##### 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, 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.)29621 Northwestern HwyPO Box 5096
    
    48034Southfield, Michigan
    
    (Zip Code)(Address of Principal Executive Offices)
  þ o
  o o þ
 o þ




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##### 



TABLE OF CONTENTS
 Item
    
    
    
    PagePART I  FINANCIAL INFORMATION1.
    

Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets
    
    3Condensed Consolidated Statements of Income
    
    4Condensed Consolidated Statements of Stockholders Equity
    
    5Condensed Consolidated Statements of Cash Flows
    
    6Notes to Condensed Consolidated Financial Statements (Unaudited)
    
    72.
    

Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    143.
    

Quantitative
and Qualitative Disclosures about Market Risk
    
    264.
    

Controls
and Procedures
    
    26PART II  OTHER INFORMATION6.
    

Exhibits
    
    27Certification of Chief Executive OfficerCertification of Chief Financial Officer1350 Certification of Chief Executive Officer1350 Certification of Chief Financial Officer
 2




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##### Table of Contents

\

FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 PART I.  FINANCIAL INFORMATION
 
 ITEM 1. Condensed Consolidated Financial Statements
 
 Condensed Consolidated Balance Sheets
 March 31,
    
    
    December 31,2007
    
    
    2006(Unaudited)(Dollars in thousands,except share and per share data)ASSETSInvestmentsDebt securities
    
    $
    310,466
    
    
    $
    260,323Equity securities and other
    
    
    2,986
    
    
    
    3,184Short-term
    
    
    46,530
    
    
    
    34,334Total Investments
    
    
    359,982
    
    
    
    297,841Cash and cash equivalents
    
    
    9,567
    
    
    
    14,335Premiums and reinsurance balances receivable
    
    
    28,155
    
    
    
    46,090Accrued investment income
    
    
    3,443
    
    
    
    2,931Accrued profit sharing commissions
    
    
    8,790
    
    
    
    7,735Reinsurance recoverable on paid and unpaid losses
    
    
    71,228
    
    
    
    69,437Prepaid reinsurance premiums
    
    
    25,454
    
    
    
    10,377Deferred acquisition costs
    
    
    14,448
    
    
    
    18,452Intangible assets, net of accumulated amortization
    
    
    37,571
    
    
    
    37,878Other assets
    
    
    8,027
    
    
    
    7,857Total Assets
    
    $
    566,665
    
    
    $
    512,933LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    211,271
    
    
    $
    191,013Unearned premium reserves
    
    
    97,943
    
    
    
    91,803Long-term debt
    
    
    46,394
    
    
    
    46,394Funds held under reinsurance treaties
    
    
    9,013
    
    
    
    Reinsurance payable on paid losses
    
    
    2,840
    
    
    
    2,877Premiums payable to insurance companies
    
    
    1,776
    
    
    
    728Deferred federal income taxes
    
    
    271
    
    
    
    1,642Accounts payable, accrued expenses, and other liabilities
    
    
    14,309
    
    
    
    5,738Total Liabilities
    
    
    383,817
    
    
    
    340,195Stockholders EquityCommon stock, $0.01 par value; authorized 100,000,000 shares; issued
and outstanding 17,335,019 and 17,330,831 shares
    
    
    174
    
    
    
    174Paid-in-capital
    
    
    153,630
    
    
    
    153,600Accumulated other comprehensive loss
    
    
    (781
    )
    
    
    (761
    )Retained earnings
    
    
    30,423
    
    
    
    20,323Treasury stock; 92,500 shares
    
    
    (598
    )
    
    
    (598
    )Total Stockholders Equity
    
    
    182,848
    
    
    
    172,738Total Liabilities and Stockholders Equity
    
    $
    566,665
    
    
    $
    512,933
  3




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Income
 (Unaudited)
 Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands, except share and per share data)Operating RevenueNet earned premiums
    
    $
    44,929
    
    
    $
    28,529Commissions and fees
    
    
    4,657
    
    
    
    4,444Net investment income
    
    
    3,294
    
    
    
    2,150Net realized gains (losses) on investments
    
    
    135
    
    
    
    (153
    )Total Operating Revenues
    
    
    53,015
    
    
    
    34,970Operating ExpensesLosses and loss adjustment expenses, net
    
    
    23,954
    
    
    
    14,907Amortization of deferred acquisition expenses
    
    
    8,739
    
    
    
    4,894Underwriting, agency and other expenses
    
    
    3,730
    
    
    
    4,210Amortization of intangible assets
    
    
    307
    
    
    
    292Total Operating Expenses
    
    
    36,730
    
    
    
    24,303Operating Income
    
    
    16,285
    
    
    
    10,667Interest Expense
    
    
    982
    
    
    
    2,648Change in Fair Value of Derivative Instruments
    
    
    107
    
    
    
    (229
    )Income Before Income Taxes
    
    
    15,196
    
    
    
    8,248Income Taxes
    
    
    5,229
    
    
    
    2,869Net Income
    
    $
    9,967
    
    
    $
    5,379Net Income Per Share:Basic
    
    $
    0.58
    
    
    $
    1.07Diluted
    
    $
    0.55
    
    
    $
    0.44Weighted Average Shares Outstanding:Basic
    
    
    17,331,901
    
    
    
    4,183,479Diluted
    
    
    18,183,841
    
    
    
    12,291,514
  4




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##### Table of Contents



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
    
    
    1
    
    
    
    
    
    
    
    243
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    244Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,379
    
    
    
    
    
    
    
    5,379Other comprehensive loss, net of taxUnrealized holding losses on securities
arising during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (822
    )
    
    
    
    
    
    
    
    
    
    
    (822
    )Less reclassification adjustment for
losses included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    99
    
    
    
    
    
    
    
    
    
    
    
    99Total other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (723
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,656Balance, March 31, 2006
    
    $
    43
    
    
    $
    
    
    
    $
    59,100
    
    
    $
    (2,007
    )
    
    $
    12,091
    
    
    $
    
    
    
    $
    69,227Balance, 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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    440
    
    
    
    
    
    
    
    
    
    
    
    440Less reclassification adjustment for
gains included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (245
    )
    
    
    
    
    
    
    
    
    
    
    (245
    )Change in fair value of interest rate swap
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (82
    )
    
    
    
    
    
    
    
    
    
    
    (82
    )Total other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    113Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,080Balance, March 31, 2007
    
    $
    174
    
    
    $
    
    
    
    $
    153,630
    
    
    $
    (781
    )
    
    $
    30,423
    
    
    $
    (598
    )
    
    $
    182,848
  5




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
 (Unaudited)
 Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Cash Flows from Operating ActivitiesNet Income
    
    $
    9,967
    
    
    $
    5,379Adjustments to reconcile net income to net cash provided by
operating activitiesDepreciation and amortization
    
    
    471
    
    
    
    612Realized (gains) losses on investments
    
    
    (135
    )
    
    
    153Deferrals of acquisition costs, net
    
    
    4,003
    
    
    
    1,891Deferred income taxes
    
    
    (1,371
    )
    
    
    (1,234
    )Stock-based compensation expense
    
    
    30
    
    
    
    Increase (decrease) in cash resulting from changes in assets
and liabilitiesPremiums and reinsurance balances receivable
    
    
    17,935
    
    
    
    (3,252
    )Accrued investment income
    
    
    (512
    )
    
    
    (198
    )Receivable from related entity
    
    
    (180
    )
    
    
    108Accrued profit sharing commissions
    
    
    (1,055
    )
    
    
    (1,101
    )Reinsurance recoverable on paid and unpaid losses
    
    
    (1,791
    )
    
    
    (9,664
    )Prepaid reinsurance premiums
    
    
    (15,077
    )
    
    
    (8,689
    )Loss and loss adjustment expense reserves
    
    
    20,258
    
    
    
    19,086Unearned premium reserves
    
    
    6,140
    
    
    
    7,448Funds held under reinsurance treaties
    
    
    9,013
    
    
    
    Reinsurance payable on paid losses
    
    
    (37
    )
    
    
    3,504Premiums payable to insurance companies
    
    
    1,048
    
    
    
    (1,482
    )Other
    
    
    2,921
    
    
    
    5,112Net Cash Provided By Operating Activities
    
    
    51,628
    
    
    
    17,673Cash Flows From Investing ActivitiesCost of short-term investments acquired
    
    
    (96,859
    )
    
    
    (71,114
    )Proceeds from disposals of short-term investments
    
    
    84,663
    
    
    
    76,657Cost of debt and equity securities acquired
    
    
    (59,587
    )
    
    
    (41,723
    )Proceeds from debt and equity securities
    
    
    16,035
    
    
    
    17,228Change in receivable from stockholders
    
    
    
    
    
    
    (16
    )Cost of fixed asset purchases
    
    
    (648
    )
    
    
    (61
    )Net Cash Used In Investing Activities
    
    
    (56,396
    )
    
    
    (19,029
    )Cash Flows From Financing ActivitiesIssuance of common stock, net of issuance costs
    
    
    
    
    
    
    244Net Cash Provided By Financing Activities
    
    
    
    
    
    
    244Net Decrease In Cash and Cash Equivalents
    
    
    (4,768
    )
    
    
    (1,112
    )Cash and Cash Equivalents, beginning of period
    
    
    14,335
    
    
    
    8,400Cash and Cash Equivalents, end of period
    
    $
    9,567
    
    
    $
    7,288Supplemental Disclosure of Non-Cash Transactions:Securities purchases payable
    
    $
    6,063
    
    
    $
    
  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 EndedMarch 31,2007
    
    
    2006(Dollars in thousands,except share and per share data)Net Income
    
    $
    9,967
    
    
    $
    5,379Less: Dividends in arrears
    
    
    
    
    
    
    (894
    )Net income available to common
    
    
    9,967
    
    
    
    4,485Weighted-average number of common and common equivalent shares outstanding:Basic number of common shares outstanding
    
    
    17,331,901
    
    
    
    4,183,479Dilutive effect of stock options
    
    
    837,213
    
    
    
    820,232Dilutive effect of unvested restricted stock
    
    
    14,727
    
    
    
    Dilutive effect of convertible preferred stock
    
    
    
    
    
    
    6,434,783Dilutive effect of cumulative dividends on preferred stock
    
    
    
    
    
    
    853,020Dilutive number of common and common equivalent shares outstanding
    
    
    18,183,841
    
    
    
    12,291,514Basic Net Income Per Common Share
    
    $
    0.58
    
    
    $
    1.07Diluted Net Income Per Common Share
    
    $
    0.55
    
    
    $
    0.44Anti-dilutive
shares excluded from diluted net income per common share
    
    
    16,181
    
    
    
    
 3.
    
    INCOME TAXES
 Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109 Accounting for Income Taxes.
 8




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 3.
    
    INCOME TAXES  (Concluded)
   4.
    
    LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Balance,beginning of period
    
    $
    191,013
    
    
    $
    113,864Less reinsurance recoverables
    
    
    66,926
    
    
    
    21,869Net Balance,beginning of period
    
    
    124,087
    
    
    
    91,995Incurred Related ToCurrent year
    
    
    24,069
    
    
    
    14,404Prior years
    
    
    (115
    )
    
    
    503Total Incurred
    
    
    23,954
    
    
    
    14,907Paid Related ToCurrent year
    
    
    177
    
    
    
    104Prior years
    
    
    5,719
    
    
    
    5,588Total Paid
    
    
    5,896
    
    
    
    5,692Net Balance
    
    
    142,145
    
    
    
    101,210Plus reinsurance recoverables
    
    
    69,126
    
    
    
    31,739Balance,end of period
    
    $
    211,271
    
    
    $
    132,949
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##### Table of Contents



FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Continued)
(Unaudited)
 5.
    
    REINSURANCE
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Written PremiumsDirect
    
    $
    59,334
    
    
    $
    55,537Assumed
    
    
    1,266
    
    
    
    1,339Ceded
    
    
    (26,140
    )
    
    
    (29,768
    )Net Written Premiums
    
    $
    34,460
    
    
    $
    27,108Earned PremiumsDirect
    
    $
    53,374
    
    
    $
    48,861Assumed
    
    
    1,086
    
    
    
    765Ceded
    
    
    (11,064
    )
    
    
    (21,278
    )Earned but unbilled premiums
    
    
    1,533
    
    
    
    181Net Earned Premiums
    
    $
    44,929
    
    
    $
    28,529
    6.
    
    RELATED PARTY TRANSACTIONS
   10




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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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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
    
    
    76,312
    
    
    
    6.49
    
    
    
    
    
    
    
    Forfeited during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercised during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cancelled during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Outstanding at March 31, 2006
    
    
    1,195,840
    
    
    $
    2.12
    
    
    
    
    
    
    $
    Oustanding 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
    
    
    $
    18.74Exercisable at:March 31, 2006
    
    
    1,119,528
    
    
    $
    1.85
    
    
    
    
    
    
    
    March 31, 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
    
    March 31, 2007
    
    
    Contractual Life
    
    
    Share
    
    
    March 31, 2007
    
    
    Share1998 Plan$1.51 - $2.14
    
    
    810,762
    
    
    3.98 Years
    
    $
    1.71
    
    
    
    810,762
    
    
    $
    1.71$4.86 - $6.49
    
    
    117,013
    
    
    
    6.77
    
    
    
    5.92
    
    
    
    117,013
    
    
    
    5.92Total
    
    
    927,775
    
    
    
    4.33
    
    
    
    2.24
    
    
    
    927,775
    
    
    
    2.24Omnibus Plan$17.00-$20.75
    
    
    466,188
    
    
    6.73 Years
    
    $
    18.74
    
    
    
    
    
    
    $
    Total
    
    
    466,188
    
    
    
    6.73
    
    
    $
    18.74
    
    
    
    
    
    
    $
    
  12




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FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements  (Concluded)
(Unaudited)
 8.
    
    STOCK COMPENSATION PLANS  (Concluded)
  Three Months EndedMarch 31,2007
    
    20061998 PlanExpected term
    
    
    
    
    
    
    2.5Expected stock price volatility
    
    
    
    
    
    
    26.51
    %Risk-free interest rate
    
    
    
    
    
    
    4.72
    %Expected dividend yield
    
    
    
    
    
    
    Estimated fair value per option
    
    
    
    
    
    $
    1.39Omnibus PlanExpected term
    
    
    5.0
    
    
    
    Expected stock price volatility
    
    
    26.50
    %
    
    
    Risk-free interest rate
    
    
    4.50
    %
    
    
    Expected dividend yield
    
    
    
    
    
    
    Estimated fair value per option
    
    $
    6.71
    
    
    
    
 Share-Based Payment (SFAS 123(R))
   9.
    
    ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Unrealized holding losses on securities, net of tax
    
    
    (687
    )
    
    
    (2,007
    )Fair value of interest rate swap, net of tax
    
    
    (94
    )
    
    
    Total accumulated other comprehensive loss
    
    $
    (781
    )
    
    $
    (2,007
    )
 13




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
   Overview
 ®
     14




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##### Table of Contents



Premiums Produced
  Critical Accounting Policies
   Use of Estimates
  Loss and Loss Adjustment Expense Reserves
   15




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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 31,2007
    
    
    2006(Dollars in thousands)GrossCase reserves
    
    $
    49,615
    
    
    $
    47,004IBNR and ULAE reserves
    
    
    161,656
    
    
    
    144,009Total reserves
    
    $
    211,271
    
    
    $
    191,013Net of reinsuranceCase reserves
    
    $
    38,359
    
    
    $
    37,376IBNR and ULAE reserves
    
    
    103,787
    
    
    
    86,711Total
    
    $
    142,146
    
    
    $
    124,087
 Revenue Recognition
 Premiums
 16




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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,
 17




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##### Table of Contents



Results of Operations
 Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006
  Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Operating RevenueNet earned premiums
    
    $
    44,929
    
    
    $
    28,529
    
    
    
    57
    %Commissions and fees
    
    
    4,657
    
    
    
    4,444
    
    
    
    5Net investment income
    
    
    3,294
    
    
    
    2,150
    
    
    
    53Net realized gains (losses) on investments
    
    
    135
    
    
    
    (153
    )
    
    
    (188
    )Total Operating Revenues
    
    
    53,015
    
    
    
    34,970
    
    
    
    52Operating ExpensesLosses and loss adjustment expenses, net
    
    
    23,954
    
    
    
    14,907
    
    
    
    61Amortization of intangible assets
    
    
    307
    
    
    
    292
    
    
    
    5Other operating expenses
    
    
    12,469
    
    
    
    9,104
    
    
    
    37Total Operating Expenses
    
    
    36,730
    
    
    
    24,303
    
    
    
    51Operating Income
    
    
    16,285
    
    
    
    10,667
    
    
    
    53Interest Expense
    
    
    1,089
    
    
    
    2,419
    
    
    
    (55
    )Income Before Income Taxes
    
    
    15,196
    
    
    
    8,248
    
    
    
    84Income Taxes
    
    
    5,229
    
    
    
    2,869
    
    
    
    82Net Income
    
    $
    9,967
    
    
    $
    5,379
    
    
    
    85
    %Loss Ratio
    
    
    53.3
    %
    
    
    52.3
    %
    
    1.0 pointUnderwriting Expense Ratio
    
    
    20.4
    %
    
    
    22.5
    %
    
    (2.1 points)Combined Ratio
    
    
    73.7
    %
    
    
    74.8
    %
    
    (1.1 points)
 Premiums Produced
  18




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##### Table of Contents



Operating Revenue
 Net Earned Premiums
 Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Written premiumsDirect
    
    $
    59,334
    
    
    $
    55,537
    
    
    
    7
    %Assumed
    
    
    1,266
    
    
    
    1,339
    
    
    
    (5
    )Ceded
    
    
    (26,140
    )
    
    
    (29,768
    )
    
    
    (12
    )Net written premiums
    
    $
    34,460
    
    
    $
    27,108
    
    
    
    27
    %Earned premiumsDirect
    
    $
    53,374
    
    
    $
    48,861
    
    
    
    9
    %Assumed
    
    
    1,086
    
    
    
    765
    
    
    
    42Ceded
    
    
    (11,064
    )
    
    
    (21,278
    )
    
    
    (48
    )Earned but unbilled premiums
    
    
    1,533
    
    
    
    181
    
    
    
    747Net earned premiums
    
    $
    44,929
    
    
    $
    28,529
    
    
    
    57
    %
     19




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##### Table of Contents



Commissions and Fees
 Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Insurance underwriting commissions and fees
    
    $
    1,872
    
    
    $
    1,431
    
    
    
    31
    %Insurance services commissions and fees
    
    
    2,785
    
    
    
    3,013
    
    
    
    (8
    )Total commissions and fees
    
    $
    4,657
    
    
    $
    4,444
    
    
    
    5
    %
  Net Investment Income and Realized Gains on Investments
  Operating Expenses
 Losses and Loss Adjustment Expenses
 Other Operating Expenses
 Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Amortization of deferred acquisition expenses
    
    $
    8,739
    
    
    $
    4,894
    
    
    
    79
    %Ceded reinsurance commissions
    
    
    (8,258
    )
    
    
    (9,063
    )
    
    
    (9
    )Other underwriting and operating expenses
    
    
    11,988
    
    
    
    13,273
    
    
    
    (10
    )Other operating expenses
    
    $
    12,469
    
    
    $
    9,104
    
    
    
    37
    %
 20




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##### Table of Contents



Interest Expense
 Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Change(Dollars in thousands)Senior notes
    
    $
    
    
    
    $
    2,210
    
    
    
    (100
    )%Junior subordinated debentures
    
    
    1,089
    
    
    
    206
    
    
    
    429Other
    
    
    
    
    
    
    3
    
    
    
    (100
    )%Total interest expense
    
    $
    1,089
    
    
    $
    2,419
    
    
    
    (55
    )%
  Income taxes
 Liquidity and Capital Resources
 Sources and Uses of Funds
 FMFC
 Insurance Subsidiaries
  Non-insurance Subsidiaries
 21




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##### Table of Contents



Cash Flows
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Cash and cash equivalents provided by (used in):Operating activities
    
    $
    51,628
    
    
    $
    17,673Investing activities
    
    
    (56,396
    )
    
    
    (19,029
    )Financing activities
    
    
    
    
    
    
    244Change in cash and cash equivalents
    
    $
    (4,768
    )
    
    $
    (1,112
    )
     Long-term debt
 Junior Subordinated Debentures
 Credit Facility
 22




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##### Table of Contents



Derivative Financial Instruments
 Cash and Invested Assets
  March 31, 2007Market Value
    
    
    % of Portfolio(Dollars in thousands)Money Market Funds
    
    $
    46,519
    
    
    
    12.9
    %Treasury Securities
    
    
    8,444
    
    
    
    2.3
    %Agency Securities
    
    
    839
    
    
    
    0.2
    %Corp / Preferred
    
    
    37,216
    
    
    
    10.3
    %Municipal Bonds
    
    
    164,080
    
    
    
    45.6
    %Asset backed Securities
    
    
    45,544
    
    
    
    12.7
    %Mortgages
    
    
    32,562
    
    
    
    9.0
    %Convertible Securities
    
    
    24,715
    
    
    
    6.9
    %Other
    
    
    63
    
    
    
    0.1
    %Total
    
    $
    359,982
    
    
    
    100.0
    %
  % of TotalAverage Life
    
    InvestmentLess than one year
    
    
    23.7
    %One to two years
    
    
    10.8
    %Two to three years
    
    
    12.1
    %Three to four years
    
    
    19.7
    %Four to five years
    
    
    12.9
    %Five to seven years
    
    
    10.8
    %More than seven years
    
    
    10.0
    %Total
    
    
    100.0
    %
  23




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##### Table of Contents



% of TotalS&P Rating
    
    InvestmentsAAA
    
    
    76.9
    %AA
    
    
    8.7
    %A
    
    
    7.7
    %BBB
    
    
    5.4
    %BB
    
    
    0.7
    %B
    
    
    0.5
    %CCC
    
    
    0.1
    %NR
    
    
    0.0
    %Total
    
    
    100.0
    %
    Deferred Policy Acquisition Costs
   24




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##### Table of Contents



Reinsurance
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Direct written premiums
    
    $
    59,334
    
    
    $
    55,537Ceded written premiums
    
    
    26,140
    
    
    
    29,768Net written premiums
    
    $
    33,194
    
    
    $
    25,769Ceded written premiums as percentage of direct written premiums
    
    
    44.1
    %
    
    
    53.6
    %
  Three Months EndedMarch 31,2007
    
    
    2006(Dollars in thousands)Ceded written premiums
    
    $
    26,140
    
    
    $
    29,768Ceded premiums earned
    
    
    11,064
    
    
    
    21,278Losses and loss adjustment expenses ceded
    
    
    3,981
    
    
    
    10,856Ceding commissions
    
    
    3,021
    
    
    
    6,586
    Recent Accounting Pronouncements
 Fair
Value Measurements (SFAS 157)
 25




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##### Table of Contents



The Fair Value Option for Financial Assets
and Financial Liabilities (SFAS 159),
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
  26




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##### Table of Contents



PART II.  OTHER INFORMATION
 
 Item 6. Exhibits
  27




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##### Table of Contents



SIGNATURES
  FIRST MERCURY FINANCIAL CORPORATIONBy:
    
    /s/ RICHARD H. SMITH

Richard H. SmithChairman, President and Chief Executive OfficerBy:
    
    /s/ JOHN A. MARAZZA

John A. MarazzaExecutive Vice President, Chief Financial Officer
and TreasurerDate:
    
    May 10, 2007
 28




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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 29