    
    
    (1,155
    )
    
    
    1,533Net Earned Premiums
    
    $
    43,571
    
    
    $
    44,929
    7. RELATED PARTY TRANSACTIONS
  8. HYBRID INSTRUMENTS
 Accounting for Certain Hybrid Financial Instruments Accounting for Derivative Instruments and Hedging Activities
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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 8. HYBRID INSTRUMENTS  (Concluded)
  9. STOCK COMPENSATION PLANS
   12




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 9. STOCK COMPENSATION PLANS  (Continued)
  1998 Plan
    
    
    Omnibus PlanNumber of Options
    
    
    Weighted Average Exercise Price
    
    
    Number of Options
    
    
    Weighted Average Exercise PriceOutstanding at January 1, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    250,000
    
    
    $
    17.00Granted during the period
    
    
    
    
    
    
    
    
    
    
    216,188
    
    
    
    20.75Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercised during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at March 31, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    466,188
    
    
    $
    18.74Outstanding at January 1, 2008
    
    
    927,775
    
    
    $
    2.24
    
    
    
    573,688
    
    
    $
    19.10Granted during the period
    
    
    
    
    
    
    
    
    
    
    148,500
    
    
    
    14.93Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    12,700
    
    
    
    18.77Exercised during the period
    
    
    287,960
    
    
    
    1.81
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at March 31, 2008
    
    
    639,815
    
    
    $
    2.48
    
    
    
    709,488
    
    
    $
    18.24Exercisable at:March 31, 2007
    
    
    927,775
    
    
    $
    2.24
    
    
    
    
    
    
    $
    March 31, 2008
    
    
    639,815
    
    
    
    2.48
    
    
    
    150,355
    
    
    
    18.75
    Options Outstanding
    
    
    Options ExercisableWeighted-Average
    
    
    Weighted-Average
    
    
    
    
    
    
    Weighted-AverageRange of
    
    Outstanding as of
    
    
    Remaining
    
    
    Exercise Price Per
    
    
    Exercisable as of
    
    
    Exercise Price PerExercisable Price
    

March 31, 2008
    
    
    Contractual Life
    
    
    Share
    
    
    March 31, 2008
    
    
    Share1998 Plan$1.73 - $1.95
    
    
    522,802
    
    
    3.36 Years
    
    $
    1.71
    
    
    
    522,802
    
    
    $
    1.71$4.86 - $6.49
    
    
    117,013
    
    
    
    2.51
    
    
    
    5.92
    
    
    
    117,013
    
    
    
    5.92Total
    
    
    639,815
    
    
    
    3.21
    
    
    
    2.48
    
    
    
    639,815
    
    
    
    2.48Omnibus Plan$14.93 - $20.75
    
    
    709,488
    
    
    8.08 Years
    
    $
    18.24
    
    
    
    150,355
    
    
    $
    18.75Total
    
    
    709,488
    
    
    
    8.08
    
    
    
    18.24
    
    
    
    150,355
    
    
    
    18.75
  13




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 9. STOCK COMPENSATION PLANS  (Concluded)
  Three Months EndedMarch 31,2008
    
    2007Omnibus PlanExpected term
    
    
    6.0
    
    
    
    5.0Expected stock price volatility
    
    
    29.23
    %
    
    
    26.50
    %Risk-free interest rate
    
    
    2.90
    %
    
    
    4.50
    %Expected dividend yield
    
    
    
    
    
    
    Estimated fair value per option
    
    $
    5.13
    
    
    $
    6.71
 (SAB 110) Share-Based Payment (SFAS 123(R))
   10. FAIR VALUE MEASUREMENT
 Accounting for Certain
Investments in Debt and Equity Securities
 The Fair Value Option of Financial Assets and Financial
Liabilities
 Fair Value Measurements
 14




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Continued)
 (Unaudited)
 10. FAIR VALUE MEASUREMENT  (Continued)
 Effective Date of FASB Statement No. 157
  
 
 
  15




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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes to Condensed
Consolidated Financial Statements  (Concluded)
 (Unaudited)
 10. FAIR VALUE MEASUREMENT  (Concluded)
  Fair Value Measurements UsingTotal
    
    
    Level 1
    
    
    Level 2(Dollars in thousands)Available for sale investments:Fixed maturity securities
    
    $
    392,768
    
    
    $
    6,393
    
    
    $
    386,375Equity securities
    
    
    2,363
    
    
    
    2,353
    
    
    
    10Short-term investments
    
    
    35,083
    
    
    
    32,057
    
    
    
    3,026Hybrid securities
    
    
    33,990
    
    
    
    
    
    
    
    33,990Alternative investments
    
    
    9,718
    
    
    
    
    
    
    
    9,718Total
    
    $
    473,922
    
    
    $
    40,803
    
    
    $
    433,119
   11. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
  Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Unrealized holding gains (losses) on
securities, net of tax
    
    $
    2,440
    
    
    $
    (687
    )Fair value of interest rate swap, net of tax
    
    
    (1,226
    )
    
    
    (94
    )Total accumulated other comprehensive loss
    
    $
    1,214
    
    
    $
    (781
    )
 16




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
   Overview
 ®
     17




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##### Table of Contents



Premiums Produced
  Critical Accounting Policies
   Use of Estimates
  Loss and Loss Adjustment Expense Reserves
  18




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##### 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.
    March 31,
    
    
    December 31,2008
    
    
    2007(Dollars in thousands)GrossCase reserves
    
    $
    79,663
    
    
    $
    69,699IBNR and ULAE reserves
    
    
    221,651
    
    
    
    202,666Total reserves
    
    $
    301,314
    
    
    $
    272,365Net of reinsuranceCase reserves
    
    $
    59,885
    
    
    $
    52,668IBNR and ULAE reserves
    
    
    138,361
    
    
    
    128,253Total
    
    $
    198,246
    
    
    $
    180,921
 19




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##### Table of Contents



Revenue Recognition
 Premiums
 Commissions and Fees
 Investments
 Accounting for Certain Hybrid Financial Instruments The Fair Value Option of Financial Assets and
Financial Liabilities
  Deferred Policy Acquisition Costs
  Intangible Assets
 Goodwill and Other Intangible Assets,
 Accounting for the Impairment or Disposal of Long-lived
Assets,
 20




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##### Table of Contents



Results of Operations
 Three Months Ended March 31, 2008 Compared to Three Months Ended March 31, 2007
  Three Months EndedMarch 31,2008
    
    
    2007
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    43,571
    
    
    $
    44,929
    
    
    
    (3)
    %Commissions and fees
    
    
    7,029
    
    
    
    4,657
    
    
    
    51Net investment income
    
    
    4,853
    
    
    
    3,294
    
    
    
    47Net realized gains on investments
    
    
    1
    
    
    
    135
    
    
    
    (99
    )Total Operating Revenues
    
    
    55,454
    
    
    
    53,015
    
    
    
    5Operating ExpensesLosses and loss adjustment expenses, net
    
    
    23,444
    
    
    
    23,954
    
    
    
    (2
    )Amortization of intangible assets
    
    
    539
    
    
    
    307
    
    
    
    76Other operating expenses
    
    
    15,265
    
    
    
    12,469
    
    
    
    22Total Operating Expenses
    
    
    39,248
    
    
    
    36,730
    
    
    
    7Operating Income
    
    
    16,206
    
    
    
    16,285
    
    
    
    (0
    )Interest Expense
    
    
    1,899
    
    
    
    1,089
    
    
    
    74Income Before Income Taxes
    
    
    14,307
    
    
    
    15,196
    
    
    
    (6
    )Income Taxes
    
    
    4,586
    
    
    
    5,229
    
    
    
    (12
    )Net Income
    
    $
    9,721
    
    
    $
    9,967
    
    
    
    (2)
    %Loss Ratio
    
    
    53.8
    %
    
    
    53.3
    %
    
    0.5 pointsUnderwriting Expense Ratio
    
    
    21.2
    %
    
    
    20.4
    %
    
    0.8 pointsCombined Ratio
    
    
    75.0
    %
    
    
    73.7
    %
    
    1.3 points
 Premiums Produced
  21




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Three Months EndedMarch 31,2008
    
    
    2007
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    76,214
    
    
    $
    59,334
    
    
    
    28
    %Assumed
    
    
    4,993
    
    
    
    1,266
    
    
    
    294Ceded
    
    
    (22,704
    )
    
    
    (26,140
    )
    
    
    (13
    )Net written premiums
    
    $
    58,503
    
    
    $
    34,460
    
    
    
    70
    %Earned premiumsDirect
    
    $
    68,653
    
    
    $
    53,374
    
    
    
    29
    %Assumed
    
    
    3,752
    
    
    
    1,086
    
    
    
    245Ceded
    
    
    (27,679
    )
    
    
    (11,064
    )
    
    
    150Earned but
unbilled premiums
    
    
    (1,155
    )
    
    
    1,533
    
    
    
    (175
    )Net earned premiums
    
    $
    43,571
    
    
    $
    44,929
    
    
    
    (3)
    %
     22




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##### Table of Contents



Commissions and Fees
 Three Months EndedMarch 31,2008
    
    
    2007
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and
fees
    
    $
    1,329
    
    
    $
    1,872
    
    
    
    (29)
    %Insurance services commissions and fees
    
    
    5,700
    
    
    
    2,785
    
    
    
    105Total commissions and fees
    
    $
    7,029
    
    
    $
    4,657
    
    
    
    51
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Three Months EndedMarch 31,2008
    
    
    2007
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition
expenses
    
    $
    8,213
    
    
    $
    8,739
    
    
    
    (6)
    %Ceded reinsurance commissions
    
    
    (8,483
    )
    
    
    (8,258
    )
    
    
    3Other underwriting and operating expenses
    
    
    15,535
    
    
    
    11,988
    
    
    
    30Other operating expenses
    
    $
    15,265
    
    
    $
    12,469
    
    
    
    22
    %
  23




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##### Table of Contents



Interest Expense
  Income taxes
 Liquidity and Capital Resources
 Sources and Uses of Funds
 FMFC
 Insurance Subsidiaries
  Non-insurance Subsidiaries
 24




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##### Table of Contents



Cash Flows
  Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Cash and cash equivalents provided
by (used in):Operating activities
    
    $
    26,162
    
    
    $
    51,628Investing activities
    
    
    (23,780
    )
    
    
    (56,396
    )Financing activities
    
    
    22
    
    
    
    Change in cash and cash equivalents
    
    $
    2,404
    
    
    $
    (4,768
    )
     Long-term debt
 Junior Subordinated Debentures
 Credit Facility
 25




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##### Table of Contents



Derivative Financial Instruments
 Cash and Invested Assets
  March 31, 2008Market Value
    
    
    % of Portfolio(Dollars in thousands)Money Market Funds
    
    $
    32,057
    
    
    
    6.8
    %Certificates of Deposit
    
    
    3,026
    
    
    
    0.6
    %Treasury Securities
    
    
    6,393
    
    
    
    1.3
    %Agency Securities
    
    
    1,496
    
    
    
    0.3
    %Corp / Preferred
    
    
    57,350
    
    
    
    12.1
    %Municipal Bonds
    
    
    216,690
    
    
    
    45.7
    %Asset backed Securities
    
    
    44,161
    
    
    
    9.3
    %Mortgages
    
    
    66,678
    
    
    
    14.1
    %Convertible Securities
    
    
    33,990
    
    
    
    7.2
    %High Yield Convertible Fund
    
    
    9,718
    
    
    
    2.1
    %Common Stock
    
    
    2,353
    
    
    
    0.5
    %Other
    
    
    10
    
    
    
    0.0
    %Total
    
    $
    473,922
    
    
    
    100.0
    %
  Average Life
    
    
    % of Total
 InvestmentLess than one year
    
    
    20.9
    %One to two years
    
    
    9.1
    %Two to three years
    
    
    17.0
    %Three to four years
    
    
    15.5
    %Four to five years
    
    
    11.8
    %Five to seven years
    
    
    9.7
    %More than seven years
    
    
    16.0
    %Total
    
    
    100.0
    %
  26




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##### Table of Contents



S&P Rating
    
    % of Total
 InvestmentsAAA
    
    
    65.7
    %AA
    
    
    14.7
    %A
    
    
    10.1
    %BBB
    
    
    5.2
    %BB
    
    
    1.3
    %B
    
    
    2.2
    %CCC
    
    
    0.1
    %NR
    
    
    0.7
    %Total
    
    
    100.0
    %
      27




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##### Table of Contents



Deferred Policy Acquisition Costs
  28




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##### Table of Contents



Reinsurance
  Three Months EndedMarch 31,2008
    
    
    2007(Dollars in thousands)Direct written premiums
    
    $
    76,214
    
    
    $
    59,334Ceded written premiums
    
    
    22,704
    
    
    
    26,140Net written premiums
    
    $
    53,510
    
    
    $
    33,194Ceded written premiums as
percentage of direct written
premiums
    
    
    29.8
    %
    
    
    44.1
    %
  Three Months EndedMarch 31,2008
    
    2007(Dollars in thousands)Ceded written premiums
    
    $
    22,704
    
    
    $
    26,140Ceded premiums earned
    
    
    27,679
    
    
    
    11,064Losses and loss
adjustment expenses
ceded
    
    
    14,893
    
    
    
    3,981Ceding commissions
    
    
    10,866
    
    
    
    3,021
    Recent Accounting Pronouncements
 Fair Value Measurements Effective Date of FASB Statement No. 157
 29




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##### Table of Contents



Business Combinations (SFAS 141(R))
 Noncontrolling Interests in Consolidated
Financial Statementsan amendment of Accounting Research Bulletin No. 51 (SFAS 160)
 Disclosures about Derivative Instruments and
Hedging Activities  an amendment of FASB Statement No. 133 (SFAS 161).
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
  30




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##### Table of Contents



PART II.  OTHER INFORMATION
 
 Item 6. Exhibits
  31




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##### Table of Contents



SIGNATURES
  FIRST MERCURY FINANCIAL CORPORATIONBy:
    /s/ RICHARD  H. SMITHRichard H. SmithChairman, President  and Chief Executive OfficerBy:
    /s/ JOHN A. MARAZZAJohn A. MarazzaExecutive Vice President, Chief Financial Officer
and TreasurerDate:
    May 9, 2008 32




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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 33