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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
OR
[ ] 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 1-8993
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2708455
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
80 SOUTH MAIN STREET, HANOVER, NEW HAMPSHIRE 03755-2053
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (603) 643-1567
Securities registered pursuant to Section 12(b) of the Act :
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
Common Stock, par value $1.00 New York Stock Exchange
per share
Securities registered pursuant to section 12(g) of the Act:
None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ______
-----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of voting shares (based on the closing price of
those shares listed on the New York Stock Exchange and the consideration
received for those shares not listed on a national or regional exchange) held by
non-affiliates of the registrant as of March 21, 1997, was $723,992,745.
As of March 21, 1997, 6,895,169 shares of Common Stock, par value of $1.00 per
share, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Notice of 1997 Annual Meeting of Shareholders and
Proxy Statement
dated March 31, 1997 (Part III)
FUND AMERICAN
TABLE OF CONTENTS
PART I
ITEM 1. Business............................................................................. 1
a. General.............................................................................. 1
b. Insurance Operations................................................................. 1
c. Mortgage Origination and Servicing Operations........................................ 5
d. Passive Investment Portfolio Management.............................................. 9
e. Certain Business Conditions.......................................................... 10
f. Competition.......................................................................... 10
g. Regulation........................................................................... 11
h. Employees............................................................................ 12
i. Forward-Looking Statements........................................................... 12
ITEM 2. Properties........................................................................... 12
ITEM 3. Legal Proceedings.................................................................... 12
ITEM 4. Submission of Matters to a Vote of Security Holders.................................. 12
PART II
ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 13
ITEM 6. Selected Financial Data............................................................... 14
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 15
ITEM 8. Financial Statements and Supplementary Data........................................... 26
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.. 26
PART III
ITEM 10. Directors and Executive Officers..................................................... 26
ITEM 11. Executive Compensation............................................................... 27
ITEM 12. Security Ownership of Certain Beneficial Owners and Management....................... 28
ITEM 13. Certain Relationships and Related Transactions....................................... 28
PART IV
ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K....................... 28
FUND AMERICAN
PART I
ITEM 1. BUSINESS
GENERAL
Fund American Enterprises Holdings, Inc., (the "Company"), is a Delaware
corporation which was organized in 1980. Within this report, the consolidated
organization is referred to as "Fund American." Fund American's principal
businesses are conducted through White Mountains Holdings, Inc. and its
operating subsidiaries ("White Mountains") and Source One Mortgage Services
Corporation and its subsidiaries ("Source One"). White Mountains is an
insurance holding company principally engaged through its subsidiaries and
affiliates in the businesses of property and casualty insurance, financial
guaranty insurance and reinsurance. Source One is one of the largest mortgage
banking companies in the United States. Fund American also owns a passive
investment portfolio. The Company's principal office is located at 80 South
Main Street, Hanover, New Hampshire, 03755-2053, and its telephone number is
(603) 643-1567.
INSURANCE OPERATIONS
In 1995 the Company capitalized White Mountains with $200.0 million of equity
capital and in 1996 further capitalized White Mountains with an additional $95.0
million of equity capital. White Mountains was formed to be the holding company
for all of Fund American's consolidated and unconsolidated insurance operating
interests. As of December 31, 1996, White Mountains' principal holdings
included investments in: Financial Security Assurance Holdings Ltd. ("FSA"), a
leading Aaa/AAA writer of financial guaranty insurance; Folksamerica Holding
Company, Inc. ("Folksamerica"), a leading multi-line broker-market reinsurer,
Main Street America Holdings, Inc. ("MSA"), an affiliate of National Grange
Mutual Insurance Company ("NGM") which is a New Hampshire-based property and
casualty insurer; and the consolidated wholly-owned subsidiaries described
below.
CONSOLIDATED INSURANCE OPERATIONS
On December 1, 1995, White Mountains acquired Valley Group, Inc. of Albany,
Oregon, and its subsidiaries (collectively, "Valley") and Charter Group, Inc. of
Dallas, Texas, and its subsidiaries (collectively, "Charter") for $41.7 million
in cash less $3.0 million of purchase price adjustments. The purchase price for
Valley and Charter was paid with proceeds from sales and maturities of short-
term investments.
Valley: Valley's wholly-owned subsidiary, Valley Insurance Company, is an "A"
rated, Northwest-based property and casualty company which writes personal and
commercial lines. Valley Insurance Company focuses on establishing strong long-
term relationships with its agents and insured customers by focusing on
providing quality insurance products to the family unit and the independently
owned business. This approach has resulted in an established track record of
growth:
- -------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------------------------------------
Statutory Basis, in Millions 1996 1995 1994 1993 1992
- -------------------------------------------------------------------------------------------------------------------------
Direct written premiums $ 81.9 $ 73.1 $64.8 $52.5 $41.8
Total assets at year-end 138.2 126.8 80.4 65.8 50.4
Policyholders' surplus at year-end 54.3 58.5 23.5 22.9 15.0
=========================================================================================================================
1
FUND AMERICAN
In 1996 Valley Insurance Company wrote $81.9 million of direct premiums
primarily in three Northwest states, through approximately 245 independent
agents:
- --------------------------------------------------------------------------------
Year Ended December 31,
1996
-----------------------------------------------------
Direct Written Policies
Dollars in Millions Premiums in Force* Agents*
- --------------------------------------------------------------------------------
Oregon $ 40.9 31,118 99
California 27.5 12,910 74
Washington 13.2 4,554 63
Arizona, Idaho and Utah .3 222 9
-----------------------------------------------------
Totals $ 81.9 48,804 245
================================================================================
* At December 31, 1996.
Valley Insurance Company began to write business in the states of Arizona,
Idaho and Utah during the last quarter of 1996. Valley Insurance Company
intends to increase its premium writings in those states during 1997.
Valley Insurance Company's focus on delivering insurance products to the
family unit and the family-owned business has resulted in a book of business
which is balanced between personal lines and commercial lines. Direct written
premiums for Valley Insurance Company's primary lines of business are shown
below:
- ------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------------------------------------------------------------
Millions 1996 1995 1994 1993 1992
- ------------------------------------------------------------------------------------------------------------------
Personal lines:
Automobile $25.9 $23.9 $22.5 $20.5 $18.1
Homeowners 12.0 10.4 8.3 6.3 4.6
Other 1.3 1.1 .8 .8 .5
-----------------------------------------------------------------------------------
Total personal lines 39.2 35.4 31.6 27.6 23.2
-----------------------------------------------------------------------------------
Commercial lines:
Multiple peril 39.1 34.3 30.2 21.3 15.6
Other 3.6 3.4 3.0 3.6 3.0
-----------------------------------------------------------------------------------
Total commercial lines 42.7 37.7 33.2 24.9 18.6
-----------------------------------------------------------------------------------
Total direct written premiums $81.9 $73.1 $64.8 $52.5 $41.8
==================================================================================================================
The long-term relationships cultivated by Valley Insurance Company with its
agents and insured customers, along with superior customer service and
convenient premium billing and payment systems, have produced a relatively high
level of persistency in Valley Insurance Company's "package" book of business.
In 1996, package business represented over 80% of Valley's premium writings for
both personal and commercial lines:
- ----------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------------------------------------------------------
Renewal Retention Ratios 1996 1995 1994 1993 1992
- ----------------------------------------------------------------------------------------------------------------------------
Personal automobile/homeowners packages 89.4% 88.2% 87.8% 89.0% 88.7%
Commercial multiple peril packages 75.5% 76.5% 84.5% 86.0% 91.0%
============================================================================================================================
Renewal persistency can be a significant indicator of an insurance company's
long-term prospects for successful underwriting. An insurance company typically
incurs more marketing and underwriting costs to write new business (i.e.,
policies and premiums written for new customers) than it does to write
"seasoned" business (i.e., business that has renewed with the company over the
years). Additionally, losses and loss adjustment expenses are typically higher
and less predictable for new business than for seasoned business.
2
FUND AMERICAN
Charter: Charter, through its wholly-owned subsidiary Charter Indemnity
Company and its controlled affiliate, Northern County Mutual Insurance Company,
markets and underwrites nonstandard automobile insurance to individuals in the
State of Texas. For the year ended December 31, 1996, Charter's gross written
premiums totalled $70.0 million. Written premiums (and related expenses and
losses) for Charter's policies written prior to January 1, 1996, were entirely
ceded to Charter's former parent. Therefore, Charter's financial results for
years prior to 1996 are not meaningful for comparison purposes.
Charter writes all its business through independent agents located in Texas.
At December 31, 1996, Charter had approximately 750 agents located throughout
the State.
The nonstandard automobile insurance market consists of drivers who are unable
to obtain coverage from standard carriers due to prior driving records, other
underwriting criteria or market conditions. Management believes that
opportunities in the nonstandard automobile insurance market in Texas are
influenced by many factors including the market conditions for standard
automobile insurance, the residual market plan of the State, and the extent to
which State motor vehicle laws are enforced. The nonstandard automobile
insurance market has grown in recent years as the result of tightening of
underwriting standards by underwriters of standard and preferred automobile
insurance, and increased enforcement of motor vehicle laws including drunk
driving and uninsured motorist laws.
Charter offers both liability and physical damage coverage in the Texas
nonstandard automobile insurance market, generally with policies having terms of
12 months. Most of Charter's policyholders choose basic limits of liability
coverage which in Texas are $20,000 per person and $40,000 per accident for
bodily injury, and $15,000 for property damage. For the year ended December 31,
1996, Charter's direct written premiums totalled $47.9 million for liability
coverages and $22.1 million for property damage coverages.
Management pursues a strategy of establishing Charter as a low-cost provider
of nonstandard automobile insurance while maintaining a commitment to provide
"service beyond expectation" to both agents and insureds. Management believes
that Charter has become a low cost provider of nonstandard automobile insurance,
as evidenced by its underwriting expense ratio which was 19.0% for the year
ended December 31, 1996. Increased automation of certain marketing,
underwriting, claims and administrative functions has provided Charter with the
ability to process more business without a corresponding increase in costs,
while maintaining a high level of service to its agents and insured customers.
Management believes that most classes of nonstandard automobile insurance can
be underwritten profitably if they are priced adequately. Charter seeks to
classify risks into narrowly defined segments through the utilization of
available underwriting criteria and internal performance statistical data.
Charter maintains a proprietary database which contains statistical records with
respect to its agents and insureds. Management believes this database enhances
Charter's flexibility to analyze loss experience, and underwrite and price its
products based on a number of variables. Charter utilizes many factors and
analysis to determine its rates including: type, age and location of the
vehicle; number of vehicles per policyholder; number and type of traffic
violations or accidents; limits of liability; deductibles; and age, sex and
marital status of the insured. Charter's loss and loss adjustment expense ratio
for the year ended December 31, 1996, was 80.4% and its combined underwriting
ratio was 99.4%.
White Mountains Insurance Company ("WMIC"): WMIC is a New Hampshire licensed
commercial property and casualty company which commenced its operations in
September 1995 and wrote $2.4 million in direct premiums during 1996. WMIC is
currently licensed to write insurance in Maine, New Hampshire, Vermont and
Massachusetts and is expected to expand its operations to other states as
additional regulatory approvals are obtained. WMIC is a wholly-owned subsidiary
of Valley Insurance Company. At December 31, 1996, WMIC had $28.5 million of
total admitted assets and $26.8 million of policyholders' surplus.
3
FUND AMERICAN
Valley National Insurance Company ("Valley National"): On January 19, 1996,
Valley purchased an inactive insurance company for $13.2 million, net of cash
balances acquired. The newly acquired insurance company, which was renamed
Valley National, is licensed to write property and casualty insurance in 48
states. Assets acquired pursuant to the Valley National acquisition included an
investment portfolio, consisting principally of fixed maturity investments,
totalling $6.7 million. Valley National wrote its first policies in December
1996 and is expected to expand its operations in 1997.
All of White Mountains' consolidated insurance subsidiaries (the "Insurance
Companies") market their products principally through independent agents.
INVESTMENTS IN UNCONSOLIDATED INSURANCE AFFILIATES
FSA: In May 1994 the Company purchased 2,000,000 shares of the common stock
of FSA ("FSA Common Stock") from U S WEST Capital Corp., a wholly-owned
subsidiary of U S WEST, Inc. The purchase was part of an initial public
offering of 8,082,385 shares of FSA Common Stock at the initial offering price
of $20.00 per share. In 1995 and 1996, respectively, the Company purchased an
additional 460,200 shares of FSA Common Stock on the open market for $8.8
million and an additional 1,000,000 shares of FSA Common Stock in a private
transaction for $26.5 million.
FSA conducts operations principally through Financial Security Assurance Inc.,
a wholly-owned monoline financial guarantee insurance subsidiary with Aaa/AAA
claims-paying ratings. FSA is principally engaged in guaranteeing municipal
bonds, and residential mortgage and other asset-backed securities. For 1996 the
present value of FSA's gross written premiums totalled $226.3 million, its net
income was $80.8 million, and its year-end total assets and shareholders' equity
were $1.5 billion and $801.3 million, respectively.
In September 1994 the Company acquired various fixed price options and shares
of convertible preferred stock ("FSA Options and Preferred Stock") which, in
total, give Fund American the right to acquire up to 4,560,607 additional shares
of FSA Common Stock for aggregate consideration of $125.7 million. All shares
of and rights to FSA Common Stock owned or acquired by the Company as described
above are subject to certain restrictions on transfer, voting provisions and
other limitations and requirements set forth in a Shareholders' Agreement, a
Registration Rights Agreement and a Voting Trust Agreement. As of December 31,
1996 and 1995, Fund American's economic interest in FSA was approximately 25.1%
and 21.0%, respectively, and Fund American's voting interest in FSA was
approximately 23.0% and 19.0%, respectively. In December 1995 and January 1996
the Company transferred all of its interests in FSA existing at the time to
White Mountains.
John J. Byrne (Chairman of the Company) is Chairman of FSA and K. Thomas Kemp
(Executive Vice President of the Company and Chairman and Chief Executive
Officer of White Mountains), James H. Ozanne, (President of Fund American
Enterprises, Inc. ("FAE"), a wholly-owned subsidiary of the Company), and Allan
L. Waters (Senior Vice President and Chief Financial Officer of the Company) are
also directors of FSA. In addition to being FSA directors, Mr. Kemp is Chairman
of FSA's Human Resources Committee, Mr. Ozanne is Chairman of FSA's Underwriting
Committee, and Mr. Waters is Chief of Staff to FSA's Audit Committee.
Fund American's investment in FSA Common Stock is accounted for using the
equity method. FSA Common Stock is publicly traded on the New York Stock
Exchange ("NYSE"). The market value of the FSA Common Stock as of December 31,
1996, as quoted on the NYSE, exceeded Fund American's carrying value of the FSA
Common Stock on the equity method. Fund American's investment in FSA Options
and Preferred Stock is accounted for under the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 115 whereby the investments are
reported at fair value as of the balance sheet date, with related unrealized
investment gains and losses excluded from earnings and reported as a net amount
in a separate component of shareholders' equity.
4
FUND AMERICAN
MSA: In December 1994 the Company acquired 90,606 shares of the common stock
of MSA ("MSA Common Stock") for $25.0 million in cash. In 1995 the Company paid
NGM an additional $1.2 million in purchase price adjustments for the MSA Common
Stock. In December 1995 the Company transferred all of its interest in MSA to
White Mountains. White Mountains' investment in MSA represented approximately
33.2% and 33.1%, respectively, of the outstanding common stock of MSA as of
December 31, 1996 and 1995. White Mountains' President, Terry L. Baxter, and K.
Thomas Kemp are directors of MSA. Fund American's investment in MSA Common
Stock is accounted for using the equity method.
MSA participates in 40% of NGM's business through a reinsurance pooling
agreement. NGM writes personal and commercial property and casualty insurance
in the Eastern United States. MSA's net written premiums totalled $147.2
million in 1996, its net income was $9.9 million, and its year-end total assets
and shareholders' equity were $313.9 million and $101.7 million, respectively.
Folksamerica: On June 19, 1996, White Mountains completed its purchase, for
$79.9 million including related expenses, of a 50.0% interest in Folksamerica.
The purchase price for Folksamerica was paid with proceeds from sales and
maturities of short-term investments. Also on June 19, 1996, Folksamerica
completed its previously announced acquisition of Christiania General Insurance
Corporation of New York for $88.0 million.
Folksamerica owns a multi-line broker-market reinsurance company which in 1996
had net written premiums of $171.9 million. At December 31, 1996, Folksamerica
had total assets $1.0 billion, shareholders' equity of $167.6 million and total
capitalization of $241.6 million. Messrs. Kemp and Waters are directors of
Folksamerica.
White Mountains' investment in Folksamerica includes (i) 6,920,000 shares of
ten-year 6.5% voting preferred stock having a liquidation preference of $79.4
million ("Folksamerica Preferred Stock") and (ii) ten-year warrants
("Folksamerica Warrants") to purchase up to 6,920,000 shares of the Common Stock
of Folksamerica ("Folksamerica Common Stock") for $11.47 per share, subject to
certain adjustments. Folksamerica reported a book value per share at December
31, 1996, of $12.11.
Fund American's investments in Folksamerica are accounted for under the
provisions of SFAS No. 115 whereby the investments are reported at fair value as
of the balance sheet date, with related unrealized investment gains and losses
excluded from earnings and reported as a net amount in a separate component of
shareholders' equity. Dividends earned on the Folksamerica Preferred Stock are
recorded as earnings from unconsolidated insurance affiliates on the income
statement.
MORTGAGE ORIGINATION AND SERVICING OPERATIONS
GENERAL
Source One engages primarily in the business of producing, selling and
servicing residential mortgage loans and subservicing residential mortgage loans
for third parties. Its sources of revenue are net mortgage servicing revenue,
net interest revenue, net gain on sales of mortgages, net gain on sales of
servicing and other revenue (including underwriting and appraisal fees).
Through subsidiaries, Source One also markets credit-related insurance products
(such as life, disability, health, accidental death and property and casualty
insurance).
Source One was incorporated in 1972 and is the successor to Citizens Mortgage
Corporation which was organized in 1946. Source One is a wholly-owned
subsidiary of FAE and its principal office is located in Farmington Hills,
Michigan.
As of December 31, 1996, Source One had a mortgage loan servicing portfolio
totaling $29.2 billion, including $2.8 billion of loans subserviced for others,
which is serviced on behalf of approximately 320 institutional investors and
numerous other security holders. As of December 31, 1996, Source One had 131
retail branch offices in 26 states and originated $3.8 billion in mortgage loans
for the year then ended.
5
FUND AMERICAN
INDUSTRY OVERVIEW
Mortgage banking is the business of serving as a financial intermediary in
the: (i) origination and purchase of mortgage loans; (ii) holding of such loans
while aggregating sufficient loans to form appropriate mortgage-backed security
pools; (iii) subsequent sale of such loans through pools or directly to
investors; and (iv) ongoing management or servicing of such loans during the
repayment period. Mortgage bankers generate revenue in each of the four stages
of the mortgage banking process.
The origination process involves providing competitive mortgage loan rates,
soliciting loan applications, reviewing title and credit matters, and funding
loans at closing. Mortgage loans are often purchased from the originators
thereof, who may receive a premium for releasing the right to service such
purchased mortgage loans. The purchase price and any premium paid for servicing
rights are greatly influenced by existing market conditions.
When interest rates on long-term mortgage loans exceed average interest rates
incurred on total borrowings by Source One, as is generally the case, the
holding of mortgage loans generates net interest income. In periods when
borrowing rates exceed long-term mortgage lending rates, the holding of mortgage
loans can generate net interest expense.
Marketing or selling mortgage loans requires matching the needs of the
production market (consisting of homebuyers and homeowners seeking new
mortgages) with the needs of the secondary market for mortgage loans (consisting
of securities broker-dealers, depository institutions, insurance companies,
pension funds and other investors). Conventional mortgage loans (i.e., those
not guaranteed or insured by agencies of the Federal government) which are
secured by one- to four-family residential properties, and which comply with
applicable requirements, are packaged for direct sale or conversion to a
mortgage-backed security, generally in pools of $1.0 million or more. Such
mortgage-backed securities are guaranteed by the Federal Home Loan Mortgage
Corporation ("FHLMC") or the Federal National Mortgage Association ("FNMA").
Mortgage-backed securities are sold by mortgage banking companies primarily to
securities broker-dealers. Federal Housing Administration ("FHA") insured
mortgage loans and Veterans Administration ("VA") partially guaranteed mortgage
loans are packaged in the form of modified pass-through mortgage-backed
securities guaranteed by the Government National Mortgage Association ("GNMA")
for sale primarily to securities broker-dealers. In addition, private entities
may pool mortgage loans in the form of collateralized mortgage obligations or
pass-through certificates, which may or may not qualify as real estate mortgage
investment conduits ("REMICs") under the Internal Revenue Code of 1986, as
amended (the "IRC"), and offer the resulting mortgage-backed securities to the
public through securities broker-dealers. There is also a limited private
market for mortgage loans which have not been pooled or securitized.
Servicing involves: (i) collecting principal, interest and funds to be
escrowed for tax and insurance payments from mortgage loan borrowers; (ii)
remitting principal and interest to mortgage loan investors; (iii) paying
property taxes and insurance premiums on mortgaged property; (iv) in some cases,
advancing uncollected payments to mortgage loan investors; (v) administering
delinquent loans; (vi) supervising foreclosures in the event of unremedied
defaults; and (vii) performing all related accounting and reporting activities.
Servicing generates cash income in the form of fees, which represent a
percentage of the declining outstanding principal amount of the loans serviced
and are collected from each mortgage loan payment received plus any late
charges.
MORTGAGE LOAN PRODUCTION
Source One produces residential mortgage loans through a system of retail
branch offices, a specialized marketing program, mortgage brokers, and a
correspondent network of banks, thrift institutions and other mortgage lenders.
The existence of multiple mortgage production sources gives Source One the
flexibility to shift its production between those sources as market conditions
warrant and allows Source One to emphasize the production mode which is most
economically advantageous at the time.
6
FUND AMERICAN
Loans produced, whether through origination or purchase, include conventional
residential mortgage loans as well as mortgage loans which are either insured by
the FHA or partially guaranteed by the VA (government loans). In evaluating
loans purchased through its correspondent network and loans originated through
its broker network, Source One applies the same quality standards as those
required for loans originated by Source One itself. Source One's quality
control department reviews a random sample of the loans purchased to determine
compliance with Source One's standards.
It is a policy of Source One to primarily produce fixed rate mortgage loans.
As of December 31, 1996, approximately 5.5% of Source One's total mortgage loan
servicing portfolio consisted of adjustable rate mortgage loans. The following
table sets forth selected information regarding Source One's mortgage loan
production:
- -----------------------------------------------------------------------------------------------------------------
Year Ended December 31,
Millions 1996 1995 1994 1993 1992
- -----------------------------------------------------------------------------------------------------------------
Loan production by type of loan:
FHA insured and VA guaranteed $ 2,035 $ 1,565 $ 2,065 $ 3,453 $ 1,927
Conventional 1,796 1,287 2,521 7,999 5,664
-------------------------------------------------------------------------
Total $ 3,831 $ 2,852 $ 4,586 $ 11,452 $ 7,591
=================================================================================================================
Loan production by origination source:
Correspondent network acquisitions $ 1,640 $ 1,157 $ 1,081 $ 2,643 $ 2,578
Retail branch office originations 1,590 1,347 2,005 4,922 3,326
Mortgage broker originations 369 196 696 1,708 1,026
Specialized marketing program 232 152 804 2,179 661
originations
-------------------------------------------------------------------------
Total $ 3,831 $ 2,852 $ 4,586 $ 11,452 $ 7,591
=================================================================================================================
RETAIL BRANCH OFFICES. As of December 31, 1996, Source One had 131 retail
branch offices in 26 states. Each office has sales representatives who originate
mortgage loans through contacts with real estate brokers, builders, developers
and others, as well as through direct contact with homebuyers.
As of December 31, 1996, Source One's retail branch offices were located in
the following states:
- -------------------------------------------------------------------------------------------------
Number of Number of Number of
State offices State offices State offices
- -------------------------------------------------------------------------------------------------
California 31 Missouri 5 Kansas 1
Washington 22 Colorado 4 Maryland 1
Texas 11 Ohio 4 Oregon 1
Illinois 7 Alaska 2 Rhode Island 1
Arizona 6 Kentucky 2 Tennessee 1
Nevada 6 Massachusetts 2 Utah 1
New York 6 New Jersey 2 Vermont 1
Florida 5 Pennsylvania 2 Virginia 1
Michigan 5 Arkansas 1
- -----------------------------------------------------------------------------------------------
Mortgage loans originated by Source One are subject to a defined underwriting
process in order to assess each prospective borrower's ability to repay the loan
requested and the adequacy of each property as collateral. In addition, Source
One is subject to the underwriting guidelines of FHA, VA, FHLMC and FNMA, as
well as specific contractual requirements of institutional investors who have
agreed to acquire mortgage loans originated by Source One. Most branch office
originations are referred to regional operating centers for preparation of loan
documentation, evaluation of compliance with Source One's underwriting
conditions and closing of the loans.
7
FUND AMERICAN
CORRESPONDENT NETWORK. Source One conducts a program through which it agrees
to purchase mortgage loans from a network of banks, thrift institutions and
other mortgage lenders. The funding price for such loans is set by Source One on
a daily basis. In addition, Source One pays a premium for the release of
servicing rights which is negotiated on a case-by-case basis. As of December 31,
1996, there were approximately 209 participants in Source One's correspondent
network, with no single participant or group of affiliated participants
accounting for more than 10% of Source One's total mortgage loan originations.
MORTGAGE BROKERS. Source One conducts a program through which it closes loans
originated by a network of mortgage brokers. The funding price for such loans is
set by Source One on a daily basis. The originating mortgage broker receives
compensation equivalent to the difference between Source One's pricing schedule
and the closing price. As of December 31, 1996, there were approximately 366
active participants in Source One's mortgage broker network, with no single
broker or group of affiliated brokers accounting for more than 10% of Source
One's total mortgage loan originations.
SPECIALIZED MARKETING PROGRAM. Source One also generates mortgage loan
originations through affinity programs and by responding to refinancing requests
from the population of loans currently serviced by Source One.
SALES OF LOANS
Source One sells loans either through mortgage-backed securities issued
pursuant to programs of GNMA, FNMA and FHLMC, or to institutional investors.
Most loans are aggregated in pools of $1.0 million or more, which are purchased
by institutional investors after having been guaranteed by GNMA, FNMA or FHLMC.
During 1996 approximately 42.8%, 35.3% and 11.6% of the principal amount of
Source One's loans were sold in pools through GNMA, FNMA and FHLMC,
respectively. During 1995 approximately 46.3%, 34.3% and 9.3% of the principal
amount of Source One's loans were sold in pools through GNMA, FNMA and FHLMC,
respectively. During 1994 approximately 40.9%, 40.6% and 16.5% of the principal
amount of Source One's loans were sold in pools through GNMA, FNMA and FHLMC,
respectively. Substantially all GNMA securities are sold without recourse to
Source One for loss of principal in the event of a subsequent default by the
mortgage borrower due to the underlying FHA and VA insurance.
Servicing agreements relating to mortgage-backed securities issued pursuant to
the programs of GNMA, FNMA or FHLMC require Source One to advance funds to make
the required payments to investors in the event of a delinquency by the
borrower. Source One expects that it would recover most funds advanced upon cure
of default by the borrower or at foreclosure. However, in connection with VA
partially guaranteed loans and certain conventional loans (which may be
partially insured by private mortgage insurers), funds advanced may not cover
losses due to potential declines in collateral value. In addition, most of
Source One's servicing agreements for mortgage-backed securities typically
require the payment to investors of a full month's interest on each loan
although the loan may be paid off (by optional prepayment or foreclosure) other
than on a month-end basis. In this instance, Source One is obligated to pay the
investor interest at the note rate from the date of the loan payoff through the
end of that calendar month without reimbursement.
Source One, through private placements and public offerings, has also sold
mortgage loans through the issuance of mortgage pass-through certificates.
Source One issued $521.7 million of REMIC certificates through December 31,
1990. Source One is the primary servicer for these REMIC certificates, which
were sold pursuant to five separate trusts that have no recourse provisions.
Source One has not issued any mortgage-backed securities since 1990; however,
Source One may offer additional mortgage-backed securities in the future if
economic and market conditions warrant.
Historically, Source One's sales of loans have generated net gains. However,
if secondary market interest rates decline after Source One obtains a mandatory
forward commitment for a loan, the loan may not close and Source One may incur a
loss from the cost of covering its obligations under such commitment. If
secondary market interest rates increase after Source One commits to an interest
rate for a loan, and Source One has not obtained a forward commitment, Source
One may incur a loss when the loan is subsequently sold. To minimize this risk,
Source One obtains mandatory forward commitments of up to 120 days to sell
mortgage-backed securities with respect to all loans which have been funded and
a substantial portion of loans in process ("pipeline") which it believes will
close.
8
FUND AMERICAN
Source One's risk management function closely monitors the mortgage loan
pipeline to determine appropriate forward commitment coverage on a daily basis.
In addition, the risk management area seeks to reduce counterparty risk by
committing to sell mortgage loans only to approved dealers, with no dealer
having in excess of 20% of current commitments. Source One currently transacts
business with seven approved dealers.
LOAN SERVICING
Source One currently retains the rights to service the majority of the
mortgage loans it produces. In addition, Source One may acquire the rights to
service or subservice a mortgage loan portfolio without originating or acquiring
the underlying mortgage loans. Source One customarily makes such purchases of
servicing rights from banks, thrift institutions and other mortgage lenders. The
fees paid to acquire such servicing rights are negotiated on a case-by-case
basis. During 1996 and 1995, Source One purchased the rights to service $2.8
billion and $4.7 billion of mortgage loans from third parties, respectively.
Source One also sells servicing rights when management deems it economically
advantageous. During 1996 and 1995 Source One sold the rights to service $3.3
billion and $11.0 billion of mortgage loans, respectively. During 1994 Source
One sold the rights to service $3.9 billion of mortgage loans and continues to
subservice a portion of these loans pursuant to a five-year subservicing
agreement.
The following table summarizes the changes in Source One's mortgage loan
servicing portfolio including loans subserviced, interim servicing contracts and
those under contract to acquire, and excluding loans sold but not transferred:
- --------------------------------------------------------------------------------------------
Year Ended December 31,
Billions 1996 1995 1994 1993 1992
- ---------------------------------------------------------------------------------------------
Balance at beginning of year $31.8 $39.6 $38.4 $37.3 $41.0
----------------------------------
Mortgage loan production 3.8 2.9 4.6 11.5 7.6
Servicing acquisitions 2.8 4.7 3.7 6.4 2.3
----------------------------------
Total servicing in 6.6 7.6 8.3 17.9 9.9
----------------------------------
Regular payoffs 3.0 2.3 4.7 13.6 11.5
Sales of servicing 3.3 11.0 - - -
Principal amortization, servicing 2.0 2.1 2.4 3.2 2.1
released and foreclosures
Subservicing transfers .9 - - - -
----------------------------------
Total servicing out 9.2 15.4 7.1 16.8 13.6
----------------------------------
Balance at end of year $29.2 $31.8 $39.6 $38.4 $37.3
=============================================================================================
RELATED ACTIVITIES
In conjunction with its mortgage origination and servicing activities, Source
One markets certain credit-related insurance products (such as life, disability,
health, accidental death, and property and casualty insurance). Source One acts
as an agent and receives fees based on premium value but does not assume any
insurance risk. Insurance products are sold through (i) solicitation at the time
of mortgage application, (ii) direct mail solicitation by Source One shortly
after mortgage loan closing, (iii) solicitation by direct solicitors and (iv)
resolicitation of Source One's mortgage loan servicing portfolio on an annual
basis. At certain locations, personal solicitation by Source One staff is
permitted by state regulations which determine allowable insurance sales
practices. Total fees recognized under these programs for 1996 and 1995 were
$4.6 and $4.8 million, respectively.
PASSIVE INVESTMENT PORTFOLIO MANAGEMENT
The Company's passive investment portfolio is primarily managed by a small
group of employees located in Hanover, New Hampshire. FAE's passive investment
portfolio is primarily managed by a small group of its employees located in
Norwich, Vermont.
9
FUND AMERICAN
During 1996 and 1995 Fund American engaged First Manhattan Co. to provide
discretionary investment management services with respect to a portfolio of
investment securities totalling approximately $31.0 million and $21.0 at
December 31, 1996 and 1995, respectively. The invested assets managed by First
Manhattan Co. include certain equity securities held by the Company, FAE, White
Mountains and the Insurance Companies. First Manhattan Co. is a registered
investment advisor.
During 1996 and 1995 Fund American also engaged affiliates of FSA and MSA to
provide discretionary investment management services with respect to the fixed
income investment portfolios of the Insurance Companies.
Fund American's philosophy is to invest all assets to maximize their total
return over a three- to five-year time frame. Under this approach, each dollar
of after tax investment income, realized capital gains and unrealized
appreciation is valued equally. Management believes that it should focus its
equity investment efforts and the entity's funds on a small number of quality
companies selling at reasonable prices in the marketplace. While such an
approach leads to a high concentration in a few securities, management believes
it will provide superior returns over a three- to five-year horizon. However,
management does not believe that owning a large portfolio of passive investment
securities in a taxable corporation format will maximize shareholder returns
over the long-term. Therefore, Fund American's long-term goal is to reinvest at
least a portion of its passive investment securities (or proceeds from sales
thereof) into operating businesses in which management has knowledge and
experience.
CERTAIN BUSINESS CONDITIONS
Inflation and changes in market interest rates can have significant effects on
White Mountains' insurance operations. Inflation increases the costs of settling
insurance claims over time. Increases in market interest rates, which often
occur during periods of high inflation, reduce the market value of the insurance
operations' fixed-income investments. Conversely, reductions in market interest
rates increase the market value of White Mountains' fixed-income investments.
Changes in the economy or prevailing interest rates can also have significant
effects, including material adverse effects, on the mortgage banking business
and Source One. Inflation and changes in interest rates can have differing
effects on various aspects of Source One's business, particularly with respect
to marketing gains and losses from the sale of mortgage loans, mortgage loan
production, the value of Source One's servicing portfolio and net interest
revenue. Historically, Source One's loan originations and loan production income
have increased in response to falling interest rates and have decreased during
periods of rising interest rates. Periods of low inflation and falling interest
rates tend to reduce loan servicing income and the value of Source One's
mortgage loan servicing portfolio because prepayments of mortgages increase and
the average life of loan servicing rights is shortened. Conversely, periods of
increasing inflation and rising interest rates tend to increase loan servicing
income and the value of Source One's mortgage loan servicing portfolio because
prepayments of mortgages decline and the average life of loan servicing rights
is lengthened.
COMPETITION
The principal competitive factors that affect White Mountains' insurance
subsidiaries are: (i) pricing; (ii) underwriting; (iii) quality of claims and
policyholder services; (iv) appointing and retaining high quality independent
agents; (v) operating efficiencies; and (vi) product differentiation and
availability. No single company or group of affiliated companies dominates the
insurance industry. The highly competitive environment in the property and
casualty insurance market during the past several years has intensified due to
increased capacity resulting from growing capital supporting the industry. Each
of White Mountains' insurance operating affiliates strives to be the low cost
operator within its sector of the insurance industry while maintaining superior
levels of customer service. Each of White Mountains' insurance affiliates also
maintains a disciplined approach to pricing and underwriting of insurance risks.
Application of this disciplined approach in a highly competitive environment
results in a lower volume of insurance premiums than would result from a less
disciplined approach, but should produce better overall financial returns from
the business over long periods of time.
10
FUND AMERICAN
Perception of financial strength, as reflected in the ratings assigned to an
insurance company, especially by A.M. Best, is also a factor in White Mountains'
insurance subsidiaries' competitive position. Each of White Mountains' insurance
operating affiliates has consistently maintained adequate capitalization and
claims payment ratings to effectively conduct its business and management
believes that such strength will continue to be maintained in the future.
In the United States, property and casualty insurance can be obtained through
national and regional companies that use an agency distribution system, direct
writers (who may have an employed agency force) or brokers, or through self-
insurance including the use by corporations of subsidiary captive insurers. All
of the Insurance Companies market their products principally through independent
agents.
Source One competes nationally and locally for loan production with other
mortgage banks, state and national banks, thrift institutions and insurance
companies. National banks and thrift institutions have substantially more
flexibility in their loan origination programs than Source One, which must
originate loans meeting the standards of the secondary market. Mortgage lenders
compete primarily with respect to price and service. Competition may also occur
on mortgage terms and closing costs. Source One competes, in part, by using its
commissioned sales force to maintain close relationships with real estate
brokers, builders and developers and members of its correspondent and broker
network. It is the opinion of the management of Source One that no single
mortgage lender dominates the industry.
REGULATION
The Insurance Companies are subject to regulation and supervision of their
operations in each of the jurisdictions where they conduct business. Regulations
vary between jurisdictions but, generally, they provide regulatory authorities
with broad supervisory, regulatory and administrative powers over such matters
as licenses, standards of solvency, premium rates, policy forms, investments,
security deposits, methods of accounting, form and content of financial
statements, reserves for unpaid losses and loss adjustment expenses,
reinsurance, minimum capital and surplus requirements, dividends and other
distributions to shareholders, periodic examinations and annual and other report
filings. Over the last several years most states have, and continue to
implement, laws which establish standards for current, as well as continued,
state accreditation. In addition, the National Association of Insurance
Commissioners ("NAIC") has adopted risk-based capital rules for property and
casualty companies. The Insurance Companies were adequately capitalized under
the NAIC's rules as of December 31, 1996.
Source One is subject to the rules and regulations of, and examinations by,
FNMA, FHLMC, GNMA, FHA and VA with respect to the origination, processing,
selling and servicing of mortgage loans. These rules and regulations, among
other things, prohibit discrimination, provide for inspections and appraisals of
properties, require credit reports on prospective borrowers and, in some cases,
establish maximum interest rates, fees and loan amounts. Lenders are required to
submit audited financial statements annually. FNMA and GNMA require the
maintenance of specified net worth levels which vary depending on the amount of
FNMA loans serviced and GNMA mortgage-backed securities issued by Source One.
Mortgage loan origination activities are also subject to fair housing laws, the
Equal Credit Opportunity Act, the Federal Truth-in-Lending Act, the Real Estate
Settlement Procedures Act, the Fair Credit Reporting Act, the Home Mortgage
Disclosure Act, and regulations promulgated thereunder which, among other
things, prohibit discrimination in residential lending and require disclosure of
certain information to borrowers. Certain conventional mortgage loans are also
subject to state usury statutes; FHA and VA loans are exempt from the effects of
such statutes. There are various other state laws and regulations affecting
Source One's mortgage banking and insurance operations. Source One's internal
audit and quality control departments monitor compliance with all these laws and
regulations.
Fund American is not aware of any current recommendations by regulatory
authorities that would be expected to have a material effect on its results of
operations or liquidity or any other matters that would require disclosure
herein.
11
FUND AMERICAN
EMPLOYEES
As of December 31, 1996, the Company employed 12 persons, FAE employed 1,683
persons (including 1,682 persons at Source One) and White Mountains employed 446
persons (including 268 persons at Valley and 162 persons at Charter). None of
Fund American's employees are covered by a collective bargaining agreement.
Management believes that Fund American's employee relations are good.
FORWARD-LOOKING STATEMENTS
From time to time, the Company may publish forward-looking statements relating
to such matters as anticipated financial performance, business prospects, new
products and similar matters. This information is often subject to various
risks and uncertainties. The Private Securities Litigation Reform Act of 1995
provides a safe harbor for forward-looking statements. In order to comply with
the terms of the safe harbor, the Company notes that numerous factors could
cause actual results and experience to differ materially from anticipated
results or other expectations expressed in its forward-looking statements. The
risks and uncertainties that may affect the operations, performance, development
and results of the Company's business include those discussed elsewhere herein
(such as competition and regulation).
ITEM 2. PROPERTIES
Fund American leases 8,600 square feet of space at 80 South Main Street,
Hanover, New Hampshire, under a lease expiring in 2006. This space is used as
the principal office for the Company, White Mountains and WMIC. Valley owns a
40,000 square foot office building in Albany, Oregon and leases 6,200 square
feet in Sacramento, California. The lease on Valley's California property
expires in 1998. Charter leases 48,400 square feet in Dallas, Texas, which lease
expires in 1997. Source One owns its principal office in Farmington Hills,
Michigan, which houses the majority of its employees. Source One also owns an
office building in West Bloomfield, Michigan which is currently subleased to a
third party. Fund American leases several other office facilities and operating
equipment under cancelable and noncancelable agreements. Most of such leases
contain renewal clauses.
ITEM 3. LEGAL PROCEEDINGS
Various claims have been made against Fund American in the normal course of
its business. In management's opinion, the outcome of such claims will not, in
the aggregate, have a material effect on Fund American's financial position or
results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of Fund American's shareholders
during the fourth quarter of 1996.
12
FUND AMERICAN
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of March 21, 1997, there were 559 registered holders of shares of the
Company's Common Stock, par value $1.00 per share ("Shares").
From 1992 to 1994 the Company did not pay regular cash dividends to holders of
Shares. In the fourth quarter of 1995 the Board of Directors reinstated a $.20
regular quarterly dividend on Shares. During 1995 and 1996, the Company declared
and paid cash dividends totalling $.20 and $.80 per Share, respectively. The
Company's Board of Directors (the "Board") currently intends to reconsider from
time to time the declaration of regular periodic dividends on Shares with due
consideration given to the financial characteristics of Fund American's
remaining invested assets and operations and the amount and regularity of its
cash flows at the time. The Company's Common Stock (symbol FFC) is listed on the
NYSE. The quarterly trading range for Shares during 1996 and 1995 is presented
below:
- ---------------------------------------------------------------
1996 1995
--------------------- ----------------------
High Low High Low
- ---------------------------------------------------------------
Quarter ended:
December 31 $ 95 3/4 $86 3/4 $ 75 $66 1/4
September 30 93 1/2 80 1/4 76 68 1/4
June 30 82 1/4 76 72 5/8 68 3/8
March 31 79 7/8 72 1/8 76 71 3/4
===============================================================
13
FUND AMERICAN
ITEM 6. SELECTED FINANCIAL DATA
Selected consolidated income statement data and ending balance sheet data for
each of the five fiscal years ended December 31, 1996, follows:
Year Ended December 31,
-----------------------------------------------------------------------------------
Millions, except per share amounts 1996 1995 1994 1993 1992
- ------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT DATA:
Revenues $ 332 $ 222 $ 229 $ 251 $ 214
Expenses 347 226 226 234 191
-----------------------------------------------------------------------------------
Pretax operating earnings (15) (4) 3 17 23
(loss)
Net investment gains 39 39 39 124 65
-----------------------------------------------------------------------------------
Pretax earnings 24 35 42 141 88
Income tax provision 19 17 21 71 34
-----------------------------------------------------------------------------------
After tax earnings 5 18 21 70 54
Gain from sale of - 66(a) - - 1
discontinued operations,
after tax
Cumulative effect of
accounting changes: - - (44)(b) - -
Purchased mortgage
servicing, after tax
Postretirement - - - - (2)(c)
benefits, after tax
Income taxes - - - - (24)(d)
Net income (loss) $ 5 $ 84 $ (23) $ 70 $ 29
- -------------------------------===================================================================================
Primary earnings per share:
After tax earnings $ .60 $ 1.71 $ 1.20 $ 5.68 $ 2.71
Net income (loss) .60 9.36 (3.51) 5.68 .74
Fully diluted earnings per
share:
After tax earnings .60 2.02 1.20 5.68 2.70
Net income (loss) .60 9.16 (3.51) 5.68 .73
Cash dividends paid per .80 .20 - - -
share of common stock
ENDING BALANCE SHEET DATA:
Total assets $ 1,981 $ 1,872 $ 1,807 $ 3,305 $ 3,129
Short-term debt 408 445 254 1,537 1,513
Long-term debt 424 407 547 601 423
Minority interest - 44 44 100 - -
preferred stock of
subsidiary
Shareholders' equity 687(e) 700(e) 661(e) 905(e)(f) 988(e)
Book value per common and 90.81 83.28 68.95 77.27(f) 80.65
equivalent share
==================================================================================================================
(a) Reflects the settlement of certain tax liabilities relating to the sale of
Fireman's Fund Insurance Company ("Fireman's Fund") for less than the
previously accrued amount. See Note 3 of the Notes to Consolidated Financial
Statements.
(b) Reflects the prior years' cumulative effect of a change in Source One's
methodology used to measure impairment of its purchased mortgage servicing
rights asset. See Note 6 of the Notes to Consolidated Financial Statements.
(c) Reflects the prior years' cumulative effect of the adoption of SFAS No. 106,
"Employers' Accounting for Postretirement Benefits Other Than Pensions."
(d) Reflects the prior years' cumulative effect of the adoption of SFAS No.
109, "Accounting for Income Taxes."
(e) Reflects redemptions of the Company's Voting Preferred Stock Series D, par
value $1.00 per share (the "Series D Preferred Stock") and/or repurchases
of Shares. See Note 13 of the Notes to Consolidated Financial Statements.
(f) Reflects the distribution of approximately 74% of the outstanding shares of
Common Stock of White River Corporation ("White River") to shareholders on
December 22, 1993.
14
FUND AMERICAN
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS: YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
CONSOLIDATED RESULTS
Fund American reported net income of $4.9 million for the year ended December
31, 1996, which compares to net income of $84.1 million for 1995 and a net loss
of $23.2 million for 1994. The 1996 income statement includes a $33.6 million
pretax write-off of all Source One's existing goodwill and certain other
intangible assets and $28.4 million of pretax impairment of Source One's
capitalized mortgage servicing asset. These two 1996 items served to decrease
1996 net income by a total of $48.5 million. The 1995 income statement includes
four non-recurring items: (i) the adoption of SFAS No. 122 as of January 1,
1995, by Source One; (ii) a $46.2 million pretax charge to compensation expense
related to outstanding employee stock warrants; (iii) a $66.0 million favorable
tax development relating to the sale of Fireman's Fund; and (iv) the receipt of
a $9.7 million pretax breakup fee, plus related expenses, from Home Holdings,
Inc. These four 1995 items served to increase 1995 net income by a total of
$41.8 million. The 1994 net loss includes a $68.1 million pretax charge related
to a change in accounting methodology adopted by Source One which served to
decrease 1994 net income by $44.3 million.
Book value per common and common equivalent share was $90.81 at December 31,
1996, which compares to $83.28 at December 31, 1995. Strong investment portfolio
results, offset by the 1996 write-offs at Source One, produced most of the
increase in book value per share from 1995 to 1996.
After tax earnings for 1996 were $4.9 million versus $18.5 million and $21.1
million for 1995 and 1994, respectively.
INSURANCE OPERATIONS
As further described under "Liquidity and Capital Resources," White Mountains
is acquiring and developing various insurance operating interests. Fund American
assigned its investment in MSA and the majority of its investments in FSA to
White Mountains in 1995, WMIC began operations in September 1995, White
Mountains acquired Valley and Charter in December 1995, and White Mountains
acquired its investment in Folksamerica in June 1996.
Valley (which includes the operations of WMIC) and Charter represent Fund
American's consolidated insurance subsidiaries. Valley and Charter's results for
the twelve month period ended December 31, 1996, included $109.7 million of
property and casualty insurance premiums earned and $85.9 million of losses and
loss adjustment expenses.
A summary of 1996 underwriting results for Valley and Charter follows:
- ------------------------------------------------------------------------------
Year Ended December 31, 1996
Dollars in Millions Valley* Charter
- ------------------------------------------------------------------------------
Net written premiums $ 77.2 $ 70.0
-------------------
Earned premiums 72.0 37.7
Losses and loss adjustment expenses 55.6 30.3
Underwriting expenses 25.8 8.0
-------------------
Underwriting loss $ (9.4) $ (.6)
===================
Statutory ratios:
Loss and loss adjustment expense 77.2% 80.4%
Underwriting expense 35.3 19.0
-------------------
Combined 112.5% 99.4%
=============================================================================
* Includes the operating results of WMIC.
15
FUND AMERICAN
Valley's 1996 underwriting results were adversely impacted by an unusual
amount of fourth quarter storm-related losses and by reserve strengthening for
losses and loss adjustment expenses incurred in prior years. Charter's earned
premiums trailed net written premiums because Charter began for the first time
in 1996 to retain virtually all its written premiums. Management expects
Charter's earned premiums to increase substantially in 1997 from the 1996
amount.
Valley and Charter's results for the one month period ended December 31, 1995,
included $5.8 million of property and casualty insurance premiums earned and
$8.2 million of losses and loss adjustment expenses.
Losses and loss adjustment expenses are charged against income as incurred.
Unpaid losses and loss adjustment expenses are based on estimates by claims
adjusters, legal counsel and actuarial staff of the ultimate costs of settling
claims, including the effects of inflation and other societal and economic
factors. Unpaid loss and loss adjustment expense reserves represent management's
best estimate of ultimate losses and loss adjustment expenses net of estimated
salvage and subrogation recoveries. Such estimates are regularly reviewed and
updated and any adjustments resulting therefrom are reflected in current
operations. The process of estimating loss and loss adjustment expenses involves
a considerable degree of judgement by management and the ultimate amount of
expense to be incurred could be considerably greater than or less than the
amounts currently reflected in the financial statements. Valley and Charter's
combined losses and loss adjustment expenses reported for the years ended
December 31, 1996 and 1995, included $3.8 million and $3.0 million of reserve
strengthening for losses and loss adjustment expenses incurred in prior periods,
respectively.
In the normal course of business, White Mountains' insurance subsidiaries seek
to reduce the loss that may arise from catastrophes or other events that may
cause unfavorable underwriting results by reinsuring certain levels of risk in
various areas of exposure with other insurance enterprises or reinsurers. White
Mountains' insurance subsidiaries remain contingently liable for risks reinsured
with third parties to the extent that the reinsurer is unable to honor its
obligations under reinsurance contracts at the time of loss.
While there may be greater individual risks of loss associated with
nonstandard automobile insurance than with standard automobile insurance (i.e.,
higher loss frequency), the insurance premiums charged in consideration of these
additional risk characteristics are generally higher than those of standard
automobile coverage and in many cases, if the coverage is properly underwritten,
the risk to rate characteristics of writing nonstandard automobile insurance are
at least equal to or more favorable than that of standard automobile coverage.
Additionally, nonstandard automobile individual liability limits are generally
lower than those of standard automobile coverages which results in the amount of
individual losses being less volatile (i.e., lower loss severity). In general,
loss costs for nonstandard automobile insurance are, in fact, more predictable
than those for several other lines of property and casualty insurance (i.e.,
catastrophe insurance or umbrella liability coverages).
FSA, Folksamerica and MSA represent Fund American's investments in
unconsolidated insurance affiliates. Fund American's investment in FSA increased
$23.1 million during 1996 (excluding Fund American's purchase of 1,000,000
additional shares of FSA Common Stock for $26.5 million during 1996) which
consisted of $7.8 million of net earnings from FSA Common Stock, $17.3 million
of pretax unrealized investment gains from FSA Options and Preferred Stock, less
$1.0 million of pretax unrealized investment losses from FSA's investment
portfolio, and $1.0 million of dividends received from FSA Common Stock. Fund
American's investment in FSA increased $9.3 million during 1995 (excluding Fund
American's purchase of 460,200 additional shares of FSA Common Stock for $8.8
million during 1995) which consisted of $5.4 million of net earnings from FSA
Common Stock, $4.5 million of pretax unrealized investment gains from FSA's
investment portfolio, $.3 million of pretax unrealized investment gains from FSA
Options and Preferred Stock, less $.9 million of dividends received from FSA
Common Stock.
White Mountains' investment in Folksamerica increased $.2 million from June
1996 to December 31, 1996, as a result of pretax unrealized investment gains
from Folksamerica Warrants and Folksamerica Preferred Stock.
16
FUND AMERICAN
White Mountains' investment in MSA increased $1.0 million during 1996 which
consisted of $1.5 million of net earnings from MSA Common Stock offset by $.5
million of pretax unrealized investment losses from MSA's investment portfolio.
White Mountains' investment in MSA increased $7.2 million during 1995 (excluding
the payment by White Mountains of $1.2 million in purchase price adjustments
during 1995) which consisted of $4.0 million of net earnings from MSA Common
Stock and $3.2 million of pretax unrealized investment gains from MSA's
investment portfolio.
Management expects that White Mountains' insurance operations will have a
significantly larger impact on Fund American's reported financial results in
1997 and future years. See "Liquidity and Capital Resources."
MORTGAGE ORIGINATION AND SERVICING OPERATIONS
Net mortgage servicing revenue was $77.6 million for the year ended December
31, 1996 which compares to $61.3 million in 1995 and $82.4 million in 1994. The
increase in net servicing revenue for 1996 compared to 1995 is primarily the
result of $9.9 million in pretax net realized and unrealized gains on financial
instruments and a $9.4 million reduction in amortization and impairment of the
capitalized mortgage servicing asset from 1995 to 1996. The decrease in 1996
amortization and impairment is due primarily to market interest rates being
higher for most of 1996, as compared to 1995, which resulted in an increase in
the estimated fair value of the servicing rights from 1995 levels. The decrease
in net mortgage servicing revenue from 1994 to 1995 reflects the sale of $11.0
billion of servicing rights to third parties during 1995, partially offset by
slower amortization of the capitalized mortgage servicing asset due to lower
actual and anticipated mortgage loan prepayments in 1995 compared to 1994.
Source One utilizes interest rate floor contracts and principal-only swaps to
mitigate the effect on earnings of higher amortization and impairment of the
capitalized servicing asset caused by changes in market interest rates. The
interest rate contracts, which were entered into in the 1995 fourth quarter and
the 1996 first half, are not subject to total losses in excess of their original
cost of $5.5 million. The interest rate floors are derivative contracts that
derive their value from differences between the floor rate specified in the
contract and prevailing market interest rates. As of December 31, 1996 and 1995,
the interest rate contracts had a fair value of $4.8 million and $3.5 million,
respectively. As of December 31, 1996, the open interest rate contracts had a
total notional principal amount of $1.0 billion. In the 1996 third quarter,
Source One entered into two principal-only swaps with an original notional value
of $150.0 million to further mitigate its sensitivity to movements in market
interest rates. The principal-only swap transactions are derivative contracts
that derive their value from changes in the value of referenced principal-only
strips. In the fourth quarter of 1996, in response to its contracted sale of
approximately $17.0 billion of mortgage servicing rights, Source One closed its
position in $100.0 million of original notional value of its principal-only
swaps at a pretax gain of $9.7 million. The carrying value of Source One's
remaining principal-only swaps as of December 31, 1996, was $3.2 million.
Source One adopted SFAS No. 122, "Accounting for Mortgage Servicing Rights,"
an amendment to SFAS No. 65, as of January 1, 1995. SFAS No. 122 requires the
total cost of acquiring mortgage loans, either through loan origination
activities or purchase transactions, to be allocated to the mortgage servicing
rights and the loans based on their relative fair values. The statement requires
entities to measure impairment on a disaggregated basis by stratifying the
capitalized servicing asset based on one or more predominant risk
characteristics of the underlying loans. Impairment is recognized through a
valuation allowance for each individual stratum. The adoption of SFAS No. 122 as
it relates to the capitalization of originated mortgage servicing rights
resulted in the recognition of an additional pretax gain on sales of mortgages
of $27.2 million for the year ended December 31, 1995. The impairment provisions
of SFAS No. 122 resulted in a pretax charge of $28.0 million in that year.
In 1994 Source One changed the methodology used to measure impairment of its
purchased mortgage servicing rights asset. The new accounting methodology
measured the asset's impairment on a disaggregated basis and discounted the
asset's estimated future cash flows using a current market rate. Prior to 1994
Source One measured the asset's impairment on a disaggregated basis including a
cost of capital charge for estimating the asset's future cash flows. The
adoption of the new accounting methodology, recorded as a cumulative adjustment
as of January 1, 1994, resulted in a $68.1 million pretax, $44.3 million after
tax, charge to income for 1994.
17
FUND AMERICAN
To measure impairment of the mortgage servicing rights, Source One stratifies
its mortgage loan servicing portfolio based on the portfolio's predominant risk
characteristics which have been determined to be prepayment, default and
operational risks. In estimating fair value, Source One used market consensus
prepayment rates and discounted the future cash flows using discount rates that
approximate current market rates. The prepayment assumptions used in the
estimation of fair values are based on market prepayment expectations. The fair
value of each stratum is computed and compared to its recorded book value to
determine if a valuation allowance, or recovery of a previously established
valuation allowance, is required.
As of December 31, 1996, Source One's $17.0 billion mortgage servicing
portfolio to be sold in 1997 was valued as one stratum using the market price as
indicated by the purchase and sale agreement with the third party purchaser.
Accordingly, Source One evaluated the predominant risk characteristics on the
remaining owned servicing portfolio which was stratified by interest rate, loan
type (investor), original term to maturity and principal recourse. The discount
rates used to estimate fair value were 10.5% for conventional loans, 12.0% for
insured loans and, for 1996, 21.0% for recourse loans. As a result of refining
the calculation during 1996 on its remaining owned servicing portfolio, Source
One recognized $13.4 million of additional pretax impairment during the fourth
quarter of 1996. As of December 31, 1995, the entire servicing portfolio was
stratified by interest rate, loan type (investor) and original term to maturity.
The discount rate and prepayment assumptions are significant factors used in
estimating the fair value of Source One's mortgage servicing rights and could be
significantly impacted by changes in interest rates and other factors.
Accordingly, it is likely that management's estimate of the fair value of the
capitalized servicing asset will change from time to time due to changes in
interest rates and other factors.
Net gains on sales of mortgages increased to $38.3 million for the year ended
December 31, 1996, from $24.0 million in 1995 and $29.5 million in 1994. The
increased gains from 1995 to 1996 reflect increased production and related
mortgage sales volumes during the period. The 1995 net gain amount includes
$27.2 million of gains related to the adoption of SFAS No. 122. Intensive price
competition during 1995 led to increased pricing subsidies on originated loans
which suppressed gains on sales of mortgages into the secondary market.
During 1996 Source One sold the rights to service $3.3 billion of mortgage
loans for net proceeds of $55.9 million, resulting in a pretax gain of $10.1
million. During 1995 Source One sold the rights to service $11.0 billion of
mortgage loans for net proceeds of $199.1 million, resulting in a pretax gain of
$40.0 million. During 1994 Source One sold the rights to service $3.9 billion of
mortgage loans for net proceeds of $70.2 million and continues to service the
majority of these loans pursuant to a subservicing agreement. A gain of $19.9
million was deferred in 1994 and is being recognized in income over the five-
year life of the subservicing agreement. The mortgage servicing portfolio as of
December 31, 1996 and 1995, includes loans subserviced for others having a
principal balance totalling $2.8 billion and $4.0 billion, respectively.
Management's intent regarding the servicing sales was to opportunistically
take advantage of increases in the value of servicing rights that are created by
rises in interest rates and to bring servicing and origination activities into
better balance. Additional sales transactions may occur in the future when
management deems it to be economically advantageous. Source One desires to
continue to maintain or increase the size of its servicing portfolio in order to
take advantage of its low cost servicing operation. Consistent with that
strategy, Source One purchased the rights to service $2.8 billion, $4.7 billion
and $3.7 billion of mortgage loans in 1996, 1995 and 1994, respectively.
Source One has recently developed a new strategy with respect to its servicing
operations. Source One's current objective is to reduce its exposure to changes
in market interest rates while preserving its reputation as a low cost and high
quality servicer. Source One has found that an effective way to accomplish these
goals is by actively pursuing and securing subservicing arrangements. Source One
currently believes that it can become a leading subservicer of mortgages for
third parties.
Consistent with Source One's subservicing strategy, on February 28, 1997,
Source One sold the rights to service approximately $17.0 billion of non-
recourse mortgage loans for gross proceeds of approximately $271.5 million.
Source One expects to record a $2.1 million after tax loss on this servicing
sale in the first quarter of 1997. The portion of Source One's mortgage
servicing portfolio sold in 1997 consisted of approximately 284,000 loans with
18
FUND AMERICAN
a weighted average interest rate of 8.39%. Source One will continue to
subservice these loans pursuant to a subservicing agreement for a period of no
less than 12 months. Source One is currently evaluating its options as to how it
will utilize the proceeds from the sale. These options include: (i) purchasing
additional mortgage servicing rights from third parties; (ii) reducing its
outstanding indebtedness; (iii) reducing its outstanding preferred or common
shareholders' equity; or (iv) any combination of the foregoing.
As a result of the 1997 servicing sale, Source One expects that its gross
mortgage servicing revenue and its related amortization for 1997 and thereafter
will be significantly less than its gross mortgage servicing revenue and its
related amortization for 1996. Source One is currently analyzing its cost
structure to identify expenses that may be reduced as a result of the sale.
Total mortgage loan production for the years ended December 31, 1996, 1995 and
1994, was $3.8 billion, $2.9 billion and $4.6 billion, respectively. The
increase in production from 1995 to 1996 is reflective of overall lower market
interest rates and a corresponding increase in refinancing activity experienced
during 1996. The decrease in production from 1994 to 1995 is reflective of
overall higher market interest rates and a corresponding decrease in refinancing
activity experienced during 1995. Production related to refinancing activity
represented 33% of total mortgage production in 1996 as compared to 23% in 1995
and 50% in 1994. Mortgage loan payoffs for the years ended December 31, 1996,
1995 and 1994, were $3.0 billion, $2.3 billion and $4.7 billion, respectively.
INVESTMENT OPERATIONS
The total return from Fund American's investment activities is shown below:
- ------------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Millions 1996 1995 1994
- ------------------------------------------------------------------------------
Net investment income:
Source One $ 40.8 $ 37.7 $ 71.5
Insurance operations and other 16.5 17.7 18.7
---------------------------
Total net investment income 57.3 55.4 90.2
Net realized investment gains 38.5 38.8 38.8
Change in net unrealized investment gains and
losses recorded directly to
Shareholders' equity (a) 68.0 20.0 (82.4)
---------------------------
Total net investment return, before tax $ 163.8 $ 114.2 $ 46.6
==============================================================================
(a) Excludes net unrealized investment gains and losses recorded from Fund
American's investments in unconsolidated insurance affiliates.
Fund American's net investment income is comprised primarily of interest
income earned on mortgage loans originated by Source One and, in 1996, on fixed
maturity investments of its consolidated insurance operations. The increase in
Source One's net investment income from 1995 to 1996 is mainly attributable to
increased interest income from mortgage loans held for sale related to higher
mortgage loan production experienced during 1996. The decrease in Source One's
net investment income from 1994 to 1995 is due primarily to decreased interest
income from mortgage loans held for sale related to lower mortgage production
experienced during 1995. Decreases in investment income from insurance and other
operations during 1996 resulted from net sales of investment securities offset
by increases in investment income from White Mountains' portfolio of fixed
maturity investments. The decrease in other net investment income from 1994 to
1995 resulted from net sales of investment securities during 1995. Cash basis
sales and maturities of investments, net of purchases and excluding short-term
investments, totalled $95.7 million, $154.1 million and $151.9 million for the
years ended December 31, 1996, 1995 and 1994, respectively.
Net realized investment gains during 1996, before tax, included $27.2 million
of gains from the sale of The Louisiana Land & Exploration Company common stock.
Net realized investment gains during 1995, before tax, included $23.9 million of
gains from the sale of American Express Company common stock. Net realized
investment
19
FUND AMERICAN
gains during 1994, before tax, included $22.6 million of gains from
the sale of The Louisiana Land and Exploration Company common stock and $21.7
million of gains from the sale of American Express Company common stock.
Total investment gains and losses during the three years ended December 31,
1996, have been substantially affected by changes in market prices for crude oil
and natural gas. At December 31, 1996, 56% of Fund American's portfolio of
common equity securities was invested in the San Juan Basin Royalty Trust which
is further described below. Fund American believes that its investment in the
San Juan Basin Royalty Trust is highly cyclical and, therefore, anticipates
continued volatility in the value of this investment in the future.
A review of certain significant holdings in Fund American's portfolio of
common equity securities and other investments at December 31, 1996 follows.
Share or unit and dollar amounts refer to the aggregate number of common shares
or units of beneficial interest owned and the aggregate fair value at December
31, 1996, of Fund American's holdings of each security discussed.
San Juan Basin Royalty Trust ("San Juan"; 10,994,876 units; $90.7 million).
San Juan units receive a 75% net overriding royalty interest from certain of
Southland Royalty Company's leasehold and royalty interests in the San Juan
Basin of Northwestern New Mexico. Fund American believes that changes in crude
oil and natural gas prices and in the level of development and production
expenditures by the operator of San Juan may affect the distributions to
unitholders of San Juan and, therefore, the market prices of the units of San
Juan. In addition, Fund American believes that the tax and accounting issues
involved in owning units in San Juan may make such units unappealing to many
investors. Fund American's investment in San Juan as of December 31, 1996 and
1995, represented greater than 20% of the total San Juan units outstanding at
those times. San Juan units are nonvoting. Fund American does not account for it
investment in San Juan units on the equity method as it does not have the
ability to exercise significant influence over the Trustee of San Juan.
Travelers Property Casualty Corp. ("Travelers"; 3,142,906 shares; $90.3
million). On March 11, 1996 Fund American purchased its investment in Travelers
for $50.0 million plus related expenses. Travelers is one of the largest
commercial lines insurers in the United States and is an independent agency
writer of personal lines insurance. John J. Byrne, Fund American's Chairman, is
a director of Travelers.
White River Corporation (718,818 "White River Shares"; $39.2 million). White
River, through its consolidated subsidiaries, provides automated vehicle
valuation and collision repair estimating services and software for use by the
insurance and automobile repair industries, and services which improve the
handling and settling of automobile damage claims. White River also owns a
passive investment portfolio. The Company owns an additional 295,932 White River
Shares, carried in other assets, which are being held for delivery upon exercise
of existing employee stock options.
Mid Ocean Limited ("Mid Ocean"; 388,140 shares ("Mid Ocean Shares"); $20.4
million). Mid Ocean provides property catastrophe, marine, energy, aviation,
satellite and other reinsurance to insurers and reinsurers on a worldwide basis.
EXPENSES
Compensation expense as reported totalled $91.3 million, $111.6 million and
$69.2 million for each of the years ended December 31, 1996, 1995 and 1994,
respectively. Compensation expense for 1995 includes a $46.2 million pretax
charge related to an extension of the expiration date of outstanding employee
stock warrants. Additionally, Source One nets mortgage loan origination fees,
less certain direct costs, against compensation and benefits expense. Excluding
the effects of the 1995 warrant extension and mortgage loan origination fees,
adjusted compensation and benefits expense was $111.1 million, $82.9 million and
$98.8 million for each of the years ended December 31, 1996, 1995 and 1994,
respectively. The increase in adjusted compensation and benefits expense from
1995 to 1996 is primarily the result of the inclusion of a full year of Valley
and Charter's personnel costs in the 1996 consolidated financial statements. The
decrease in adjusted compensation and benefits expense from 1994 to 1995 is
primarily the result of lower personnel and related costs at Source One due to a
decrease in mortgage loan originations in 1995 versus 1994.
20
FUND AMERICAN
General expenses of $120.0 million for 1996 compare to 1994 and 1993 amounts
of $60.3 million and $77.7 million, respectively. The increase in general
expenses from 1995 to 1996 is primarily the result of the inclusion of Valley
and Charter's operations in the 1996 consolidated financial statements, and a
$33.6 million pretax write-off of goodwill and certain other intangible assets
of Source One. During 1996 Fund American had been re-assessing the
recoverability of goodwill and certain other intangible assets related to Source
One and, in the fourth quarter of 1996, determined that it should write-off all
such assets related to Source One. Factors considered in the determination to
write-off all Source One's goodwill were (i) increased competition and industry
consolidation during 1996 which had adversely impacted the value of both the
mortgage loan production and servicing operations of Source One and (ii) the
attainment of a definitive agreement in the fourth quarter of 1996 to sell the
majority of Source One's mortgage servicing portfolio at essentially book value.
The decrease in general expenses from 1994 to 1995 was the result of efforts to
reduce Source One's operating expenses in response to the contraction in
mortgage originations which began to take effect in late 1994 and continued
through 1995.
Interest expense increased to $50.0 million in 1996 which compares to $45.8
million for 1995 and $78.8 million for 1994. The fluctuations in interest
expense reflect primarily increases and decreases in average indebtedness
outstanding during each year at Source One. Source One's inventory of mortgage
loans held for sale declined in 1995 from 1994 levels and increased in 1996 from
1995 levels due to fluctuations in mortgage production levels. Source One's
mortgage loans held for sale are funded mainly with debt. Therefore, Source
One's average indebtedness outstanding declined in 1995 from 1994 levels and
increased in 1996 from 1995 levels.
Source One's provision for mortgage loan losses, included in general expenses,
was $10.3 million in 1996 which compares to $7.0 million for 1995 and $8.2
million for 1994. The increase in the provision for loan losses from 1995 to
1996 is due primarily to (i) higher average loss volumes relating to certain
California residential mortgage loans, (ii) charge-offs relating to certain
commercial real estate owned properties and (iii) an increase in delinquencies
as the result of servicing portfolio acquisitions made by Source One during the
period. The delinquency rates of the newly acquired portfolios (which were
acquired on favorable terms considered to be reflective of these higher
delinquency rates) were generally higher than those of Source One's existing
portfolio resulting in a higher provision for loan losses; however, it is
expected that Source One's proactive management of such delinquencies will
reduce delinquency rates on the acquired portfolios to a level commensurate with
the balance of Source One's servicing portfolio.
The provision for loan losses decreased from $8.2 million for 1994 to $7.0
million for 1995. The 1994 amount includes charge-offs relating to certain
commercial real estate owned properties.
Source One closely monitors the rate of delinquencies and foreclosures
incident to its servicing portfolio. The following table summarizes delinquency
and foreclosure experience with respect to the residential mortgage loans
serviced by Source One:
---------------------------------------------------------------------------------
December 31,
--------------------------------
1996 1995 1994 1993 1992
- ----------------------------------------------------------------------------------
Percent of total residential loans serviced:
Past due:
31-59 days 4.74% 3.99% 3.15% 3.41% 3.26%
60-89 days .95 .70 .54 .58 .65
90 days or more .55 .59 .38 .45 .48
--------------------------------
Total delinquencies 6.24% 5.28% 4.07% 4.44% 4.39%
- --------------------------------------------------================================
Foreclosures .93% .80% .77% .92% .77%
==================================================================================
Source One has established an allowance for mortgage loan losses which
totalled $15.4 million and $13.5 million as of December 31, 1996 and 1995,
respectively. Source One believes that the allowance is adequate to provide for
estimated uninsured losses on the mortgage servicing portfolio.
21
FUND AMERICAN
INCOME TAXES
The income tax provision related to pretax earnings for 1996, 1995 and 1994
represents an effective tax rate of 79.3%, 47.3% and 49.3%, respectively. The
primary reason for the increase in Fund American's effective tax rate from 1995
to 1996 is the 1996 write-off of goodwill and certain other intangible assets
related to Source One. The total pretax write-off of these assets was $33.6
million and the related tax benefit was $3.6 million, as no deferred tax
liability was established related to Source One's goodwill. This had the effect
of increasing Fund American's 1996 effective income tax rate from 45.4% to
79.3%.
Fund American has recorded a net deferred Federal income tax liability of $1.3
million as of December 31, 1996. The deferred tax liability includes a $49.0
million liability related to net unrealized gains on investment securities
partially offset by a $47.7 million net asset related to various operating
items.
On January 2, 1991, the Company sold Fireman's Fund to Allianz of America,
Inc. The $1.3 billion gain from the sale as reported in 1991 included a $75.0
million tax benefit related to the Company's estimated tax loss from the sale.
Since 1991 the Company has carried an estimated reserve related to tax matters
affecting the amount of the deductible tax loss from the sale and other tax
matters. The conclusion in 1995 of Internal Revenue Service ("IRS") audits of
Fund American's Federal income tax returns for all years through December 31,
1985, resolved certain of the tax matters affecting the amount of the Company's
deductible tax loss from the sale of Fireman's Fund and the Company, therefore,
re-estimated its tax reserve. As a result of the reserve re-estimation, the
Company included in its 1995 income statement an additional $66.0 million income
tax benefit from the sale. The amount of tax benefit from the sale of Fireman's
Fund ultimately realized by the Company may be significantly more or less than
the Company's current estimate due to possible changes in or new interpretations
of tax rules, possible amendments to Fund American's 1990 or prior years'
Federal income tax returns, the results of further IRS audits and other matters
affecting the amount of the deductible tax loss from the sale.
LIQUIDITY AND CAPITAL RESOURCES
Since the sale of Fireman's Fund, Fund American has been gradually liquidating
its portfolio of passive investment securities. Management's primary strategic
goal is to either (i) reinvest Fund American's passive investments, together
with other resources available to Fund American, into operating businesses in
which management has knowledge and experience (if appropriate opportunities can
be found) or (ii) return excess capital to shareholders through additional
repurchases of Shares. Management believes that this strategy will, over time,
further enhance shareholder value. As is further described below, the formation,
capitalization and ongoing development of White Mountains embodies this
strategy.
PARENT COMPANY
The primary sources of cash inflows for the Company are investment income,
sales of investment securities and dividends received from its operating
subsidiaries.
In June 1994 the Company entered into a revolving credit agreement with a
syndicate of banks. Under the agreement, through August 9, 1996, the Company and
certain of its subsidiaries could borrow up to $75.0 million at short-term
market interest rates. The credit agreement contained certain customary
covenants, including a $475.0 million minimum tangible net worth requirement and
a minimum financial asset coverage requirement. At December 31, 1995, the
Company had no borrowings outstanding under the agreement.
In November 1996 the Company entered into a new revolving credit agreement
with a syndicate of banks. Under the agreement, through November 25, 1997, the
Company and certain of its subsidiaries may borrow up to $35.0 million at short-
term market interest rates. The credit agreement contains certain customary
covenants including a minimum tangible net worth requirement, a minimum
financial asset coverage requirement and a maximum leverage ratio requirement.
At December 31, 1996, the Company was in compliance with all covenants under the
facility and had no borrowings outstanding under the agreement.
22
FUND AMERICAN
During 1993 the Company issued $150.0 million in principal amount of medium-
term notes for net cash proceeds of $148.0 million after related costs.
Proceeds from the issuance of the notes were used to repay an existing revolving
credit facility and for general corporate purposes. During 1995 and 1994 the
Company repurchased $8.8 million and $25.0 million, respectively, in principal
amount of the notes due in February 2003. At December 31, 1996, the remaining
outstanding notes had an average maturity of 6.4 years and an average yield to
maturity of 7.82%.
In August 1994 the Company redeemed 22,778 shares of the Series D Preferred
Stock for $82.0 million. In July 1995 the Company redeemed the remaining 20,833
shares of the Series D Preferred Stock outstanding for $75.0 million. The
redemption price for the shares of Series D Preferred Stock redeemed was equal
to the stock's liquidation preference. The annual dividend rate on the Series D
Preferred Stock was 7.75% through July 1994 and 8.75% from August 1994 through
July 1995.
During 1996, 1995 and 1994 the Company repurchased 779,077 Shares, 877,868
Shares and 1,128,057 Shares, respectively, for $66.3 million, $65.5 million and
$78.8 million, respectively. All such repurchased Shares have been retired. The
repurchases of Shares represent a return of excess capital to the Company's
shareholders.
During 1994 the Company did not pay regular cash dividends to holders of
Shares. In the fourth quarter of 1995 the Board reinstated a $.20 regular
quarterly dividend on Shares. During 1995 and 1996 the Company declared and paid
cash dividends totalling $.20 and $.80 per Share, respectively. The Board
currently intends to reconsider from time to time the declaration of regular
periodic dividends on Shares with due consideration given to the financial
characteristics of Fund American's remaining invested assets and operations and
the amount and regularity of its cash flows at the time. There can be no
assurance, therefore, as to whether or when the Board will declare additional
dividends on Shares.
In connection with Source One's February 28, 1997, sale of approximately $17.0
billion of mortgage servicing rights to a third party, the Company has made
certain collection, payment and performance guarantees to the buyer for a period
of no more than ten years. The aggregate amount of the Company's guaranty is
initially limited to $20.0 million and is expected to amortize down to $15.0
million.
On December 22, 1993, the Company distributed approximately 74% of the
outstanding White River Shares to its shareholders. White River commenced
operations on September 24, 1993, concurrent with the purchase and transfer of
selected assets and the assumption of certain liabilities from Fund American.
The assets sold or otherwise transferred by Fund American to White River
included primarily $84.0 million of common equity securities, $147.1 million of
securities classified as other investments and $25.8 million of short-term
investments. White River's initial capitalization consisted of a $50.0 million
term note payable to Fund American (the "Term Note"), $7.0 million of redeemable
preferred stock and $200.0 million of common shareholder's equity. Of the
1,014,750 White River Shares retained by Fund American, 295,932 have been
reserved by Fund American for delivery upon exercise of existing employee stock
options and warrants.
Pursuant to the terms of a December 1993 credit agreement among the Company
and White River, the Company provided White River with the Term Note and a $40.0
million revolving credit facility (the "Revolver"). The credit agreement granted
White River the right to use certain of its investment securities to repay its
borrowings under the Term Note and the Revolver.
On June 29, 1995, White River repaid $35.1 million in principal amount of the
Revolver with (i) 930,000 Mid Ocean Shares and (ii) options to acquire an
additional 388,140 Mid Ocean Shares through November 2002. On July 3, 1995,
White River repaid the remaining $4.9 million principal balance of the Revolver
and $5.0 million in principal amount of the Term Note in exchange for certain
common equity securities. On August 31, 1995, White River repaid the remaining
$45.0 million principal balance of the Term Note with 1,525,424 shares of common
stock of Zurich Reinsurance Centre Holdings, Inc.
WHITE MOUNTAINS
In 1995 the Company capitalized White Mountains with $200.0 million of equity
capital and in 1996 further capitalized White Mountains with an additional $95.0
million of equity capital. White Mountains was formed to be the holding company
for all of Fund American's insurance operating interests including Valley,
Charter and WMIC, as well as its investments in FSA, Folksamerica and MSA.
23
FUND AMERICAN
In November 1995 Charter issued two notes totalling $20.2 million. Certain
of the notes were due in 1996 and other notes could be extended to be payable in
three equal installments in 1997, 1998 and 1999. During 1996 Charter elected to
extend the maturity of $3.2 million of notes payable. The notes are
collateralized by certain assets of Charter.
In November 1996 White Mountains and Valley entered into a five year credit
facility under which they may borrow $50.0 million and $15.0 million,
respectively, at market interest rates. The $15.0 million of borrowings under
the facility available to Valley are guaranteed by White Mountains. The
facility contains certain customary covenants including a minimum tangible net
worth requirement, a minimum financial asset coverage requirement, a maximum
leverage ratio requirement, a minimum fixed charge coverage ratio requirement
and a minimum policyholders' surplus requirement. The facility also limits
White Mountains' ability to pay dividends to its shareholders. As of December
31, 1996, White Mountains and its subsidiaries were in compliance with all
covenants under the facility. During 1996 Valley borrowed $15.0 million under
the facility with a weighted average interest rate of 5.825%. White Mountains
had no borrowings during 1996 under the facility.
On November 1, 1996, Fund American signed a definitive agreement (the "MSA
Agreement") to increase its ownership of MSA from 33% to 50%. MSA currently
shares in 40% of NGM's business through a quota share reinsurance agreement
which is expected to be increased to 60% pursuant to the MSA Agreement. Also
pursuant to the MSA Agreement, NGM will contribute certain of its insurance,
reinsurance and information and financial services subsidiaries to MSA. The
aggregate purchase price to be paid by Fund American pursuant to the MSA
Agreement is approximately $60.2 million, subject to certain purchase price
adjustments. Fund American expects to assign the additional investment in MSA
to White Mountains. White Mountains expects that the purchase price for the
additional MSA investment will be paid with proceeds from borrowings under White
Mountains' $50.0 million revolving credit facility, and sales and maturities of
passive investment securities. The closing is dependent upon the receipt of
state regulatory approvals and is expected to occur in the second quarter of
1997.
On March 17, 1997, the Boards of Directors of the Company, White Mountains,
Source One and FAE approved a plan whereby Source One will become a part of Fund
American's permanent operating group. The plan also calls for approximately
$139 million of capital infusions into Source One. This step is intended to
improve Source One's debt ratings and reduce Source One's borrowing costs. As a
result of the transaction, White Mountains' shareholder's equity is expected to
increase to more than $760 million. Portions of the plan are subject to
insurance regulatory approvals and will require amending various credit
facilities of the Company, White Mountains, Source One, FAE, and Valley. Fund
American believes that it will receive the requisite insurance regulatory and
banking approvals to proceed with the transaction in the second quarter of 1997;
however, there is no assurance that such approvals will be obtained.
Under the insurance laws of the various states under which the Insurance
Companies are incorporated or licensed to write business, an insurer is
restricted with respect to the amount of dividends it may pay without prior
approval by state regulatory authorities. Accordingly, there is no assurance
that dividends may be paid by the Insurance Companies in the future.
SOURCE ONE
Source One's investments, mortgage loans held for sale and mortgage loan
servicing portfolio provide a liquidity reserve since they may be sold to meet
liquidity needs.
On February 28, 1997, Source One sold the rights to service $17.0 billion
of mortgage loans to a third party for gross proceeds of $271.5 million. Source
One will continue to service these loans pursuant to a subservicing agreement
for a period of no less than 12 months. Source One is currently evaluating its
options as to how it will utilize the proceeds from the sale. These options
include: (i) purchasing additional mortgage servicing rights from third
parties; (ii) reducing its outstanding indebtedness; (iii) reducing its
outstanding preferred or common shareholders' equity; or (iv) any combination of
the foregoing.
In 1996 Source One sold the rights to service $3.3 billion of mortgage
loans to third parties for net cash proceeds of $55.9 million. The proceeds
were used by Source One for general corporate purposes.
24
FUND AMERICAN
In 1995 Source One sold the rights to service $11.0 billion of mortgage
loans to third parties for net cash proceeds of $181.1 million. The proceeds
were used by Source One to retire debt and to repurchase shares of its common
stock from FAE.
In 1994 Source One sold the rights to service $3.9 billion of mortgage
loans to third parties for net cash proceeds of $70.2 million. Source One
continues to service these loans pursuant to a subservicing agreement which ends
in 1999. The proceeds were used by Source One to retire debt and for general
corporate purposes.
In August 1995 Source One entered into a $60.0 million unsecured revolving
credit facility which was extended in 1996 and expires in July 1997. As of
December 31, 1996 and 1995, there was $45.0 million and $60.0 million
outstanding under this arrangement, respectively. Source One also has a
revolving credit agreement under which it can borrow up to $10.0 million through
June 30, 1997. As of December 31, 1996 and 1995, there was $0 and $4.5 million
outstanding under this agreement, respectively.
In November 1996 Source One amended and restated its secured revolving
credit agreement dated March 1995. The provisions of the amended agreement
increased the size of the facility from $500 million to $750 million. The size
of the facility may be further increased at Source One's option with bank
concurrence up to $1.25 billion. Borrowings under the facility and commercial
paper backed by the facility are secured primarily by Source One's mortgage
loans receivable and mortgage servicing portfolio. The facility expires on
November 12, 1999. As of December 31, 1996, Source One had no outstanding
borrowings under this facility.
Source One must comply with certain financial covenants provided in its
secured and unsecured revolving credit facilities, including restrictions
relating to tangible net worth and leverage. In addition, the secured facility
contains certain covenants which limit Source One's ability to pay dividends or
make distributions of its capital in excess of preferred stock dividends and
subordinated debt interest requirements each year. Source One is currently in
compliance with all such covenants.
Source One has a $650.0 million domestic and Euro commercial paper program.
As of December 31, 1996 and 1995, there was $362.2 million and $256.6 million of
commercial paper outstanding, respectively. The weighted average number of days
to maturity of commercial paper outstanding at December 31, 1996 and 1995, was
23 days and 19 days, respectively.
In 1992 Source One issued $100.0 million of 9% debentures due in 2012
pursuant to a $250.0 million shelf registration statement. The proceeds from
issuance were used for general corporate purposes.
In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in
2001. During 1995 Source One repurchased and retired in principal amount $21.6
million of these notes.
In 1989 Source One issued $40.0 million of medium-term notes due in 1996
and having a total weighted average interest rate of 9.65%. During 1996 and
1995 Source One repurchased and retired $29.7 million and $10.3 million in
principal amount of these notes, respectively.
In 1986 Source One issued $125.0 million of 8.25% debentures due November
1, 1996. During 1996 and 1995 Source One repurchased and retired $74.6 and
$50.4 million in principal amount of these debentures, respectively.
On December 8, 1995, Source One exchanged and retired 2,239,061 shares of
preferred stock (the "Source One Preferred Stock") for $56.0 million in
principal amount of 9.375% subordinated debentures. The subordinated debentures
are due on December 31, 2025, but are redeemable at the option of Source One, in
whole or part, at any time on or after May 1, 1999. Source One pays quarterly
cash dividends on the Source One Preferred Stock at an annual rate of 8.42%.
Dividends on the Source One Preferred Stock totalled $3.7 million, $8.4 million
and $5.2 million for the years ended December 31, 1996, 1995 and 1994,
respectively.
On March 17, 1997, the Boards of Directors of the Company, White Mountains,
Source One and FAE approved a plan whereby Source One will become a part of Fund
American's permanent operating group. The plan also calls for approximately
$139 million of capital infusions into Source One. As a result of the
transaction, Source One's pro forma common shareholders' equity is expected to
increase to more than $400 million. This step is intended to improve Source
One's debt ratings and reduce Source One's borrowing costs. Portions of the
plan are subject to insurance regulatory approvals and will require amending
various credit facilities of the Company, White Mountains, Source One, FAE, and
Valley. Fund American believes that it will receive the requisite insurance
regulatory and banking approvals to proceed with the transaction in the second
quarter of 1997; however, there is no assurance that such approvals will be
obtained.
25
FUND AMERICAN
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data have been filed as a part of
this Annual Report on Form 10-K as indicated in the Index to Financial
Statements and Financial Statement Schedules appearing on page 33 of this
report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On January 24, 1997, the Company's Board of Directors, upon recommendation of
the Audit Committee, appointed KPMG Peat Marwick LLP as its independent auditors
for the fiscal year ending December 31, 1997, to replace Ernst & Young LLP
("Ernst & Young") as independent auditors for the Company and Coopers & Lybrand
L.L.P. ("Coopers & Lybrand") as independent auditors for Valley, effective upon
the date of their reports on such consolidated financial statements for the year
ended December 31, 1996, contained herein.
In connection with the audits of the two years ended December 31, 1996, there
were no disagreements with Ernst & Young on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope and procedures
which, if not resolved to their satisfaction, would have caused them to make
reference in connection with their opinion to the subject matter of the
disagreement.
The Company acquired Valley on December 1, 1995. Coopers & Lybrand has served
as the independent auditors of Valley. The report of Coopers & Lybrand on the
consolidated financial statements of Valley for the year ended December 31,
1996, has been relied upon in the Ernst & Young report contained herein. There
have been no disagreements with Coopers & Lybrand on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope and
procedures with respect to Valley.
The Company has requested Ernst & Young and Coopers & Lybrand to furnish a
letter addressed to the Commission stating whether it agrees with the above
statements. Copies of those letters, dated March 27, 1997, are filed herein as
Exhibits 16(a) and 16(b).
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
A. DIRECTORS (AS OF MARCH 21, 1997)
Reported under the caption "Election of Directors" on pages 3 through 5 of the
Company's 1997 Proxy Statement, herein incorporated by reference.
B. EXECUTIVE OFFICERS (AS OF MARCH 21, 1997)
- ------------------------------------------------------------------------------------
Executive
officer
Name Position Age since
- ------------------------------------------------------------------------------------
Terry L. Baxter President of White Mountains 51 1994
Dennis P. Beaulieu Vice President and Secretary 49 1995
John J. Byrne Chairman, President and CEO 64 1985
Reid T. Campbell Assistant Controller 29 1996
James A. Conrad President and CEO of Source One 55 1986
K. Thomas Kemp Executive Vice President of the Company,
Chairman and CEO of White Mountains 56 1991
James H. Ozanne President of FAE 53 1997
Michael S. Paquette Vice President and Controller 33 1993
David G. Staples Vice President and Director of Taxation 36 1997
Allan L. Waters Senior Vice President and Chief Financial Officer 39 1990
====================================================================================
26
FUND AMERICAN
All executive officers are elected by the Company's Board of Directors for a
term of one year or until their successors have been elected and have duly
qualified.
MR. BAXTER was elected President of White Mountains in February 1997 and
has served as Chairman of Source One since May 1996. Mr. Baxter previously
served as President and Secretary of FAE which positions he held since 1994.
Prior to joining Fund American in 1994, Mr. Baxter was Managing Director of the
National Transportation Safety Board from 1990. Prior to that, he was the
Assistant Director of OMB in the Reagan Administration. Mr. Baxter is a
director of FAE, MSA, Source One, White Mountains and WMIC.
MR. BEAULIEU was elected Vice President and Secretary in February 1995 and
also serves as Vice President and Secretary of White Mountains and Chief
Financial Officer of WMIC. Prior to joining Fund American in 1995, Mr. Beaulieu
was Senior Vice President and Chief Financial Officer of New Dartmouth Bank.
Mr. Beaulieu is a director of White Mountains and WMIC.
MR. BYRNE has served as Chairman, President and Chief Executive Officer
since 1990, as Chairman and Chief Executive Officer from 1985 to 1990 and was
Chairman and Chief Executive Officer of Fireman's Fund from 1989 through January
2, 1991. Mr. Byrne is also Chairman of FSA and FAE.
MR. CAMPBELL was elected Assistant Controller in February 1996 and has been
with Fund American since 1994. Mr. Campbell is also Assistant Controller of
White Mountains and is a director of WMIC. Prior to joining Fund American, Mr.
Campbell was with KPMG Peat Marwick from 1990 to 1994.
MR. CONRAD has served as President and Chief Executive Officer of Source
One since 1990, as Executive Vice President of its Production Division from 1987
to 1989, and as Corporate Vice President of its Wholesale Division from 1985 to
1987. Mr. Conrad is also a director of Source One.
MR. KEMP has served as Executive Vice President since 1993 and became a
director of the Company in 1994. He served as Vice President, Treasurer and
Secretary from 1991 to 1993. He is also Chairman and Chief Executive Officer of
White Mountains and Chairman of WMIC. Mr. Kemp was a Vice President of
Fireman's Fund from 1990 to January 2, 1991. Prior to joining Fireman's Fund,
Mr. Kemp was President of Resolute Reinsurance Company. Mr. Kemp is Chairman of
White Mountains, Valley, Charter and WMIC. Mr. Kemp is also a director of
Folksamerica, FSA, FAE, MSA and White Mountains.
MR. OZANNE was elected President of FAE in February of 1997 and is
currently Vice Chairman of Source One. Mr. Ozanne has previously served in
various capacities at Nations Financial Holdings Corporation including Chairman
and Director from 1993 to 1996 and was President and CEO of U S WEST Capital
Corporation from 1989 to 1993. Prior to 1989, Mr. Ozanne was Executive Vice
President at General Electric Capital Corporation. Mr. Ozanne is a director of
FSA, Source One and FAE.
MR. PAQUETTE was elected Vice President and Chief Accounting Officer in
1993 and was appointed Vice President and Controller in February 1995. Mr.
Paquette is also Vice President and Controller of White Mountains and WMIC. He
was formerly Secretary of FAE from 1990 to 1993 and has been a member of the
Fund American organization since 1989. Mr. Paquette is a director of FAE, White
Mountains and WMIC.
MR. STAPLES was elected Vice President and Director of Taxation in February
1997 and has been with Fund American since 1996. Prior to joining Fund
American, Mr. Staples served as Vice President and Director of Taxation for Crum
& Forster Holdings, Inc. from 1993 to 1996, and was with KPMG Peat Marwick from
1983 to 1993.
MR. WATERS was elected Senior Vice President and Chief Financial Officer in
1993. Mr. Waters is also Senior Vice President and Chief Financial Officer of
White Mountains. He was formerly Vice President and Controller of FAE from 1991
to 1993; was Vice President, Controller and Assistant Secretary of the Company
from 1990 to 1991, and was Vice President, Finance of the Company from 1988 to
1990. Mr. Waters is a director of Folksamerica, FSA, FAE, Source One, White
Mountains and WMIC.
ITEM 11. EXECUTIVE COMPENSATION
Reported under the captions "Compensation of Executive Officers" on pages 8
through 10, "Reports of the Compensation Committees on Executive Compensation"
on pages 11 though 14, "Shareholder Return Graph" on page 15, and "Compensation
Plans" on pages 16 through 17 of the Company's 1997 Proxy Statement, herein
incorporated by reference.
27
FUND AMERICAN
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Reported under the caption "Voting Securities and Principal Holders Thereof"
on pages 6 through 7 of the Company's 1997 Proxy Statement, herein incorporated
by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Reported under the captions "Certain Transactions" on page 10 and
"Compensation Committee Interlocks and Insider Participation in Compensation
Decisions" on page 17 of the Company's 1997 Proxy Statement, herein incorporated
by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
B. REPORTS ON FORM 8-K
No Reports on Form were filed during the fourth quarter of 1996 by the
Company.
28
FUND AMERICAN
C. EXHIBITS
EXHIBIT
NUMBER NAME
- ------- ----
3 (i) - Amended and Restated Certificate of Incorporation of the Company
(incorporated by reference to Exhibit 3(a) of the Company's 1993
Annual Report on Form 10-K).
(ii) - Amended and Restated By-Laws of the Company (incorporated by
reference to Exhibit 3(b) of the Company's 1993 Annual Report on
Form 10-K)
4 - Indenture dated January 1, 1993, with The First National Bank of
Chicago, as trustee, pursuant to the Company's offering of $150
million of medium-term notes (incorporated by reference to Exhibit
(4) of the Company's Report on Form 8-K dated January 15, 1993)
9 - Voting Trust Agreement dated September 2, 1994 between the Company,
U S WEST Capital Corporation and First Chicago Trust Company of New
York (filed pursuant to Exhibit 10(f) herein)
10 (a) - Credit Agreement dated June 2, 1994 among the Company, Fund
American Enterprises, Inc., FFOG, Inc., the banks named therein and
The Chase Manhattan Bank (incorporated by reference to Exhibit
10(a) of the Company's 1994 Annual Report on Form 10-K)
(b) - Amendment No. 1 to the Credit Agreement dated June 1, 1995 among
the Company, Fund American Enterprises, Inc., FFOG, Inc., the banks
named therein and The Chase Manhattan Bank (incorporated by
reference to Exhibit 10(b) of the Company's 1995 Annual Report on
Form 10-K)
(c) - Amendment No. 2 to the Credit Agreement dated August 2, 1995 among
the Company, Fund American Enterprises, Inc., FFOG, Inc., the banks
named therein and The Chase Manhattan Bank (incorporated by
reference to Exhibit 10(c) of the Company's 1995 Annual Report on
Form 10-K)
(d) - Amendment No. 3 to the Credit Agreement dated August 11, 1995 among
the Company, Fund American Enterprises, Inc., FFOG, Inc., the banks
named therein and The Chase Manhattan Bank (incorporated by
reference to Exhibit 10(d) of the Company's 1995 Annual Report on
Form 10-K)
(e) - Credit Agreement dated November 26, 1996 among the Company, Fund
American Enterprises, Inc., the Lenders (as named therein) and The
First National Bank of Chicago(*)
(f) - Credit Agreement dated November 26, 1996 among the White Mountains
Holdings, Inc., the Lenders (as named therein) and The First
National Bank of Chicago(*)
(g) - Credit Agreement dated November 26, 1996 among Valley Group, Inc.,
the Lenders (as named therein) and The First National Bank of
Chicago(*)
(h) - Securities Purchase Agreement dated April 10, 1994 between the
Company, U S WEST, Inc., U S WEST Capital Corporation and Financial
Security Assurance Holdings Ltd. (incorporated by reference to
Exhibit 10(a) of the Company's Report on Form 8-K dated April 10,
1994)
(i) - Stock Purchase Agreement dated August 8, 1995 between the Company,
Skandia U.S. Holding Corporation, and Skandia America Corporation
(incorporated by reference to Exhibit 10(e) of the Company's 1995
Annual Report on Form 10-K)
(j) - Securities Purchase Agreement dated March 6, 1996 between the
Company and Folksamerica Holdings Company, Inc. (incorporated by
reference to Exhibit 10(a) of the Company's Report on Form 8-K
dated June 19, 1996)
(k) - Employment Agreement dated February 15, 1995, between the Company
and John J. Byrne (incorporated by reference to Appendix II of the
Company's Notice of 1995 Annual Meeting of Shareholders and Proxy
Statement)(**)
(l) - Common Stock Warrant Agreement with respect to shares of the
Company's Common stock between the Company and John B. Byrne
(incorporated by reference to Exhibit 10(v) of the Company's
Registration Statement on Form S-1 (No. 33-0199))(**)
(m) - The Company's Retirement Plan for Non-Employee Directors
(incorporated by reference to Exhibit 10(aa) of the Company's 1992
Annual Report on Form 10-K)(**)
29
FUND AMERICAN
(n) - The Company's Voluntary Deferred Compensation Plan, as amended
on November 15, 1996 (*)(**)
(o) - The Company's Deferred Benefit Plan, as amended on November 15,
1996 (*)(**)
(p) - The Company's Long-Term Incentive Plan, as amended February 15,
1995 (incorporated by reference to Appendix I of the Company's
Notice of 1995 Annual Meeting of Shareholders and Proxy
Statement (**)
(q) - Agreement dated June 5, 1996 among Source One Mortgage Services
Corporation and Robert T. Richards (*)(**)
(r) - Source One Mortgage Services Corporation's Long-Term Incentive
Plan (incorporated by reference to Exhibit 10(n) of the
Company's 1994 Annual Report on Form 10-K)(**)
(s) - Source One Mortgage Services Corporation's Voluntary Deferred
Compensation Plan (incorporated by reference to Exhibit 10(s) of
the Company's 1993 Annual Report on Form 10-K)(**)
(t) - Source One Mortgage Services Corporation's Amended and Restated
Executive Phantom Stock Plan (incorporated by reference to
Exhibit 10(t) of the Company's 1993 Annual Report on Form
10-K)(**)
(u) - Source One Mortgage Services Corporation's Stock Appreciation
Rights Plan (incorporated by reference to Exhibit 10(u) of the
Company's 1993 Annual Report on Form 10-K)(**)
(v) - Investment Contract by and between Source One Mortgage Services
Corporation and James A. Conrad (incorporated by reference to
Exhibit 10(v) of the Company's 1993 Annual Report on Form
10-K)(**)
(w) - Investment Contract by and between Source One Mortgage Services
Corporation and Robert W. Richards (incorporated by reference
to Exhibit 10(w) of the Company's 1993 Annual Report on Form
10-K(**)
(x) - Credit Agreement, dated December 13, 1993, among the Company
and White River Corporation (incorporated by reference to
Exhibit 10(x) of the Company's 1993 Annual Report on Form
10-K)(**)
(y) - Guaranty, dated February 28, 1997, by the Company to and for the
benefit of Chemical Mortgage Company (*)
11 - Statement Re Computation of Per Share Earnings (*)
16(a) - Letter of Ernst & Young LLP dated March 27, 1997(*)
(b) - Letter of Coopers & Lybrand L.L.P. dated March 27, 1997 (*)
18 - Letter from Ernst & Young LLP regarding change in accounting
principle (incorporated by reference to Exhibit 18 of the
Company's 1994 Annual Report on Form 10-K)
21 - Subsidiaries of the Registrant (*)
23(a) - Consent of Ernst & Young LLP dated March 27, 1997(*)
(b) - Consent of Coopers & Lybrand L.L.P. dated March 27, 1997
relating to Valley (*)
(c) - Consent of Coopers & Lybrand L.L.P. dated March 27, 1997
relating to FSA (*)
24 - Powers of Attorney (*)
27 - Financial Data Schedule (*)
99(a) - Report to Coopers & Lybrand L.L.P. dated February 14, 1997
relating to Valley(*)
99(a) - Report to Coopers & Lybrand L.L.P. dated January 24, 1997
relating to FSA (*)
==========================================================================
(*) included herein.
(**) management contracts or compensation plans/arrangements required to be
filed as an exhibit pursuant to Item 14(a) of Form 10-K.
D. FINANCIAL STATEMENT SCHEDULES
The financial statement schedules and report of independent auditors have
been filed as part of this Annual Report on Form 10-K as indicated in the
Index to Financial Statements and Financial Statement Schedules appearing
on page 33 of this report.
30
FUND AMERICAN
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
Date: March 27, 1997 By: /s/ MICHAEL S. PAQUETTE
---------------------------------
Michael S. Paquette
Vice President and Controller
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
JOHN J. BYRNE* Chairman, President and March 27, 1997
- --------------------------- Chief Executive Officer
John J. Byrne
HOWARD L. CLARK* Director March 27, 1997
- ---------------------------
Howard L. Clark
HOWARD L. CLARK, JR.* Director March 27, 1997
- ---------------------------
Howard L. Clark, Jr.
ROBERT P. COCHRAN* Director March 27, 1997
- ---------------------------
Robert P. Cochran
GEORGE J. GILLESPIE, III* Director March 27, 1997
- ---------------------------
George J. Gillespie, III
/s/ K. THOMAS KEMP Executive Vice President and March 27, 1997
- --------------------------- Director
K. Thomas Kemp
GORDON S. MACKLIN* Director March 27, 1997
- ---------------------------
Gordon S. Macklin
FRANK A. OLSON* Director March 27, 1997
- ---------------------------
Frank A. Olson
MICHAEL S. PAQUETTE* Vice President and Controller March 27, 1997
- ---------------------------
Michael S. Paquette
ALLAN L. WATERS* Senior Vice President and March 27, 1997
- --------------------------- Chief Financial Officer
Allan L. Waters
ARTHUR ZANKEL* Director March 27, 1997
- ---------------------------
Arthur Zankel
*By: /s/ K. THOMAS KEMP
- -----------------------------------
K. Thomas Kemp, Attorney-in-Fact
32
FUND AMERICAN
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
- --------------------------------------------------------------------------------------------
Form
10-K
page(s)
- --------------------------------------------------------------------------------------------
FINANCIAL STATEMENTS:
Consolidated balance sheets as of December 31, 1996 and 1995.......................... F-1
Consolidated income statements for each of the years
ended December 31, 1996, 1995 and 1994............................................... F-2
Consolidated statements of shareholders' equity for
each of the years ended December 31, 1996, 1995 and 1994............................. F-3
Consolidated statements of cash flows for each of the
years ended December 31, 1996, 1995 and 1994......................................... F-4
Notes to consolidated financial statements............................................ F-5
OTHER FINANCIAL INFORMATION:
Selected quarterly financial data (unaudited)......................................... F-33
Report on management's responsibilities............................................... F-34
Report of independent auditors........................................................ F-35
FINANCIAL STATEMENT SCHEDULES:
I. Marketable securities and other investments................................ FS-1
III. Condensed financial information of registrant.............................. FS-2
============================================================================================
All other schedules are omitted as they are not applicable or the information
required is included in the financial statements or notes thereto.
33
FUND AMERICAN
CONSOLIDATED BALANCE SHEETS
- ----------------------------------------------------------------------
December 31,
----------------------
Dollars in millions 1996 1995
- ----------------------------------------------------------------------
ASSETS
Common equity securities, at fair value
(cost $101.1 and $232.1) $ 160.8 $ 274.5
Fixed maturity investments, at fair
value (cost $154.5 and $109.8) 155.4 110.7
Other investments (cost $119.7 and $86.7) 176.5 95.9
Short-term investments, at amortized
cost (which approximated fair value) 67.5 103.6
----------------------
Total investments 560.2 584.7
Cash 4.8 2.7
Capitalized mortgage servicing, net of
accumulated amortization 410.9 397.1
Mortgage loans held for sale 314.9 381.0
Pool loan purchases 131.5 119.0
Mortgage claims receivable and real
estate acquired, less allowance for
mortgage loan losses of $15.4 and $13.5 51.5 45.4
Insurance premiums receivable 52.2 45.3
Investments in unconsolidated insurance
affiliates 226.9 96.2
Other assets 227.7 200.5
----------------------
Total assets $ 1,980.6 $ 1,871.9
======================================================================
LIABILITIES
Short-term debt $ 407.9 $ 445.4
Long-term debt 424.2 407.3
Unearned insurance premiums 72.6 35.0
Loss and loss adjustment expense
reserves 65.4 44.1
Accounts payable and other liabilities 279.5 196.4
----------------------
Total liabilities 1,249.6 1,128.2
- ----------------------------------------------------------------------
Minority interest - preferred stock of
subsidiary 44.0 44.0
- ----------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common stock - authorized 125,000,000 shares,
issued 31,940,202 and 32,719,279 shares 31.9 32.7
Paid-in surplus 366.5 375.5
Retained earnings 1,067.1 1,124.6
Common stock in treasury, at cost:
25,034,939 shares (871.0) (871.0)
Net unrealized investment gains, after tax 92.5 37.9
----------------------
Total shareholders' equity 687.0 699.7
- ----------------------------------------------------------------------
Total liabilities, minority
interest and shareholders' equity $ 1,980.6 $ 1,871.9
======================================================================
See Notes to Consolidated Financial Statements.
F-1
FUND AMERICAN
CONSOLIDATED INCOME STATEMENTS
- ------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------
Millions, except per share amounts 1996 1995 1994
- ------------------------------------------------------------------------------------------
REVENUES:
Gross mortgage servicing revenue $ 139.6 $ 141.9 $ 169.3
Amortization and impairment of
capitalized mortgage servicing (71.9) (81.4) (86.9)
Net gain on financial instruments 9.9 .8 -
-----------------------------
Net mortgage servicing revenue 77.6 61.3 82.4
Net gain on sales of mortgages 38.3 24.0 29.5
Gain on sales of mortgage servicing rights 10.1 40.0 -
Other mortgage operations revenue 18.1 15.6 23.9
Property and casualty insurance premiums earned 109.7 5.8 -
Earnings from unconsolidated insurance affiliates 12.0 9.4 2.5
Other insurance operations revenue 9.4 10.8 -
Net investment income 57.3 55.4 90.2
-----------------------------
Total revenues 332.5 222.3 228.5
- ------------------------------------------------------------------------------------------
EXPENSES:
Compensation and benefits 91.3 111.6 69.2
General expenses 120.0 60.3 77.7
Interest expense 50.0 45.8 78.8
Insurance losses and loss adjustment expenses 85.9 8.2 -
-----------------------------
Total expenses 347.2 225.9 225.7
- ------------------------------------------------------------------------------------------
Pretax operating earnings (loss) (14.7) (3.6) 2.8
Net realized investment gains 38.5 38.8 38.8
-----------------------------
Pretax earnings 23.8 35.2 41.6
Income tax provision 18.9 16.7 20.5
-----------------------------
AFTER TAX EARNINGS 4.9 18.5 21.1
Tax benefit from sale of discontinued operations - 66.0 -
Loss on early extinguishment of debt, after tax - (.4) -
Cumulative effect of accounting change -
purchased mortgage servicing, after tax - - (44.3)
-----------------------------
Net income (loss) 4.9 84.1 (23.2)
Dividends on preferred stock - (3.8) (9.9)
-----------------------------
Net income (loss) applicable to common stock 4.9 $ 80.3 $ (33.1)
- -------------------------------------------------------------=============================
PRIMARY EARNINGS PER SHARE:
After tax earnings $ .60 $ 1.71 $ 1.20
Tax benefit from sale of discontinued operations - 7.69 -
Loss on early extinguishment of debt, after tax - (.04) -
Cumulative effect of accounting change - - (4.71)
-----------------------------
Net income (loss) $ .60 $ 9.36 $ (3.51)
- -------------------------------------------------------------=============================
FULLY DILUTED EARNINGS PER SHARE:
After tax earnings $ .60 $ 2.02 $ 1.20
Tax benefit from sale of discontinued operations - 7.18 -
Loss on early extinguishment of debt, after tax - (.04) -
Cumulative effect of accounting change - - (4.71)
-----------------------------
Net income (loss) $ .60 $ 9.16 $ (3.51)
==========================================================================================
See Notes to Consolidated Financial Statements.
F-2
FUND AMERICAN
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
--------------------------------------------------------------------------------------------------------------------------------
Net
Common unrealized Loan for
stock and investment common
Preferred paid-in Retained Common stock gains stock
Millions Total stock surplus earnings in treasury (losses) issued
- ---------------------------------------------------------------------------------------------------------------------------------
Balances at January 1, 1994 $905.0 $157.0 $384.2 $1,198.6 $(884.9) $ 74.5 $(24.4)
Net loss (23.2) - - (23.2) - - -
Dividends to preferred
stockholders (9.4) - - (9.4) - - -
Redemption of preferred stock (82.0) (82.0) - - - - -
Purchases of common stock
retired (78.8) - (12.5) (66.3) - - -
Stock warrants exercised 4.9 - - (1.5) 6.4 - -
Change in net unrealized
investment gains and losses,
after tax (54.8) - - - - (54.8) -
Other (.6) - - - - - (.6)
-----------------------------------------------------------------------------------------------
Balances at December 31, 1994 661.1 75.0 371.7 1,098.2 (878.5) 19.7 (25.0)
Net income 84.1 - - 84.1 - - -
Dividends to stockholders (4.8) - - (4.8) - - -
Redemption of preferred stock (75.0) (75.0) - - - - -
Purchases of common stock
retired (65.4) - (9.7) (55.7) - - -
Stock options and warrants
exercised 10.3 - - 2.8 7.5 - -
Extension of outstanding
stock warrants 46.2 - 46.2 - - - -
Change in net unrealized
investment gains and
losses, after tax 18.2 - - - - 18.2 -
Repayment of loan for common
stock issued 25.0 - - - - - 25.0
-----------------------------------------------------------------------------------------------
Balances at December 31, 1995 699.7 - 408.2 1,124.6 (871.0) 37.9 -
Net income 4.9 - - 4.9 - - -
Dividends to common stockholders (5.9) - - (5.9) - - -
Purchases of common stock
retired (66.3) - (9.8) (56.5) - - -
Change in net unrealized
investment gains and
losses, after tax 54.6 - - - - 54.6 -
-----------------------------------------------------------------------------------------------
Balances at December 31, 1996 $687.0 $ - $398.4 $1,067.1 $(871.0) $ 92.5 $ -
=================================================================================================================================
See Notes to Consolidated Financial Statements.
F-3
FUND AMERICAN
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------------
Millions 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------
Net income (loss) $ 4.9 $ 84.1 $ (23.2)
Charges (credits) to reconcile net income (loss)
to cash flows from operations:
Tax benefit from sale of discontinued operations - (66.0) -
Cumulative effect of accounting change - purchased
mortgage servicing, after tax servicing, after taxservicn - - 44.3
Undistributed earnings from unconsolidated insurance affiliates (8.2) (8.6) (2.3)
Compensation expense resulting from warrant extension - 46.2 -
Net realized investment gains (38.5) (38.8) (38.8)
Decrease (increase) in mortgage loans held for sale 66.1 (170.5) 1,088.0
Gain on sales of mortgage servicing rights (10.1) (40.0) -
Increase in unearned insurance premiums 37.6 2.7 -
Increase in insurance premiums receivable (6.9) (1.3) -
(Decrease) increase in deferred insurance policy acquisition costs (6.5) .2 -
Net increase in insurance loss reserves 21.2 12.3 -
Write-off of goodwill and other intangible assets 32.6 - -
Depreciation and amortization of servicing assets, goodwill
and other 85.4 86.4 99.2
Capitalized excess mortgage servicing income (10.1) (7.4) (16.7)
Net change in current and deferred income taxes receivable
and payable 11.8 14.9 21.2
Change in other assets (29.3) (4.9) 24.8
Change in accounts payable and other liabilities 33.7 35.9 (7.3)
Other, net 4.6 (7.0) 4.7
-----------------------------------
Net cash provided from (used for) operating activities 188.3 (61.8) 1,193.9
- --------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Net decrease in short-term investments 36.1 15.6 133.3
Sales and maturities of common stocks and other investments 229.8 204.5 338.2
Sales and maturities of fixed maturity investments 131.7 62.1 -
Purchases of common stocks and other investments (85.0) (63.7) (137.8)
Purchases of fixed maturity investments (180.8) (48.8) (48.5)
Acquisitions of consolidated insurance affiliates (13.2) (42.2) -
Investments in unconsolidated insurance affiliates (107.6) (33.0) (44.0)
Collections on mortgage origination and servicing assets 160.9 192.7 232.3
Additions to purchased mortgage servicing rights (40.5) (82.1) (90.1)
Originated mortgage servicing rights (38.0) (31.2) -
Proceeds from sales of mortgage servicing rights 11.7 181.1 70.2
Additions to other mortgage origination and servicing assets (189.8) (150.4) (242.8)
Net (purchases) sales of fixed assets (7.3) .4 (3.6)
-----------------------------------
Net cash (used for) provided from investing activities (92.0) 205.0 207.2
- --------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Net (repayments) issuances of short-term debt (36.2) 96.5 (1,314.5)
Issuances of long-term debt 15.0 - -
Repayments of long-term debt - (93.7) (23.9)
Proceeds from issuances of preferred stock by subsidiary - - 96.9
Redemptions of preferred stock - (75.0) (82.0)
Purchases of common stock retired (66.3) (65.5) (78.8)
Cash dividends paid to shareholders (5.9) (6.4) (10.8)
Other (.8) 2.1 2.8
-----------------------------------
Net cash used for financing activities (94.2) (142.0) (1,410.3)
- --------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash during year 2.1 1.2 (9.2)
Cash balance at beginning of year 2.7 1.5 10.7
-----------------------------------
Cash balance at end of year $ 4.8 $ 2.7 $ 1.5
==============================================================================================================
See Notes to Consolidated Financial Statements.
F-4
FUND AMERICAN
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. Fund American's principal businesses are
conducted through White Mountains and Source One. White Mountains is an
insurance holding company principally engaged through its subsidiaries and
affiliates in the businesses of property and casualty insurance, financial
guaranty insurance and reinsurance. Source One is one of the largest mortgage
banking companies in the United States. Fund American also owns a passive
investment portfolio.
The financial statements have been prepared in accordance with Generally
Accepted Accounting Principles ("GAAP"). All significant intercompany
transactions have been eliminated in consolidation. The financial statements
include all adjustments considered necessary by management to fairly present the
financial position, results of operations and cash flows of Fund American. The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates. Certain amounts in the prior year financial
statements have been reclassified to conform with the current year presentation.
INVESTMENT SECURITIES
Under the provisions of SFAS No. 115, substantially all of Fund American's
portfolio of common equity securities, fixed maturity investments and other
investments are classified as securities available for sale and are reported at
fair value as of the balance sheet date, with related unrealized investment
gains and losses excluded from earnings and reported as a net amount in a
separate component of shareholders' equity.
Other investments include: non-redeemable preferred and common equity
securities having no established public market value and carried at internally
appraised fair value; securities which, due to restrictions regarding resale,
are carried at a discount to the quoted market value for similar unrestricted
securities; investment partnership interests accounted for using the equity
method; mortgage loans held for investment; residual interests in REMIC's;
interest rate floor contracts; and principal-only swap agreements. Mortgage
loans held for investment are stated at the lower of cost or fair value,
determined on an individual loan basis at the time the permanent investment
decisions were made. REMICs are classified as held to maturity and are carried
at amortized cost using a method which approximates the effective yield method
of amortization. Interest rate floor contracts and principal-only swap
agreements are considered held for interest rate risk management purposes and
are carried at fair value with unrealized gains and losses reported in net gain
on financial instruments.
Short-term investments are carried at amortized cost which approximated fair
value as of December 31, 1996 and 1995. Short-term mortgage-backed securities
are classified as trading securities and are stated at fair value with
unrealized gains and losses, if any, reported in income.
Premiums and discounts on fixed maturity investments are accreted to income
over the anticipated life of the investment.
Realized gains and losses resulting from sales of investment securities or
from other than temporary impairments of value are accounted for using the
specific identification method.
INSURANCE OPERATIONS
Premiums are taken into income as earned on a daily pro rata basis over the
terms of the policies. Unearned premiums represent the portion of premiums
applicable to future insurance coverage provided by policies in force. As of
December 31, 1996, White Mountains' insurance subsidiaries insured property and
casualty risks in Arizona, California, Idaho, New Hampshire, Oregon, Texas, Utah
and Washington.
F-5
FUND AMERICAN
Policy acquisition costs include commissions and other costs that vary with
and are primarily related to the acquisition of new and renewal insurance
policies. Policy acquisition costs are deferred and amortized over the terms of
the applicable policies.
Losses and loss adjustment expenses are charged against income as incurred.
Unpaid losses and loss adjustment expenses are based on estimates by claims
adjusters, legal counsel and actuarial staff of the ultimate costs of settling
claims, including the effects of inflation and other societal and economic
factors. Unpaid loss and loss adjustment expense reserves represent
management's best estimate of ultimate losses and loss adjustment expenses net
of estimated salvage and subrogation recoveries. Such estimates are regularly
reviewed and updated and any adjustments resulting therefrom are reflected in
current operations. The process of estimating loss and loss adjustment expenses
involves a considerable degree of judgement by management and the ultimate
amount of expense to be incurred could be considerably greater than or less than
the amounts currently reflected in the financial statements.
In the normal course of business, White Mountains' insurance subsidiaries seek
to reduce the loss that may arise from catastrophes or other events that may
cause unfavorable underwriting results by reinsuring certain levels of risk in
various areas of exposure with other insurance enterprises or reinsurers. White
Mountains' insurance subsidiaries remain contingently liable for risks reinsured
with third parties to the extent that the reinsurer is unable to honor its
obligations under reinsurance contracts at the time of loss.
Amounts recoverable from reinsurers are estimated in a manner consistent with
the claim liability associated with the reinsured policy. Reinsurance premiums,
commissions, expense reimbursements and reserves related to reinsured business
are accounted for on a basis consistent with those used in accounting for the
original policies issued and the terms of the reinsurance contracts. Premiums
ceded to other companies have been reported as a reduction of premiums written.
Amounts applicable to reinsurance ceded for unearned premium reserves, and loss
and loss adjustment expense reserves, (i.e., prepaid reinsurance premiums and
reinsurance recoverable on unpaid losses, respectively) are not material and
have been included as a component of other assets. Expense allowances received
in connection with reinsurance ceded have been accounted for as a reduction of
the related policy acquisition costs and are deferred and amortized accordingly.
White Mountains' insurance subsidiaries have not entered into any surplus relief
reinsurance arrangements or similar arrangements designed to materially enhance
statutory surplus.
MORTGAGE ORIGINATION AND SERVICING
Fund American acquired Source One in 1986. The purchase price paid for Source
One in 1986 was in excess of the estimated fair value of the net assets acquired
on that date and was allocated to goodwill. Prior to December 1996 Source One's
goodwill was being amortized over 20 years. In December 1996 Fund American
wrote off the remaining unamortized balance of Source One's goodwill and certain
other intangible assets. See Note 5.
Mortgage loans held for sale are stated at the lower of aggregate cost or fair
value.
Conventional mortgage loans are placed on a non-accrual basis when delinquent
90 days or more as to interest or principal. Interest on delinquent FHA insured
loans is accrued at the insured rate beginning on the sixty-first day of
delinquency. Interest on delinquent VA guaranteed loans is accrued at the loan
rate during the period of delinquency.
Gains and losses from sales of mortgage loans are recognized when the proceeds
are received. Loan origination fees, net of certain direct costs, have been
deferred and are recognized as income when the related mortgage loans are sold.
Discounts from the origination of mortgage loans held for sale are deferred and
recognized as adjustments to gains or losses on sales.
Capitalized mortgage servicing includes certain costs incurred in the
origination and acquisition of mortgage servicing rights which are deferred and
amortized over the expected life of the loan. The total cost of acquiring
mortgage loans, either through origination activities or purchase transactions,
is allocated between the mortgage servicing rights and the loans based on their
relative fair values. The fair values of mortgage servicing rights are
estimated by calculating the present value of the expected future cash flows
associated with such rights, incorporating assumptions that market participants
would use in their estimates of future servicing income and expense. A current
market rate is used to discount estimated future cash flows. Impairment of
mortgage servicing
F-6
FUND AMERICAN
rights is measured on a disaggregated basis by stratifying the mortgage
servicing rights based on one or more predominant risk characteristics of the
underlying loans. Impairment is recognized through a valuation allowance for
each individual stratum.
Capitalized mortgage servicing also includes the present value of future
servicing revenue in excess of normal servicing revenue on loans sold with
servicing retained. Such "excess servicing" is deferred and amortized using a
method that relates the anticipated servicing revenue to total projected
servicing revenue to be received over the expected life of the loan. Impairment
tests for excess servicing are performed on a disaggregated basis. The original
discount rate is used to discount excess servicing future cash flows.
Pool loan purchases, which are carried at cost, represent FHA insured, VA
guaranteed and conventional loans which were either delinquent or in the process
of foreclosure at the time they were purchased from GNMA, FNMA or FHLMC
mortgage-backed security pools which Source One services or, to a lesser degree,
from private investors. Interest is accrued on these purchased loans at a rate
based on expected recoveries.
Mortgage claims receivable represent claims filed primarily with FHA and VA.
These receivables are carried at cost less an estimated allowance for amounts
that are not fully recoverable from the claims filed with the underlying
mortgage insuring agencies.
Real estate acquired is stated at the lower of net realizable value or the
recorded balance satisfied at the date of acquisition, as determined on an
individual property basis. Costs related to holding the properties are charged
to expense as incurred.
The allowance for mortgage loan losses is based on an analysis of the mortgage
loan servicing portfolio and, in management's judgment, is adequate to provide
for estimated losses.
Mortgage servicing revenue represents fees earned for servicing real estate
mortgage loans owned by investors and late charge income. The servicing fees
are calculated based on the outstanding principal balances of the loans serviced
and are recognized together with late charge income when received.
Source One adopted the provisions of SFAS No. 122, "Accounting for Mortgage
Servicing Rights," an amendment to SFAS No. 65, as of January 1, 1995. SFAS No.
122 requires the total cost of acquiring mortgage loans, either through loan
origination activities or purchase transactions, to be allocated to the mortgage
servicing rights and the loans based on their relative fair values. The
statement requires entities to measure impairment on a disaggregated basis by
stratifying the mortgage servicing rights based on one or more predominant risk
characteristics of the underlying loans. Impairment is recognized through a
valuation allowance for each individual stratum. In accordance with SFAS No.
122, financial statements prior to 1995 have not been restated.
EARNINGS PER SHARE
For purposes of earnings per share, common stock equivalents include stock
options, warrants and non-cash performance shares. The Series D Preferred Stock
was not a common stock equivalent.
Primary earnings per share amounts are based on the weighted average number of
common shares and dilutive common stock equivalents outstanding. In the
calculation, income is adjusted for any preferred stock dividends. The weighted
average shares used in the primary computation were 8,110,143; 8,581,456 and
9,405,093 for the years ended December 31, 1996, 1995 and 1994, respectively.
Fully diluted earnings per share amounts are based on the weighted average
number of common shares outstanding, assuming full dilution. Income is adjusted
for any preferred stock dividends when the preferred shares are anti-dilutive.
The weighted average shares used in the fully diluted computation were
8,110,229; 9,189,054 and 9,408,785 for the years ended December 31, 1996, 1995
and 1994, respectively.
FUTURE APPLICATION OF ACCOUNTING STANDARD
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities," was issued in June 1996. SFAS No. 125
eliminates the distinction between "normal" servicing rights and excess
servicing receivable and will change Source One's method of measuring the value
of its capitalized excess servicing asset. In November 1996 the effective date
of certain provisions of SFAS No. 125, including those impacting Source
F-7
FUND AMERICAN
One's capitalized excess servicing asset, was proposed to be deferred and is
expected to become effective for all transfers of financial assets occurring
after December 31, 1997. Earlier or retroactive application of SFAS No. 125 is
not currently permitted. The Company has not yet determined what impact, if
any, the adoption of this statement will have on its financial position or
results of operations.
NOTE 2. INSURANCE OPERATIONS
CONSOLIDATED INSURANCE OPERATIONS RECENTLY ACQUIRED AND FORMED
On December 1, 1995, White Mountains acquired Valley and Charter for $41.7
million in cash less $3.0 million of purchase price adjustments. The purchase
price for Valley and Charter was paid with proceeds from sales and maturities of
short-term investments. Valley's wholly owned subsidiary, Valley Insurance
Company, is an "A" rated, Northwest-based property and casualty company which
writes personal and commercial lines through independent agents. In 1996 Valley
Insurance Company wrote $81.9 million of direct premiums primarily in Oregon,
Washington and California. Charter's wholly owned subsidiary, Charter Indemnity
Company, wrote $70.0 million of gross non-standard automobile insurance premiums
in Texas during 1996. The purchase price paid for Valley and Charter was $.9
million less than the aggregate book value and estimated fair value of the net
assets of the companies on the date of acquisition. The resulting negative
goodwill is being amortized to income on a straight-line basis over five years.
WMIC, a New Hampshire licensed commercial property and casualty insurance
company, commenced its operations in September 1995 and wrote $2.4 in direct
premiums during the year ended December 31, 1996. WMIC is currently licensed to
write business in Maine, Massachusetts, New Hampshire and Vermont and is
expected to expand its operations to other states as additional state approvals
are obtained. WMIC is a wholly-owned subsidiary of Valley Insurance Company.
On January 19, 1996, Valley Insurance Company purchased Valley National for
$13.2 million, net of cash balances acquired. Valley National is licensed to
write property and casualty insurance in 48 states. Assets acquired pursuant to
the Valley National acquisition included an investment portfolio, consisting
principally of fixed maturity investments, totalling $6.7 million. Valley
National wrote its first policies in December 1996 and is expected to expand its
operations in 1997. The purchase price paid for Valley National exceeded the
fair value of the tangible assets received. The excess purchase price of $6.4
million is being amortized over a five year period.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVE ACTIVITY
The following table summarizes the Insurance Companies' loss and loss
adjustment expense reserve activity for the years ended December 31, 1996 and
1995:
- --------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Millions 1996 1995
- --------------------------------------------------------------------------
Beginning balance $ 44.1 $ -
Reserves acquired through the purchase
of Valley and Charter - 39.9
Estimated losses and loss adjustment
expenses incurred 82.1 5.2
Reserve strengthening for prior
periods' losses and loss adjustment expenses 3.8 3.0
Losses and loss adjustment expenses paid (64.6) (4.0)
---------------------------
Ending balance $ 65.4 $44.1
==========================================================================
F-8
FUND AMERICAN
ADDITIONAL INSURANCE OPERATIONS INFORMATION
Under the insurance laws of the various states under which the Insurance
Companies are incorporated or licensed to write business, an insurer is
restricted with respect to the amount of dividends it may pay without prior
approval by state regulatory authorities. Accordingly, there is no assurance
that dividends may be paid by the Insurance Companies in the future.
Total policyholders' surplus of the Insurance Companies, as reported to
various regulatory authorities, as of December 31, 1996 and 1995, was $81.4
million and $86.8 million, respectively. The principal differences between the
Insurance Companies' statutory amounts and the amounts reported in accordance
with GAAP are not material and include deferred taxes, surplus debentures and
deferred acquisition costs. The Insurance Companies' statutory policyholders'
surplus at December 31, 1996, was in excess of the minimum requirements of
relevant state insurance regulations. The Insurance Companies' ability to pay
dividends is limited by the statutory capital requirements. At December 31,
1996, $75.6 million of the Insurance Companies' statutory surplus was
unavailable for the payment of dividends to its shareholders without prior
approval of regulatory authorities.
NOTE 3. TAX BENEFIT FROM SALE OF SUBSIDIARY
On January 2, 1991, the Company sold Fireman's Fund to Allianz of America,
Inc. The $1.3 billion gain from the sale as reported in 1991 included a $75.0
million tax benefit related to the Company's estimated tax loss from the sale.
Since 1991 the Company has carried an estimated reserve related to tax matters
affecting the amount of the deductible tax loss from the sale and other tax
matters.
The conclusion in 1995 of IRS audits of Fund American's Federal income tax
returns for all years through December 31, 1985, resolved certain of the tax
matters affecting the amount of the Company's deductible tax loss from the sale
of Fireman's Fund and the Company, therefore, re-estimated its tax reserve. As
a result of the reserve re-estimation, the Company included in its 1995 income
statement an additional $66.0 million income tax benefit from the sale.
The amount of tax benefit from the sale of Fireman's Fund ultimately realized
by the Company may be significantly more or less than the Company's current
estimate due to possible changes in or new interpretations of tax rules,
possible amendments to Fund American's 1990 or prior years' Federal income tax
returns, the results of further IRS audits and other matters affecting the
amount of the deductible tax loss from the sale.
NOTE 4. INVESTMENT SECURITIES
Net investment income consisted of the following:
- -----------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------
Millions 1996 1995 1994
- -----------------------------------------------------------------------------------------
Investment income:
Mortgage loans held for sale $ 39.3 $ 35.9 $ 66.6
Fixed maturity investments 10.4 9.0 3.3
Short-term investments 6.6 6.6 7.8
Common equity securities 4.3 2.5 11.1
Other (2.3) 1.7 2.0
-----------------------------
Total investment income 58.3 55.7 90.8
Less investment expenses and other charges (1.0) (.3) (.6)
-----------------------------
Net investment income, before tax $ 57.3 $ 55.4 $ 90.2
=========================================================================================
Net realized investment gains and changes in net unrealized investment gains
and losses were as follows:
F-9
FUND AMERICAN
- -----------------------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Millions 1996 1995 1994
- -----------------------------------------------------------------------------------------
Gross realized investment gains $ 43.3 $ 46.3 $ 67.0
Gross realized investment losses (4.8) (7.5) (28.2)
---------------------------
Net realized investment gains 38.5 38.8 38.8
Net unrealized investment gains (losses) (a) 68.0 20.0 (82.4)
---------------------------
Total net investment gains (losses), before tax $106.5 $ 58.8 $ (43.6)
=========================================================================================
(a) Excludes net unrealized investment gains and losses recorded from Fund
American's investments in unconsolidated insurance affiliates.
Sales of investments, excluding short-term investments, totalled $364.1
million, $252.1 million and $340.3 million for the years ended December 31,
1996, 1995 and 1994, respectively.
The components of ending net unrealized investment gains and losses were as
follows:
- --------------------------------------------------------------------------
December 31,
-------------------
Millions 1996 1995
- --------------------------------------------------------------------------
Investment securities:
Unrealized investment gains $ 121.0 $ 54.5
Unrealized investment losses (.8) (2.3)
--------------------
Total investment securities 120.2 52.2
Net unrealized gains from investments 22.1 6.1
in unconsolidated insurance affiliates
--------------------
Total net unrealized investment gains, before tax $ 142.3 $ 58.3
==========================================================================
The cost or amortized cost, gross unrealized investment gains and losses, and
carrying values of fixed maturity investments as of December 31, 1996 and 1995,
were as follows:
- ------------------------------------------------------------------------------------------------------------------------
December 31, 1996
-------------------------------------------------------------------
Cost or Gross Gross
amortized unrealized unrealized Carrying
Millions cost gains losses value
- ------------------------------------------------------------------------------------------------------------------------
U. S. Government and agency obligations $ 63.6 $ .8 $ (.1) $ 64.3
U S WEST, Inc. redeemable preferred stock 49.1 - - 49.1
Debt securities issued by industrial corporations 31.3 .3 (.1) 31.5
GNMA Mortgage-backed securities 9.1 - - 9.1
Aggregate of holdings less than $10 million 1.4 - - 1.4
-------------------------------------------------------------------
Total fixed maturity investments $154.5 $1.1 $ (.2) $155.4
========================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------
December 31, 1996
-------------------------------------------------------------------
Cost or Gross Gross
amortized unrealized unrealized Carrying
Millions cost gains losses value
- ------------------------------------------------------------------------------------------------------------------------
U S WEST, Inc. redeemable $ 48.8 $ - $ - $ 48.8
preferred stock
State and municipal 33.3 .1 (.1) 33.3
obligations
U. S. Government and 23.5 .7 - 24.2
agency obligations
Aggregate of holdings less 4.2 .2 - 4.4
than $10 million
-------------------------------------------------------------------
Total fixed maturity investments $109.8 $1.0 $ (.1) $110.7
=========================================================================================================================
F-10
FUND AMERICAN
The cost or amortized cost and carrying value of fixed maturity investments at
December 31, 1996 and 1995, are shown below by contractual maturity. Actual
maturities could differ from contractual maturities because borrowers have the
right to call or prepay certain obligations with or without call or prepayment
penalties.
- ------------------------------------------------------------------------------------------------------------------------
December 31,
-------------------------------------------------------------------
1996 1995
--------------------------------- -------------------------------
Cost or Cost or
amortized Carrying amortized Carrying
Millions cost value cost value
- ------------------------------------------------------------------------------------------------------------------------
Due in one year or less $ 7.1 $ 7.1 $ 3.0 $ 3.0
Due after one year through five years 6.6 6.6 16.7 17.2
Due after five years through ten years 98.2 98.5 60.0 60.1
Due after ten years 33.5 34.1 30.1 30.4
GNMA Mortgage-backed securities 9.1 9.1 - -
-------------------------------------------------------------------
Total $154.5 $155.4 $109.8 $110.7
========================================================================================================================
Non-cash exchanges of investment securities totalling $2.3 million, $90.4
million and $.3 million during 1996, 1995 and 1994, respectively, are not
reflected in the Consolidated Statements of Cash Flows.
NOTE 5. MORTGAGE SERVICING
Source One services loans throughout the United States. Source One's
portfolio of mortgage loans serviced (including loans subserviced, interim
servicing contracts and portfolios under contract to acquire but excluding loans
sold but not transferred) totalled $29.2 billion and $31.8 billion as of
December 31, 1996 and 1995, respectively. The servicing portfolio included GNMA
guaranteed mortgage-backed securities of $13.5 billion and $10.7 billion as of
December 31, 1996 and 1995, respectively. The following table summarizes the
mortgage loan servicing portfolio as of December 31, 1996:
Weighted average
-------------------------------------------------------------------
Outstanding Remaining
principal Loan Net contractual
balance balance Interest servicing life
(millions) (thousands) rate fee rate (months)
- ------------------------------------------------------------------------------------------------
Loan Type:
Residential:
Conventional $12,266 $ 69 8.41% .409% 213
FHA 9,546 51 8.85 .434 271
VA 4,525 52 8.54 .434 260
Commercial 73 695 7.49 .154 166
-------------
26,410 58 8.59 .422 242
Subservicing 2,791
-------------
Total servicing portfolio $29,201
================================================================================================
The servicing fee rates in the preceding table are shown after deducting
applicable guarantee fees. Guarantee fees, when applicable, range from six basis
points for governmental loans to approximately 30 basis points for certain
conventional loans. Certain loans sold to private investors have no guarantee
fees.
F-11
FUND AMERICAN
The following tables summarize Source One's mortgage loan servicing portfolio
by interest rate range and by location of property:
- ------------------------------------------------------------------------------------------------------------
December 31, 1996 December 31, 1995
------------------------------------ ---------------------------------------
Aggregate Weighted Aggregate Weighted
Number principal average Number principal average
Interest rate of balance interest of balance interest
range loans (millions) rate loans (millions) rate
- ----------------- ------------------------------------- ---------------------------------------
5.99% and lower 1,239 $ 87 5.49% 2,674 $ 114 5.51%
6.00% - 6.49% 5,477 291 6.22 8,208 434 6.19
6.50% - 6.99% 18,449 1,443 6.71 25,192 2,077 6.69
7.00% - 7.49% 51,791 3,416 7.15 64,052 4,573 7.16
7.50% - 7.99% 71,954 5,436 7.63 84,899 6,745 7.63
8.00% - 8.49% 62,120 4,455 8.10 60,843 4,315 8.10
8.50% - 8.99% 77,020 4,043 8.58 80,936 4,217 8.60
9.00% - 9.49% 37,690 2,049 9.06 38,939 2,234 9.08
9.50% - 9.99% 69,506 3,614 9.57 57,131 3,185 9.60
10% and above 83,533 4,367 10.49 71,177 3,937 10.55
------------------------------------- ---------------------------------------
Total 478,779 $29,201 8.48% 494,051 $31,831 8.33%
============================================================================================================
- ------------------------------------------------------------------------------------------------------------
December 31, 1996 December 31, 1995
------------------------------------ ---------------------------------------
Aggregate Aggregate
Number principal Percentage Number principal Percentage
of balance of servicing of balance of servicing
State loans (millions) portfolio loans (millions) portfolio
- ----------------- ------------------------------------- ---------------------------------------
California 67,559 $ 5,811 19.9% 73,865 $ 6,668 20.9%
New York 43,406 2,555 8.7 45,830 2,803 8.8
Washington 26,583 2,054 7.0 30,064 2,386 7.5
Texas 31,603 1,673 5.7 28,841 1,705 5.4
Florida 29,463 1,495 5.1 28,123 1,502 4.7
Illinois 26,873 1,128 3.9 18,486 1,291 4.1
Michigan 17,836 1,157 4.0 30,235 1,308 4.1
New Jersey 14,446 979 3.4 15,201 1,056 3.3
Arizona 15,657 899 3.1 15,751 949 3.0
Virginia 16,116 840 2.9 15,481 826 2.6
Other 189,237 10,610 36.3 192,174 11,337 35.6
------------------------------------ ---------------------------------------
Total 478,779 $29,201 100.0% 494,051 $31,831 100.0%
============================================================================================================
The tables above include $2,791 million and $4,039 million outstanding
principal balance of loans subserviced for others as of December 31, 1996 and
1995, respectively.
Escrow funds of approximately $207.8 million and $236.0 million as of December
31, 1996 and 1995, respectively, relating to mortgages serviced and subserviced,
were held in non-interest bearing accounts at non-affiliated banks and are not
included in the consolidated financial statements.
Source One has in force an errors and omissions policy in the amount of $20.0
million. Primary fidelity coverage with a single loss limit of $20.0 million and
an aggregate loss limit of $40.0 million is provided under a Fund American
master policy for which Source One pays a portion of the premium.
In December 1996, Fund American wrote off all $33.6 million pretax ($30.0
million after tax) of the remaining unamortized balance of goodwill and certain
other intangible assets related to Source One. During 1996, Fund American had
been re-assessing the recoverability of goodwill and certain other intangible
assets related to Source
F-12
FUND AMERICAN
One and, in the fourth quarter of 1996, determined that it should write-off all
such assets related to Source One. Factors considered in the determination to
write-off all Source One's goodwill were (i) increased competition and industry
consolidation during 1996 which had adversely impacted the value of both the
mortgage loan production and servicing operations of Source One and (ii) the
attainment of a definitive agreement in the fourth quarter of 1996 to sell the
majority of Source One's mortgage servicing portfolio at essentially book value.
NOTE 6. CAPITALIZED SERVICING
Source One estimates the fair values of its mortgage servicing rights by
calculating the present value of the expected future cash flows associated with
such rights. In making those estimates, Source One incorporates assumptions that
market participants would use in their estimates of future servicing income and
expense.
To measure impairment of the mortgage servicing rights, Source One stratifies
its mortgage loan servicing portfolio based on the portfolio's predominant risk
characteristics which have been determined to be prepayment, default and
operational risks. In estimating fair value, Source One used market consensus
prepayment rates and discounted the future cash flows using discount rates that
approximate current market rates. The prepayment assumptions used in the
estimation of fair values are based on market prepayment expectations. The fair
value of each stratum is computed and compared to its recorded book value to
determine if a valuation allowance, or recovery of a previously established
valuation allowance, is required.
As of December 31, 1996, Source One's $17.0 billion mortgage servicing
portfolio to be sold in 1997 was valued as one stratum using the market price as
indicated by the purchase and sale agreement with the third party purchaser.
Accordingly, Source One evaluated the predominant risk characteristics on the
remaining owned servicing portfolio which was stratified by interest rate, loan
type (investor), original term to maturity and principal recourse. The discount
rates used to estimate fair value were 10.5% for conventional loans, 12.0% for
insured loans and, for 1996, 21.0% for recourse loans. As a result of refining
the calculation during 1996 on its remaining owned servicing portfolio, Source
One recognized $13.4 million of additional pretax impairment during the fourth
quarter of 1996. As of December 31, 1995, the entire servicing portfolio was
stratified by interest rate, loan type (investor) and original term to maturity.
The discount rate and prepayment assumptions are significant factors used in
estimating the fair value of Source One's mortgage servicing rights and could be
significantly impacted by changes in interest rates. Accordingly, it is likely
that management's estimate of the fair value of the capitalized servicing asset
will change from time to time due to changes in interest rates.
The following table summarizes the fair value of mortgage servicing rights and
certain characteristics of Source One's servicing portfolio related to such
mortgage servicing rights by loan type as of December 31, 1996:
- -----------------------------------------------------------------------------------------------------------------------------------
Fair value Principal Weighted Weighted Weighted
of mortgage balance average average average
servicing rights serviced (a) interest maturity service
Loan type (millions) (millions) rate (months) fee
- -----------------------------------------------------------------------------------------------------------------------------------
Insured $207.3 $11,933 8.88% 264 .45%
Conventional 124.3 7,855 8.44 215 .38
Recourse 26.4 2,188 8.72 214 .31
Adjustable rate 16.2 997 7.97 301 .31
----------------------------------
Total $374.2 $22,973 8.67% 244 .41%
==================================================================================================================================
(a) Excludes $2.8 billion of subservicing and $3.4 billion of mortgage
servicing rights related to originations not capitalized prior to the
adoption of SFAS No. 122.
F-13
FUND AMERICAN
The 1995 adoption of SFAS No. 122 as it relates to the capitalization of
originated mortgage servicing rights resulted in the recognition of an
additional pretax gain on sales of mortgages of $27.2 million for the year ended
December 31, 1995. The impairment provisions of SFAS No. 122 resulted in a
pretax charge of $28.0 million for 1995.
In 1994 Source One adopted an accounting methodology that measured impairment
of the purchased mortgage servicing rights asset on a disaggregated basis by
discounting estimated future cash flows using a current market rate. Prior to
1994 Source One measured impairment of the purchased mortgage servicing rights
asset on a disaggregated basis including a cost of capital charge for estimating
future cash flows. The adoption of the new accounting methodology, recorded as a
cumulative adjustment as of January 1, 1994, resulted in a $68.1 million pretax,
$44.3 million after tax, charge to income for 1994.
Source One estimates the fair value of its capitalized excess servicing asset
by discounting the anticipated future cash flows over the estimated life of the
related loans. Source One uses interest only ("I/O") strip interest rates as
quoted by market participants to determine the appropriate discount rates and
prepayment speed assumption rates that are based on interest rates, loan types
and original term to maturity. The discount rate used to capitalize excess
servicing for the year ended December 31, 1996, ranged from 12.0% to 12.6%; was
12.0% for the year ended December 31, 1995; and ranged from 8.0% to 10.0% for
the year ended December 31, 1994. For the years ended December 31, 1996, 1995
and 1994, the weighted average discount rates inherent in the carrying amount of
the capitalized excess servicing asset were 10.4%, 10.0% and 9.1%, respectively.
The following table summarizes changes in Source One's capitalized servicing
asset:
- --------------------------------------------------------------------------------------------------------------------
Deferred
gain on Total
Purchased Originated Excess Valuation sale of capitalized
Millions servicing servicing servicing allowance servicing servicing
- --------------------------------------------------------------------------------------------------------------------
Balances at January 1, 1994 $ 570.2 $ - $ 96.5 $ - $ - $ 666.7
Cumulative effect of
accounting change (68.1) - - - - (68.1)
Additions 69.7 - 16.7 - (19.9) 66.5
Scheduled amortization (61.7) - (12.1) - - (73.8)
Impairment and unscheduled
amortization (12.8) - (.4) - - (13.2)
Amortization of deferred gain - - - - 2.7 2.7
Sales (21.7) - (28.6) - - (50.3)
- --------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1994 475.6 - 72.1 - (17.2) 530.5
Additions 64.2 31.2 7.4 - - 102.8
Scheduled amortization (43.9) (1.4) (7.5) - - (52.8)
Impairment and unscheduled
amortization - - (.5) (28.0) - (28.5)
Amortization of deferred gain - - - - 4.2 4.2
Sales (132.4) - (26.7) - - (159.1)
- --------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995 363.5 29.8 44.8 (28.0) (13.0) 397.1
Additions 77.4 38.0 10.1 - - 125.5
Scheduled amortization (56.7) (6.3) (6.9) - - (69.9)
Impairment and unscheduled
amortization - - (1.1) (.9) - (2.0)
Amortization of deferred gain - - - - 6.1 6.1
Sales (37.7) - (8.2) - - (45.9)
- --------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 $ 346.5 $61.5 $ 38.7 $(28.9) $ (6.9) $ 410.9
====================================================================================================================
F-14
FUND AMERICAN
During 1996 Source One sold the rights to service $3.3 billion of mortgage
loans for net proceeds of $55.9 million, resulting in a pretax gain of $10.1
million. During 1995 Source One sold the rights to service $11.0 billion of
mortgage loans for net proceeds of $199.1 million, resulting in a pretax gain of
$40.0 million. During 1994 Source One sold the rights to service $3.9 billion
of mortgage loans for net proceeds of $70.2 million and continues to service a
portion of these loans pursuant to a subservicing agreement. A gain of $19.9
million was deferred in 1994 and is being recognized as income over the five-
year life of the subservicing agreement. In the fourth quarter of 1996, the
third party sold the rights to service approximately $1.0 billion of these loans
subserviced by Source One which resulted in Source One recognizing $2.4 million
of the deferred gain on an accelerated basis.
NOTE 7. MORTGAGE LOANS HELD FOR SALE AND POOL LOAN PURCHASES
The following tables summarize Source One's mortgage loans held for sale and
pool loan purchases:
-------------------------------------------------------------------------------------------
December 31,
---------------------
Millions 1996 1995
- --------------------------------------------------------------------------------------------
Adjustable rate mortgage loans, weighted average
interest rates of 6.60% and 6.55% $ 35.1 $ 17.5
Fixed rate five year through 20 year mortgage loans,
weighted average interest rates of 7.73% and 7.47% 51.2 59.5
Fixed rate 30 year mortgage loans, weighted average
interest rates of 8.19% and 7.89% 228.0 383.0
---------------------
Total principal amount 314.3 380.1
Net premiums .6 .9
---------------------
Total mortgage loans held for sale $314.9 $381.0
============================================================================================
- --------------------------------------------------------------------------------------------
December 31,
--------------------------------------------------
Principal balance Number of loans
----------------- ---------------
Dollars in Millions 1996 1995 1996 1995
- ----------------------------------------------------------- ---------------
Loan type: FHA $ 89.9 $ 77.6 1,621 1,433
VA 35.3 32.5 592 545
Conventional 6.3 8.9 75 106
----------------- ---------------
Total pool loan purchases $131.5 $119.0 2,288 2,084
============================================================================================
F-15
FUND AMERICAN
NOTE 8. DEBT
SHORT-TERM DEBT
Short-term debt outstanding consisted of the following:
- -------------------------------------------------------------------------------
December 31,
-------------------
Millions 1996 1995
- -------------------------------------------------------------------------------
Charter: Notes payable due in 1996 and 1997
and lease obligations $ 1.7 $ 20.8
------------------
Source One:
Commercial paper 362.2 256.6
Credit agreement borrowings 45.0 64.5
Debentures due in 1996 - 74.6
Medium term notes due in 1996 - 29.7
Less net discounts (1.0) (.8)
-------------------
Total Source One 406.2 424.6
-------------------
Total short-term debt $ 407.9 $ 445.4
==============================================================================
The weighted average interest rates of short-term debt outstanding during 1996
and 1995 were as follows:
- --------------------------------------------------------------------------------
Year Ended December 31,
------------------------
1996 1995
- --------------------------------------------------------------------------------
Parent Company:
Revolving credit facility 5.82% 6.57%
Loan guarantee - 5.36%
Charter: Notes payable 6.50% 6.50%
Source One:
Commercial paper 5.69% 6.14%
Credit agreements and bid loans 6.19% 6.57%
==============================================================================
In June 1994 the Company entered into a revolving credit agreement with a
syndicate of banks. Under the agreement, through August 9, 1996, the Company and
certain of its subsidiaries could borrow up to $75.0 million at short-term
market interest rates. The credit agreement contained certain customary
covenants, including a $475.0 million minimum tangible net worth requirement and
a minimum financial asset coverage requirement. At December 31, 1995, the
Company had no borrowings outstanding under the agreement.
In November 1996 the Company entered into a new revolving credit agreement
with a syndicate of banks. Under the agreement, through November 25, 1997, the
Company and certain of its subsidiaries may borrow up to $35.0 million at short-
term market interest rates. The credit agreement contains certain customary
covenants including a minimum tangible net worth requirement, a minimum
financial asset coverage requirement and a maximum leverage ratio requirement.
At December 31, 1996, the Company was in compliance with all covenants under the
facility and had no borrowings outstanding under the agreement.
In August 1993 the Company sold a $30.0 million principal amount secured loan
receivable from the Company's Chairman to a third party. The Company had
guaranteed repayment of the loan and, therefore, in accordance with GAAP, had
reflected the guarantee of the loan as indebtedness on the balance sheet. The
loan matured and was repaid on October 23, 1995.
In November 1995 Charter issued two notes totalling $20.2 million. Certain of
the notes were due in 1996 and other notes could be extended to be payable in
three equal installments in 1997, 1998 and 1999. During 1996 Charter elected to
extend the maturity of $3.2 million of notes payable. The notes are
collateralized by certain assets of Charter.
F-16
FUND AMERICAN
Source One has a $650.0 million domestic and Euro commercial paper program.
The weighted average number of days to maturity of commercial paper outstanding
at December 31, 1996 and 1995, was 23 days and 19 days, respectively.
In August 1995 Source One entered into a $60.0 million unsecured revolving
credit facility which expires in July 1997. As of December 31, 1996 and 1995,
there was $45.0 million and $60.0 million outstanding under this arrangement,
respectively. Source One also has a revolving credit agreement under which it
can borrow up to $10.0 million through June 30, 1997. As of December 31, 1996
and 1995, there was $0 and $4.5 million outstanding under this agreement,
respectively.
In 1986 Source One issued $125.0 million of 8.25% debentures due November 1,
1996. During 1996 and 1995 Source One repurchased and retired $74.6 and $50.4
million in principal amount of these debentures, respectively.
In 1989 Source One issued $40.0 million of medium-term notes due in 1996 and
having a total weighted average interest rate of 9.65%. During 1996 and 1995
Source One repurchased and retired in principal amount $29.7 million and $10.3
million of these notes, respectively.
In November 1996 Source One amended and restated its secured revolving credit
agreement. The provisions of the amended agreement increased the size of the
facility from $500 million to $750 million. The size of the facility may be
further increased at Source One's option with bank concurrence up to $1.25
billion. Borrowings under the facility and commercial paper backed by the
facility are secured primarily by Source One's mortgage loans receivable and
mortgage servicing portfolio. The facility expires on November 12, 1999. As of
December 31, 1996, Source One had no outstanding borrowings under this facility.
Source One must comply with certain financial covenants provided in its
secured and unsecured revolving credit facilities, including restrictions
relating to tangible net worth and leverage. In addition, the secured facility
contains certain covenants which limit Source One's ability to pay dividends or
make distributions of its capital in excess of preferred stock dividends and
subordinated debt interest requirements each year. Source One is currently in
compliance with all such covenants.
Under the credit agreements described above, Source One receives interest
expense credits as a result of holding escrow and custodial funds in trust
accounts at non-affiliated banks.
LONG-TERM DEBT
Long-term debt outstanding consisted of the following:
- -----------------------------------------------------------------------------
December 31,
---------------------
Millions 1996 1995
- -----------------------------------------------------------------------------
Parent Company:
Medium-term notes $ 116.2 $ 116.2
Less net discounts (.8) (.9)
---------------------
Total Parent Company 115.4 115.3
---------------------
Source One:
Medium-term notes, 8.875% due in 2001 138.4 138.4
Debentures, 9.0% due in 2012 100.0 100.0
Subordinate debentures, 9.375% due in 2025 56.0 56.0
Less net discounts (2.8) (2.4)
---------------------
Total Source One 291.6 292.0
---------------------
Valley: Medium-term notes 15.0 -
Charter: Notes payable in 1998 and 1999 2.2 -
---------------------
Total long-term debt $ 424.2 $ 407.3
=============================================================================
During 1993 the Company issued $150.0 million in principal amount of medium-
term notes for net cash proceeds of $148.0 million after related costs.
Proceeds from the issuance of the notes were used to repay an
F-17
FUND AMERICAN
existing revolving credit facility and for general corporate purposes. During
1995 and 1994 the Company repurchased $8.8 million and $25.0 million,
respectively, in principal amount of the notes due February 2003. At December
31, 1996, the remaining outstanding notes had an average maturity of 6.4 years
and an average yield to maturity of 7.82%.
In November 1996 White Mountains and Valley entered into a five year credit
facility under which they may borrow $50.0 million and $15.0 million,
respectively, at market interest rates. The $15.0 million of borrowings under
the facility available to Valley are guaranteed by White Mountains. The
facility contains certain customary covenants including a minimum tangible net
worth requirement, a minimum financial asset coverage requirement, a maximum
leverage ratio requirement, a minimum fixed charge coverage ratio requirement
and a minimum policyholders' surplus requirement. The facility also limits
White Mountains' ability to pay dividends to its shareholders. As of December
31, 1996, White Mountains and its subsidiaries were in compliance with all
covenants under the facility. During 1996 Valley borrowed $15.0 million under
the facility with a weighted average interest rate of 5.825%. White Mountains
had no borrowings during 1996 under the facility.
In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in
2001. During 1995 Source One repurchased and retired in principal amount $21.6
million of these notes.
In 1992 Source One issued $100.0 million of 9% debentures due in 2012 pursuant
to a $250.0 million shelf registration statement. The proceeds from issuance
were used for general corporate purposes.
On December 8, 1995, Source One exchanged and retired 2,239,061 shares of
Source One Preferred Stock for $56.0 million in principal amount of 9.375%
subordinated debentures. The subordinated debentures are due on December 31,
2025. The subordinated debentures are redeemable at the option of Source One,
in whole or part, at any time on or after May 1, 1999. The non-cash portion of
the exchange of subordinated debentures for Source One Preferred Stock is not
reflected in the Consolidated Statements of Cash Flows.
Total interest paid by Fund American for both short-term and long-term debt
was $51.5 million, $47.9 million and $80.1 million in 1996, 1995 and 1994,
respectively.
NOTE 9. INCOME TAXES
The Company and its qualifying subsidiaries file a consolidated Federal income
tax return. The Federal income tax provision is computed on the consolidated
taxable income of the Company and those subsidiaries.
The total income tax provision (benefit) consisted of the following:
- -----------------------------------------------------------------------------------------
Year Ended December 31,
--------------------------------
Millions 1996 1995 1994
- -----------------------------------------------------------------------------------------
Tax on pretax earnings:
Federal $ 18.1 $ 16.6 $ 20.2
State and local .8 .1 .3
-------------------------------
Income tax provision on pretax earnings 18.9 16.7 20.5
Tax benefit from sale of discontinued operations - (66.0) -
Tax benefit from loss on early extinguishment of debt - (.2) -
Tax benefit from cumulative effect of accounting change -
purchased mortgage servicing - - (23.8)
-------------------------------
Total income tax provision (benefit) $ 18.9 $ (49.5) $ (3.3)
- ----------------------------------------------------------===============================
Net income tax payments (recoveries) $ 7.0 $ 2.6 $ (.7)
- ----------------------------------------------------------===============================
Tax provision (benefit) recorded directly to
shareholders' equity related to:
Exercises of employee stock options and warrants $ - $ .2 $ (2.0)
Changes in net unrealized investment gains and losses $ 29.4 $ 9.8 $ (29.5)
=========================================================================================
F-18
FUND AMERICAN
The components of the income tax provision (benefit) on pretax earnings
follow:
- ----------------------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Millions 1996 1995 1994
- ----------------------------------------------------------------------------------------
Current provision $ 22.5 $ 26.4 $ 21.9
Deferred benefit (3.6) (9.7) (1.4)
---------------------------
Total income tax provision on pretax earnings $ 18.9 $ 16.7 $ 20.5
========================================================================================
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax return purposes. Significant
components of Fund American's net deferred Federal income tax asset and
liability follow:
- --------------------------------------------------------------------------
December 31,
------------------------
Millions 1996 1995
- --------------------------------------------------------------------------
Deferred tax assets related to:
Employee compensation and benefit accruals $ 32.8 $ 30.3
Capitalized mortgage servicing 18.4 13.7
Unearned insurance premiums 4.9 2.3
Allowance for mortgage loan losses 4.8 4.8
Other items 12.8 10.2
------------------------
Total deferred tax assets 73.7 61.3
- --------------------------------------------------------------------------
Deferred tax liabilities related to:
Net unrealized investment gains 49.0 13.4
Earnings from insurance affiliates 6.7 4.0
Purchase accounting adjustments 6.2 10.2
Deferred acquisition costs 4.6 2.3
Other items 8.5 6.6
------------------------
Total deferred tax liabilities 75.0 36.5
- --------------------------------------------------------------------------
Net deferred Federal income tax (liability) asset $ (1.3) $ 24.8
==========================================================================
A reconciliation of taxes calculated using the 35% Federal statutory rate to
the income tax provision on pretax earnings follows:
- ------------------------------------------------------------------------------
Year Ended December 31,
--------------------------
Millions 1996 1995 1994
- ------------------------------------------------------------------------------
Tax provision at Federal statutory rate $ 8.3 $ 12.3 $ 14.6
Differences in taxes resulting from:
Minority interest dividends 1.3 2.7 2.3
Write-off of goodwill and other intangible
assets 8.1 - -
Purchase accounting adjustments .7 .7 .7
Dividends received deduction (2.3) (1.9) (2.2)
Tax reserve adjustments 4.2 2.3 4.6
Other, net (1.4) .6 .5
--------------------------
Total income tax provision on pretax earnings $ 18.9 $ 16.7 $ 20.5
==============================================================================
F-19
FUND AMERICAN
Sections 382 and 383 of the IRC impose limitations on the use of certain tax
benefits by a corporation that undergoes a more than 50% ownership change. The
tax benefits which may be limited include loss carryforwards and built-in losses
and deductions existing on the date of ownership change. The annual limitation
for the utilization of such benefits during a five-year post-change period is
generally calculated by multiplying the value of the corporation (as defined by
the IRC) at the time of the ownership change by an interest rate (a long-term
tax-exempt bond rate defined by the IRC). While regulatory guidance on the
subject is not complete, the Company believes that it had an ownership change
during 1992 so as to make the Section 382 and 383 limitations applicable to Fund
American. Fund American believes that the imposition of such limitations will
not have a material adverse effect on its financial position or results of
operations.
NOTE 10. RETIREMENT AND POST-RETIREMENT PLANS
In 1993 the Company and certain of its subsidiaries established nonqualified
defined contribution plans for a select group of management employees for the
purpose of providing retirement and postretirement benefits (the "Deferred
Benefit Plans"). The amount of annual contributions to the Deferred Benefit
Plans are determined using actuarial assumptions; however, participants in the
Deferred Benefit Plans may choose between various investment options for their
plan balances. At December 31, 1996 and 1995, Fund American's liability to
participants pursuant to the Deferred Benefit Plans was $2.9 million and $1.9
million, respectively.
In 1993 the Company and certain of its subsidiaries also established
nonqualified plans for a select group of management employees for the purpose of
deferring current compensation (the "Deferred Compensation Plans"). Pursuant to
the Deferred Compensation Plans, participants may voluntarily defer all or a
portion of qualifying remuneration payable by Fund American. Participants in the
Deferred Compensation Plans may choose between various investment options for
their plan balances. At December 31, 1996 and 1995, Fund American's liability to
participants pursuant to the Deferred Compensation Plans was $21.8 million and
$16.5 million, respectively.
Through December 1, 1995, substantially all the employees of Valley and
Charter were covered under a defined benefit pension plan sponsored by the
former parent of Valley and Charter. Coverage for employees under that plan was
terminated as of December 31, 1995. Valley established a new defined
contribution plan for the benefit of substantially all Valley and Charter
employees as of January 1, 1996. The new plan provides Valley and Charter
employees with full credit for prior service. The pension cost and funding
status of the new plan are not material to Fund American's financial statements.
Substantially all Valley and Charter employees are eligible to participate in
an employee savings plan qualified under Section 401(k) of the IRC (the "Valley
401(k) Plan"). Contributions to the Valley 401(k) Plan can be invested in
various investment options which do not currently include Shares. There is an
employer match provision to the Valley 401(k) Plan which is equal to 50% of the
first 6% of employee compensation contributed to the plan, subject to IRC
limits. Employees of the Company and White Mountains are eligible to participate
in the Valley 401(k) Plan beginning January 1, 1997. Fund American expects to
add Shares to the investment options offered under the Valley 401(k) Plan
beginning in the third quarter of 1997.
Source One established its defined benefit pension plan as of July 1, 1986,
for the benefit of its employees. Benefits under the Source One plan are based
on years of service and each employee's highest average eligible compensation
over five consecutive years in his or her last ten years of employment. Funding
of retirement costs complies with the minimum funding requirements specified by
the Employee Retirement Income Security Act. Cash contributions made by Source
One to the plan for the years ended December 31, 1996, 1995 and 1994, totalled
$1.3 million, $1.7 million and $1.1 million, respectively.
Source One also has a supplemental pension plan which is a nonqualified,
unfunded benefit plan designed to provide supplementary retirement benefits for
employees whose pensionable compensation exceeds statutory limits.
F-20
FUND AMERICAN
The following table sets forth the pension cost and actuarial assumptions used
in determining the funded status of Source One's qualified defined benefit
pension plan:
- -------------------------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Dollars in millions 1996 1995 1994
- -------------------------------------------------------------------------------------------
PENSION COST FOR PERIOD:
Service cost for period $ 1.6 $ 1.4 $ 1.6
Interest cost on projected benefit obligation 1.6 1.4 1.3
Actual return on plan assets (2.0) (3.8) 1.0
Net amortization and deferral .9 2.6 (1.5)
---------------------------
Total pension cost $ 2.1 $ 1.6 $ 2.4
- ----------------------------------------------------------------===========================
FUNDED STATUS AT END OF PERIOD:
Actuarial present value of benefit obligation:
Accumulated benefit obligation, including
vested benefits of $16.6, $15.1 and $11.0 $18.6 $17.2 $12.6
Effect of projected future salary increases 5.1 6.8 5.1
---------------------------
Total projected benefit obligation 23.7 24.0 17.7
Plan assets at fair value 20.9 18.1 13.1
---------------------------
Projected benefit obligation in excess of plan assets 2.8 5.9 4.6
Aggregate of items not yet charged to earnings (.3) (4.2) (2.7)
---------------------------
Pension cost accrued at end of period $ 2.5 $ 1.7 $ 1.9
- ----------------------------------------------------------------===========================
ACTUARIAL ASSUMPTIONS:
Discount rate 7.25% 7.0% 8.0%
Rate of increase in future compensation levels 5.0% 6.0% 6.0%
Expected long-term rate of return on plan assets 8.0% 8.0% 8.0%
===========================================================================================
Total accrued postretirement benefit costs included in accounts payable and
other liabilities for Source One employees was $3.5 million and $3.3 million at
December 31, 1996 and 1995, respectively.
NOTE 11. EMPLOYEE STOCK PLANS
At the Company's 1995 Annual Meeting shareholders approved certain amendments
to the Fund American Long-Term Incentive Plan (the "Incentive Plan"). The
Incentive Plan provides for granting to executive officers and other key
employees of the Company (and certain of its subsidiaries) various types of
stock-based incentive awards including stock options and performance shares. At
December 31, 1996, 430,000 Shares remained available for grants under the
Incentive Plan.
Stock options are rights to purchase a specified number of Shares at or above
the fair market value of Shares at the time an option is granted. Stock options
generally vest over a four year period and expire no later than ten years after
the date on which they are granted.
Performance shares are conditional grants of a specified maximum number of
Shares or an equivalent amount of cash. The grants are generally payable,
subject to the attainment of a specified return on equity, at the end of three
to five year periods or as otherwise determined by the Compensation Committee of
the Board. The Compensation Committee consists solely of non-management
directors.
F-21
FUND AMERICAN
The following table details the transactions applicable to non-qualified stock
options to acquire Shares:
- ---------------------------------------------------------------
Number Exercise price
- ---------------------------------------------------------------
Balance at December 31, 1993 and 1994 7,125 $24.82-$32.60
Exercised during 1995 4,125 $ 24.82
------------------------
Balance at December 31, 1995 and 1996 3,000 $27.13-$32.60
===============================================================
All Fund American stock options outstanding during the three year period ended
December 31, 1996, were fully vested and exercisable.
Pursuant to the Incentive Plan 70,000 and 56,429 performance shares were
granted in 1996 and 1995, respectively. No performance shares were granted in
1994. During 1996, no performance shares were cancelled and 10,650 performance
shares were paid in cash. No performance shares were cancelled or paid during
1994 and 1995. At December 31, 1996, 235,529 performance shares were
outstanding. Of the performance shares outstanding at December 31, 1996, 54,100
are valued as being equivalent to one Fund American Share plus one-half White
River Share. The remaining 181,429 performance shares outstanding at December
31, 1996, are valued as being equivalent to one Fund American Share. The
financial goal for full payment of the performance shares is the achievement of
a 13% to 15% annual return on equity measured over the applicable performance
periods.
In 1985 the Company's Chairman purchased warrants from American Express
Company ("American Express") entitling him to buy 1,700,000 Shares for $25.75
per Share. Warrants to purchase 420,000 Shares, 130,000 Shares and 150,000
Shares were exercised by the Chairman during 1992, 1994 and 1995, respectively,
leaving warrants to purchase 1,000,000 Shares outstanding at December 31, 1995.
Pursuant to a proposal approved by shareholders at the Company's 1995 Annual
Meeting, the expiration date with respect to the warrants outstanding at
December 31, 1995, was extended from January 2, 1996, to January 2, 2002. In
accordance with APB No. 25, the warrant extension resulted in a $46.2 million
pretax charge to compensation expense which was recorded in the second quarter
of 1995. No warrants were exercised by the Chairman during 1996.
Pursuant to certain anti-dilution adjustments related to the distribution of
White River Shares to the Company's shareholders, the Chairman received in 1993
warrants entitling him to purchase 640,000 White River Shares for $8.18 per
share, and the exercise price for the Chairman's warrants to purchase Fund
American Shares was reduced to $21.66 per Share. The Chairman exercised all the
warrants to purchase White River Shares on November 19, 1993.
Source One has various long-term incentive plans which provide for the
granting, to key senior management employees of Source One, stock-based and cash
incentive awards. Awards made pursuant to the plans are payable upon the
achievement of specified financial goals over multi-year periods.
Source One also has a qualified employee stock plan. Contributions to this
plan are determined at the discretion of Source One's Board of Directors. In
October 1996 Source One amended this plan to add an employee savings plan
feature qualified under Section 401(k) of the IRC. Contributions to the plan can
be invested in various investments including Shares. There is no employer match
provision to the plan.
SFAS No. 123, "Accounting for Stock Based Compensation," was issued in October
1995. That standard requires significantly more disclosure regarding all
employee stock options and encourages companies to recognize compensation
expense for stock-based awards based on the fair value of such awards on the
date of grant. Alternatively, companies may continue following existing
accounting standards provided that disclosures are made regarding the net income
and earnings per share impact as if the value recognition and measurement
criteria of SFAS No. 123 had been adopted. Fund American has not adopted the
recognition and measurement criteria of SFAS No. 123 and alternatively has
chosen to disclose the pro forma effects of SFAS No. 123 as it relates to
outstanding warrants and performance shares granted in 1995 and 1996, as
follows:
F-22
FUND AMERICAN
- -----------------------------------------------------------------------------------
Year Ended December 31,
---------------------------
Millions, except per share amounts 1996 1995
- -----------------------------------------------------------------------------------
Net income (loss):
As reported $ 4.9 $ 84.1
Pro forma (.9) 108.6
- --------------------------------------------------------------------------------
Primary net income (loss) per share:
As reported $ .60 $ 9.36
Pro forma (.11) 12.21
- --------------------------------------------------------------------------------
Fully diluted net income (loss) per share:
As reported $ .60 $ 9.16
Pro forma (.11) 11.82
================================================================================
NOTE 12. MINORITY INTEREST - PREFERRED STOCK OF SUBSIDIARY
In March 1994 Source One issued 4,000,000 shares of 8.42% Source One Preferred
Stock, having a liquidation preference of $25.00 per share, for net cash
proceeds of $96.9 million. On December 8, 1995, Source One exchanged and retired
2,239,061 shares of Source One Preferred Stock for $56.0 million in principal
amount of subordinated debentures. The Source One Preferred Stock is not
redeemable prior to May 1, 1999. In consolidation, dividends on the Source One
Preferred Stock are included as a component of Fund American's interest expense.
NOTE 13. SHAREHOLDERS' EQUITY
SERIES D AND E PREFERRED STOCK
Through July 31, 1994, the Series D Preferred Stock had an annual dividend
rate of 7.75% and was initially redeemable for cash or, at the Company's option,
for Shares (based on the then current market value of Shares) on July 31, 1994.
On August 1, 1994, the Company redeemed 22,778 shares of the Series D Preferred
Stock for $82.0 million, an amount equal to the stock's liquidation preference.
In accordance with the terms of the Series D Preferred Stock, the annual
dividend rate for the remaining 20,833 shares of the Series D Preferred Stock
outstanding was increased to 8.75% and the stock's term was extended to July 31,
1995. On July 31, 1995, the Company redeemed all 20,833 remaining shares of the
Series D Preferred Stock for $75.0 million of cash, an amount equal to the
stock's liquidation preference.
COMMON SHARE REPURCHASES
During 1996, 1995 and 1994 the Company repurchased 779,077 Shares, 877,868
Shares and 1,128,057 Shares, respectively, for $66.3 million, $65.5 million and
$78.8 million, respectively. All such repurchased Shares have been retired. At
December 31, 1996, the Company had outstanding authorization to purchase an
additional 250,923 Shares.
LOAN FOR COMMON STOCK ISSUED
On December 30, 1992, pursuant to a request from the Board, the Company's
Chairman, John J. Byrne, agreed to an early exercise of stock options and
warrants to purchase 1,000,000 Shares. The Board's request reflected concerns
regarding proposed tax legislation which could have limited or eliminated the
Company's tax benefits from certain employee stock options and warrants
exercised in 1993 and thereafter. To encourage exercise of the stock options and
warrants, the Company provided a $30.0 million 4% secured loan to Mr. Byrne. The
loan was reported on the December 31, 1994, balance sheet in other assets ($4.3
million) and shareholders' equity ($25.0 million). The non-recourse loan was
fully repaid on its maturity date, October 23, 1995.
F-23
FUND AMERICAN
As approved by shareholders at the 1995 Annual Meeting, the Company entered
into a five year employment contract (the "Agreement") with Mr. Byrne. The
Agreement provided Mr. Byrne with the right to receive from the Company a
guarantee of a loan obtained from a third party, in an amount up to $15.0
million, upon the maturity of his existing loan with the Company. In accordance
with the Agreement, in October 1995 the Company guaranteed a $15.0 million loan
from a third party to Mr. Byrne. The new loan is recourse to Mr. Byrne's net
worth and has a term ending December 31, 1999, a market interest rate and
otherwise standard commercial terms. The Company was not required to provide
collateral protection for its guarantee of the loan and, accordingly, the loan
guarantee is not recorded on the balance sheet.
COMMON STOCK DIVIDENDS
During 1994 the Company did not pay regular cash dividends to holders of
Shares. In the fourth quarter of 1995 the Board reinstated a $.20 regular
quarterly dividend on Shares. During 1995 and 1996, the Company declared and
paid cash dividends totalling $.20 and $.80 per Share, respectively. The Board
currently intends to reconsider from time to time the declaration of regular
periodic dividends on Shares with due consideration given to the financial
characteristics of Fund American's remaining invested assets and operations and
the amount and regularity of its cash flows at the time.
NOTE 14. SHAREHOLDERS' RIGHTS PLAN
The Board adopted in 1987, and in 1988 and 1993 amended, a Shareholders'
Rights Plan under which rights to purchase preferred stock were distributed to
shareholders at the rate of one right for each Share (the "Rights"). Each Right
entitles the holder to purchase one one-thousandth of a share of the Company's
Series A Cumulative Participating Preferred Stock ("Series A Preferred").
The Rights enable the holders to acquire additional equity in either the
Company or an "Acquiring Person," and are exercisable if an unrelated person or
group (other than American Express or a wholly-owned subsidiary thereof, any
subsidiary of the Company, any employee benefit plan of the Company or its
subsidiaries or certain affiliates of the Company and certain persons who
inadvertently and temporarily cross the 25% threshold) acquires beneficial
ownership of 25% or more of the outstanding Shares (such a 25% or more
beneficial owner is deemed an "Acquiring Person"). Thereafter, the Rights would
trade separately from Shares and separate certificates representing the Rights
would be issued. The terms of the Series A Preferred are such that each one one-
thousandth of a share would be entitled to participate in dividends and to vote
on an equivalent basis with one whole Share, along with other preferential
dividend rights and preferential distribution rights in liquidation.
Upon the existence of an Acquiring Person, the Rights would entitle each
holder of a Right to purchase, at the exercise price, that number of one one-
thousandth of a share of Series A Preferred equivalent to the number of Shares
which, at the time of the transaction, would have a market value of twice the
exercise price. If certain acquisitions of the Company occur, a similar right to
purchase securities of the Company or the entity acquiring the Company at a
discount would arise.
Any Rights that are beneficially owned by an Acquiring Person (or any
affiliate or associate of an Acquiring Person) are null and void and any holder
of any such Right (including any subsequent holder) will be unable to exercise
or transfer any such Right. At any time after a person becomes an Acquiring
Person, the Board may mandatorily exchange all or some of the Rights for
consideration per Right equal to one-half of the securities issuable upon the
exercise of one Right pursuant to the terms of the Rights Agreement (or the
common share equivalent) and without payment of the exercise price. The Rights,
which do not have the right to vote or receive dividends, expire November 25,
1997, and may be redeemed by the Company at a price of $.01 per Right at any
time prior to the earlier of (i) such time as a person becomes an Acquiring
Person or (ii) the expiration date. Under certain circumstances, the Board may
redeem the Rights only if a majority of the disinterested directors (as defined
in the Shareholders' Rights Plan) agrees that the redemption is in the best
interests of the Company and its shareholders.
In 1987 the Company reserved 600,000 of its authorized preferred shares as
Series A Preferred for issuance pursuant to the Shareholders' Rights Plan.
F-24
FUND AMERICAN
NOTE 15. INDUSTRY SEGMENTS
Revenues, pretax earnings and ending identifiable assets for Fund American's
industry segments are shown below:
- -----------------------------------------------------------------------------------
Year Ended December 31,
----------------------------------
Millions 1996 1995 1994
- -----------------------------------------------------------------------------------
REVENUES:
Mortgage operations $ 184.7 $ 175.9 $ 202.5
Insurance operations 142.3 33.2 2.6
Other 5.5 13.2 23.4
----------------------------------
Total $ 332.5 $ 222.3 $ 228.5
- -------------------------------------------------==================================
PRETAX EARNINGS:
Mortgage operations $ (2.1) $ 35.3 $ (1.7)
Insurance operations .2 18.9 2.6
Other 25.7 (19.0) 40.7
----------------------------------
Total $ 23.8 $ 35.2 $ 41.6
- -------------------------------------------------==================================
ENDING IDENTIFIABLE ASSETS:
Mortgage operations $1,131.1 $ 1,138.5 $ 1,213.9
Insurance operations 586.2 373.7 124.0
Other 263.3 359.7 469.4
----------------------------------
Total $1,980.6 $ 1,871.9 $ 1,807.3
===================================================================================
NOTE 16. INVESTMENTS IN UNCONSOLIDATED AFFILIATES
INVESTMENT IN FSA
Fund American owned 3,460,200 and 2,460,200 shares of FSA Common Stock at
December 31, 1996 and 1995, respectively. This represented approximately 11.5%
and 7.8%, respectively, of the total shares of FSA Common Stock outstanding at
those times. Fund American had voting rights to an additional 3,893,940 shares
of FSA Common Stock at December 31, 1996 and 1995, raising Fund American's
voting control of FSA to approximately 23.0% and 19.0%, respectively. At
December 31, 1996 and 1995, Fund American also owned FSA Options and Preferred
Stock which, in total, give Fund American the right to acquire up to 4,560,607
additional shares of FSA Common Stock for aggregate consideration of $125.7
million. As of December 31, 1996 and 1995, Fund American's economic interest in
FSA was 25.1% and 21.0%, respectively.
Fund American's investment in FSA Common Stock is accounted for using the
equity method. FSA Common Stock is publicly traded on the NYSE. The market value
of the FSA Common Stock as of December 31, 1996, as quoted on the NYSE, exceeded
Fund American's carrying value of the FSA Common Stock on the equity method.
Fund American's investment in FSA Options and Preferred Stock is accounted for
under the provisions of SFAS No. 115 whereby the investments are reported at
fair value as of the balance sheet date, with related unrealized investment
gains and losses excluded from earnings and reported as a net amount in a
separate component of shareholders' equity.
F-25
FUND AMERICAN
The following table summarizes financial information for FSA:
- -----------------------------------------------------------------
Millions 1996 1995
- -----------------------------------------------------------------
FSA BALANCE SHEET DATA:
Total investments $ 1,154.4 $ 1,110.7
Total assets 1,537.7 1,490.3
Deferred premium revenue, net 360.0 330.3
Loss and loss adjustment expense
reserve, net 42.2 50.2
Preferred shareholder's equity .7 .7
Common shareholders' equity 800.6 777.2
FSA INCOME STATEMENT DATA:
Gross premiums written $ 177.0 $ 110.7
Net premiums written 121.0 77.6
Net premiums earned 90.4 69.3
Net investment income 65.1 49.0
Net income 80.8 55.0
- -----------------------------------------------------------------
AMOUNTS RECORDED BY FUND AMERICAN:
Investment in FSA Common Stock $ 92.3 $ 60.0
Investment in FSA Options and
Preferred Stock 19.8 2.5
-------------------------
Total Investment in FSA $ 112.1 $ 62.5
=========================
Equity in earnings from FSA Common
Stock (a) $ 7.8 $ 5.4
Equity in net unrealized investment
gains (losses) from FSA's investment
portfolio, before tax (b) (1.0) 4.5
Unrealized investment gains on FSA
Options and Preferred Stock, before 17.3 .3
tax (b)
=================================================================
(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to shareholders' equity.
At December 31, 1996 and 1995, Fund American's consolidated retained earnings
included $13.8 million and $6.9 million, respectively, of undistributed earnings
of FSA.
INVESTMENT IN FOLKSAMERICA
Fund American owned 6,920,000 shares of Folksamerica Preferred Stock at
December 31, 1996. This represents 50.0% of the total Folksamerica voting shares
outstanding at that time. At December 31, 1996, Fund American also owned ten
year Folksamerica Warrants to purchase up to 6,920,000 shares of Folksamerica
Common Stock for aggregate consideration of $79.4 million. Fund American
acquired its investments in Folksamerica on June 19, 1996.
Fund American's investments in Folksamerica are accounted for under the
provisions of SFAS No. 115 whereby the investments are reported at fair value as
of the balance sheet date, with related unrealized investment gains and losses
excluded from earnings and reported as a net amount in a separate component of
shareholders' equity. Dividends earned on the Folksamerica Preferred Stock are
recorded as earnings from unconsolidated insurance affiliates.
F-26
FUND AMERICAN
The following table summarizes financial information for Folksamerica:
- ----------------------------------------------------------------------
Millions 1996
- ----------------------------------------------------------------------
FOLKSAMERICA BALANCE SHEET DATA:
Total investments $ 711.4
Total assets 994.8
Unearned premium reserve, net 59.9
Loss and loss adjustment expense reserve, net 490.0
Preferred shareholder's equity 79.4
Common shareholders' equity 88.2
FOLKSAMERICA INCOME STATEMENT DATA:
Gross premiums written $ 187.2
Net premiums written 171.9
Net premiums earned 181.4
Net investment income 32.4
Net income 17.1
- ----------------------------------------------------------------------
AMOUNTS RECORDED BY FUND AMERICAN:
Investment in Folksamerica Preferred Stock $ 77.9
Investment in Folksamerica Warrants 2.2
----------
Total Investment in Folksamerica $ 80.1
----------
Dividends from Folksamerica Preferred Stock (a) $ 2.7
Unrealized investment gains on
Folksamerica Warrants and Folksamerica
Preferred Stock, before tax (b) .2
======================================================================
(a) Recorded net of related amortization of goodwill and accretion of discount.
(b) Recorded directly to shareholders' equity.
INVESTMENT IN MSA
At December 31, 1996 and 1995, Fund American owned 90,606 shares of MSA Common
Stock. This represented approximately 33.2% and 33.1%, respectively, of the
total shares of MSA Common Stock outstanding at those times. Fund American's
investment in MSA is accounted for using the equity method.
The following tables summarize financial information for MSA:
- ----------------------------------------------------------------------
Millions 1996 1995
- ----------------------------------------------------------------------
MSA BALANCE SHEET DATA:
Total investments $ 249.4 $ 240.8
Total assets 316.2 309.6
Unearned premium reserve 64.0 58.4
Loss and loss adjustment expense reserves 120.1 116.2
Shareholders' equity 101.4 92.0
MSA INCOME STATEMENT DATA:
Net premiums written $ 147.2 $ 130.9
Net premiums earned 141.6 127.7
Net investment income 14.9 15.0
Net income 9.7 12.4
======================================================================
F-27
FUND AMERICAN
- ----------------------------------------------------------------------------
Millions 1996 1995
- ----------------------------------------------------------------------------
AMOUNTS RECORDED BY FUND AMERICAN:
Investment in MSA Common Stock $ 34.7 $ 33.7
Equity in earnings from MSA Common Stock (a) 1.5 4.0
Equity in net unrealized investment
gains from MSA's investment portfolio, before tax (b) (.5) 3.2
============================================================================
(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to shareholders' equity.
At December 31, 1996 and 1995, Fund American's consolidated retained earnings
included $6.5 million and $4.6 million, respectively, of undistributed earnings
of MSA.
NOTE 17. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
Fund American utilizes derivative financial instruments in the management of
interest rate risk. Fund American does not use derivative financial instruments
for trading purposes. Fund American's use of derivative financial instruments is
primarily limited to (i) commitments to extend credit, (ii) mandatory forward
commitments, (iii) interest rate floor contracts and principal-only swap
agreements and (iv) to achieve a fixed interest rate on existing variable rate
obligations.
Source One is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers and
to reduce its exposure to fluctuations in interest rates. These financial
instruments primarily include commitments to extend credit and mandatory forward
commitments. Those instruments involve, to varying degrees, elements of credit
and market interest rate risk in excess of the amounts recognized in the
consolidated balance sheets. The contract or notional amounts of those
instruments reflect the extent of risk Source One has related to the
instruments.
Source One's exposure to credit loss in the event of nonperformance by the
other party for commitments to extend credit (mortgage loan pipeline) is
represented by the contractual notional amount of those commitments. Source
One's locked mortgage loan pipeline commitments expected to close totalled
$175.7 million and $221.9 million at December 31, 1996 and 1995, respectively.
Fixed rate commitments result in Source One having market interest rate risk as
well as credit risk. Variable rate commitments expose Source One primarily to
credit risk. The amount of collateral required upon extension of credit is based
on management's credit evaluation of the mortgagor and consists of the
mortgagor's residential property.
Source One obtains mandatory forward commitments of up to 120 days to sell
mortgage-backed securities to hedge the market interest rate risk associated
with the portion of the mortgage loan pipeline that is expected to close and all
mortgage loans receivable. At December 31, 1996 and 1995, Source One had $454.6
million and $561.0 million, respectively, of mandatory forward commitments
outstanding. If secondary market interest rates decline after Source One commits
to an interest rate for a loan, the loan may not close and Source One may incur
a loss from the cost of covering its obligations under a related mandatory
forward commitment. If secondary market interest rates increase after Source One
commits to an interest rate for a loan and Source One has not obtained a forward
commitment, Source One may incur a loss when the loan is subsequently sold.
Source One's risk management function closely monitors the mortgage loan
pipeline to determine appropriate forward commitment coverage on a daily basis
in order to manage the risk inherent in these off-balance-sheet financial
instruments. In addition, the risk management area seeks to reduce counterparty
risk by committing to sell mortgage loans only to approved dealers with no
dealer having in excess of 20% of current commitments.
Source One sells loans through mortgage-backed securities issued pursuant to
programs of GNMA, FNMA and FHLMC, or through institutional investors. Most loans
are aggregated in pools of $1.0 million or more which are purchased by
institutional investors after having been guaranteed by GNMA, FNMA or FHLMC.
Substantially all GNMA securities are sold by Source One without recourse for
loss of principal in the event of a subsequent default
F-28
FUND AMERICAN
by the mortgagor due to the FHA and VA insurance underlying such securities.
Prior to December 1992, substantially all conventional securities were sold with
recourse to Source One, to the extent of insufficient proceeds from private
mortgage insurance, foreclosure and other recoveries. Since December 1992 all
conventional loans have been sold without recourse to Source One.
Servicing agreements relating to mortgage-backed securities issued pursuant to
programs of GNMA, FNMA or FHLMC require Source One to advance funds to make the
required payments in the event of a delinquency by the borrower. Source One
expects that it would recover most funds advanced upon cure of default by the
borrower or foreclosure. However, funds advanced in connection with VA partially
guaranteed loans and certain conventional loans (which are at most partially
insured by private mortgage insurers) may not be fully recovered due to
potential declines in collateral value. Source One is subject to limited amounts
of risk with respect to these loans since the insurer has the option to
reimburse the servicer for the lower of fair value of the property or the
mortgage loan outstanding, in addition to the VA guarantee on the loan. In
addition, most of Source One's servicing agreements for mortgage-backed
securities typically require the payment to investors of a full month's interest
on each loan although the loan may be paid off (by optional prepayment or
foreclosure) other than on a month-end basis. In this instance, Source One is
obligated to pay the investor interest at the note rate from the date of loan
payoff through the end of the calendar month without reimbursement.
At December 31, 1996 and 1995, Source One serviced approximately $13.5 billion
and $10.7 billion of GNMA loans (without substantial recourse), respectively,
and $2.9 billion and $3.5 billion of conventional loans (with recourse),
respectively.
To cover loan losses that may result from these servicing arrangements and
other losses, Source One has provided an allowance for loan losses of $15.4
million and $13.5 million on the consolidated balance sheets at December 31,
1996 and 1995, respectively. Source One's management believes the allowance for
loan losses is adequate to cover unreimbursed foreclosure advances and principal
losses. During 1995 Source One refined the estimates used to calculate the
allowance for loan losses to more accurately reflect Source One's loss
experience. This change reduced the amount that would have been computed using
the prior estimates.
In order to offset changes in the value of Source One's portfolio of
mortgage servicing rights and to mitigate the effect on earnings of higher
amortization and impairment of such rights which results from increased
prepayment activity, Source One invests in various financial instruments. As
interest rates decline, prepayment activity increases, thereby reducing the
value of the mortgage servicing rights, while the value of the financial
instrument increases. Conversely, as interest rates increase, the value of the
servicing rights increases while the value of the financial instrument
decreases. The financial instruments utilized by Source One include interest
rate floor contracts and principal-only swap transactions.
The interest rate floor contracts derive their value from differences between
the floor rate specified in the contract and market interest rates. The floor
yields range from 5.47% to 6.24%. To the extent that market interest rates
increase, the value of the floors declines. However, Source One is not exposed
to losses in excess of its initial investment in the floors. The interest rate
floor contracts are carried at fair value with unrealized gains and losses
recorded in other mortgage operations revenue on the consolidated income
statements. As of December 31, 1996 and 1995, the carrying value of Source One's
open interest rate floor contracts totalled $4.8 million and $3.5 million,
respectively, with a total notional principal amount of $1.0 billion and $.5
billion, respectively. The floors have terms ranging from two to five years.
The value of the principal-onlys swaps is determined by changes in the value
of referenced principal-only strips. As of December 31, 1996, the carrying value
of Source One's principal-only swap transactions totalled $3.2 million, with an
original notional principal amount of $50.0 million. The principal-only swaps
have a remaining term of 4.5 years.
White Mountains' insurance subsidiaries extend credit to their policyholders
in the normal course of business, perform credit evaluations and maintain
allowances for potential credit losses. Concentration of credit risk with
respect to receivables is limited due to the large number of policyholders and
their dispersion across a multi-state area.
NOTE 18. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values for Fund American's financial instruments have been
determined by using appropriate market information and valuation methodologies.
Considerable judgement is required to develop the estimates of fair value.
Therefore, the estimates provided herein are not necessarily indicative of the
amounts that could be
F-29
FUND AMERICAN
realized in a current market exchange. Carrying value equals or approximates
fair value for common equity securities, fixed maturity investments, derivative
instruments, short-term investments, cash, other financial assets and other
financial liabilities. For each other class of financial instrument for which it
is practicable to estimate fair value, the following methods and assumptions
were used to estimate such value:
Other Investments. The fair values of mortgage loans held for investment are
estimated using quoted market prices for securities backed by similar loans,
adjusting for differences in loan characteristics. Fair values of REMICs are
estimated using discounted cash flow analyses reflecting I/O strip and LIBOR
interest rates, and "Prepayment Speed Assumption" rates, taking into
consideration the characteristics of the related collateral. For interest rate
floor contracts and principal-only swap transactions, fair value is estimated
based on quoted market prices for those or similar investments and equals
carrying value. For all other securities classified as other investments fair
values have been determined using quoted market values or internal appraisal
techniques.
Capitalized Excess Mortgage Servicing. Fair value is estimated by computing
the anticipated revenue to be received over the life of the related loans based
on market consensus prepayment rates, discounted using quoted I/O strip interest
rates.
Mortgage Loans Held for Sale. Fair values are estimated using quoted market
prices for securities backed by similar loans, adjusting for differences in loan
characteristics.
Pool Loan Purchases. Fair values are estimated using (i) discounted cash flow
analyses reflecting Source One's short-term incremental borrowing rate or (ii)
quoted market prices for securities backed by similar loans.
Loans in Foreclosure and Mortgage Claims Receivable. Fair values are estimated
by discounting anticipated future cash flows using Source One's short-term
incremental borrowing rate.
Debt. Fair value is estimated by discounting future cash flows using
incremental borrowing rates for similar types of borrowing arrangements. For
subordinated debentures, fair value is based on quoted market prices.
Off-Balance-Sheet Financial Instruments. Fair value for commitments to sell
mortgage loans is based on current settlement values for those commitments. Fair
value for commitments to extend credit is based on current quoted market prices
for securities backed by similar loans.
F-30
FUND AMERICAN
The carrying amounts and estimated fair values of Fund American's financial
instruments were as follows:
---------------------------------------------------------------------------------------------------------------------------
December 31, 1996 December 31, 1995
---------------------- -----------------------
Carrying Fair Carrying Fair
Millions amount value amount value
- ----------------------------------------------------------------------------------------------------------------------------
FINANCIAL ASSETS:
Common equity securities $160.8 $160.8 $274.5 $274.5
Fixed maturity investments 155.4 155.4 110.7 110.7
Other investments (excluding derivative instruments) 168.5 168.4 92.4 93.0
Derivative instruments:
Interest rate floor contracts 4.8 4.8 3.5 3.5
Principal-only swaps 3.2 3.2 - -
Short-term investments 67.5 67.5 103.6 103.6
Cash 4.8 4.8 2.7 2.7
Capitalized excess mortgage servicing 38.7 39.6 44.7 46.0
Mortgage loans held for sale 314.9 315.9 381.0 391.5
Pool loan purchases 131.5 135.8 119.0 122.3
Loans in foreclosure and mortgage claims receivable, net (a) 38.4 37.7 29.6 29.0
Other 35.9 35.9 25.7 25.7
FINANCIAL LIABILITIES:
Short-term debt 407.9 407.9 445.4 449.0
Long-term debt 424.2 460.2 407.3 450.8
Other 18.3 18.3 12.4 12.4
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS:
Mandatory forward commitments - 454.5 - 562.4
Commitments to extend credit expected to close - 176.8 - 226.6
============================================================================================================================
(a) Excludes $13.1 million and $15.8 million of real estate owned in 1996 and
1995, respectively.
Other financial assets includes investment income receivable, accounts
receivable from securities sales, notes receivable and White River Shares held
for delivery upon exercise of existing employee stock options. Other financial
liabilities includes accrued interest payable, accounts payable on securities
purchases, dividends payable to shareholders and liability for existing employee
stock options to purchase White River Shares.
The estimated fair value amounts for Fund American's financial instruments
have been determined using available market information and valuation
methodologies. Such estimates provided herein are not necessarily indicative of
the amounts that would be potentially realized in a current market exchange.
It is not practicable without incurring excessive costs to estimate the fair
value of conventional loans sold with recourse, which is an off-balance-sheet
financial instrument representing Source One's obligation to repurchase loans
sold that subsequently default.
NOTE 19. RELATED PARTY TRANSACTIONS
For corporate travel purposes Fund American jointly owns two short-range
aircraft with Haverford Utah, LLC ("Haverford"). Messrs. Byrne and Kemp are
principals of Haverford. Both aircraft were acquired from unaffiliated third
parties during 1996. In exchange for Haverford's 20% ownership interest in the
aircraft, Haverford contributed capital equal to 20% of the total initial cost
of the aircraft and Haverford bears the full costs of its usage and maintenance
of the aircraft pursuant to a Joint Ownership Agreement dated September 16,
1996.
Prior to the Joint Ownership Agreement, Fund American was a party to a "dry
lease" agreement dated January 2, 1995, for the use of aircraft owned by
Haverford Transportation Inc. ("HTI") for corporate travel purposes. Messrs.
Byrne and Kemp are the sole shareholders of HTI. During 1996, 1995 and 1994 Fund
American paid HTI a total of $279,739, $183,563 and $190,150, respectively,
pursuant to the dry lease arrangement. The terms of the
F-31
FUND AMERICAN
agreement provided for the use of HTI's aircraft (excluding pilot and fuel) for
a fixed hourly charge of $200 for a single engine piston aircraft and $800 to
$1,000 for a twin engine turbine aircraft. Based on the Company's experience in
operating comparable aircraft, the hourly operating charges incurred by the
Registrant pursuant to the HTI dry lease are considered to be representative of
the actual hourly costs of operating HTI's aircraft. Fund American believes that
its arrangement with HTI was on terms that were no less favorable to Fund
American than would generally be available if secured through an arrangement
with an unaffiliated third party.
In December 1993, BYRNE & sons, l.p. ("BYRNE & sons"), a partnership in which
Mr. Byrne is the sole general partner, made an investment in the Merastar
Partners Limited Partnership and the Southern Heritage Limited Partnership (the
"Partnerships"). The Partnerships are involved in various property and casualty
insurance ventures. Shortly after making its investment, BYRNE & sons offered
one-third of the investment in the Partnerships to Fund American on equal terms
and conditions. In May 1994 Fund American accepted the offer and paid BYRNE &
sons a total of $338,558 representing reimbursement for one-third of Byrne &
sons' cost for its investment in the Partnerships including interest of $5,225
at a 6.0% annual rate.
Through December 22, 1993, White River was a wholly-owned subsidiary of the
Company. The Company currently owns 1,014,750 White River Shares, or
approximately 20.8% of the outstanding White River Shares of which 295,932
shares, or 6.0% of the outstanding White River Shares, have been reserved by
Fund American for delivery upon exercise of existing employee stock options and
warrants. White River had outstanding the $50.0 million Term Note and the $40.0
million Revolver payable to the Company which were repaid on various dates
during 1995. Gordon S. Macklin, a director of the Company, is the non-executive
Chairman of White River.
Mr. Howard Clark, Jr., a director of the Company, is Vice Chairman of Lehman
Brothers, Inc. Lehman Brothers Inc. has, from time to time, provided various
services to Fund American including investment banking services, brokerage
services, underwriting of debt and equity securities and financial consulting
services.
Mr. Robert P. Cochran, a director of the Company, is Chief Executive Officer
of FSA. FSA has been retained by Fund American to manage portions of its fixed
maturity portfolio.
Mr. George J. Gillespie, III, a director of the Company, is a Partner in the
firm Cravath, Swaine & Moore, which has been retained by Fund American from time
to time to perform legal services.
Mr. Arthur Zankel, a director of the Company, is Co-Managing Partner of First
Manhattan Co. First Manhattan Co. has provided brokerage, discretionary
investment management and non-discretionary investment advisory services to Fund
American from time to time.
Fund American believes that all the above transactions were on terms that were
reasonable and competitive. Additional transactions of this nature may be
expected to take place in the ordinary course of business in the future.
F-32
FUND AMERICAN
SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data for 1996 and 1995 is shown in the following
table. The quarterly financial data includes, in the opinion of management, all
recurring adjustments necessary for a fair presentation of the results of
operations for the interim periods.
- -------------------------------------------------------------------------------------------------------------------------
1996 Three Months Ended (a) 1995 Three Months Ended (b)
---------------------------------------- ----------------------------------------
Millions, except per share amounts Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31
- -------------------------------------------------------------------------------------------------------------------------
Revenues $ 72.0 $ 90.0 $ 82.8 $ 87.7 $ 53.6 $ 48.6 $ 43.3 $ 76.8
Expenses 119.3 81.3 77.0 69.6 52.8 42.9 86.8 43.4
---------------------------------------------------------------------------------------
Pretax operating earnings (loss) (47.3) 8.7 5.8 18.1 .8 5.7 (43.5) 33.4
Net realized investment
gains (losses) 10.4 (1.6) 1.3 28.4 7.0 4.4 10.4 17.0
---------------------------------------------------------------------------------------
Pretax earnings (loss) (36.9) 7.1 7.1 46.5 7.8 10.1 (33.1) 50.4
Income tax provision (benefit) (5.8) 3.4 3.6 17.7 5.4 3.5 (10.6) 18.4
---------------------------------------------------------------------------------------
After tax earnings (loss) (31.1) 3.7 3.5 28.8 2.4 6.6 (22.5) 32.0
Tax benefit from sale of
discontinued operations - - - - - - 66.0 -
Loss on early extinguishment
of debt, after tax - - - - - - (.2) (.2)
---------------------------------------------------------------------------------------
Net income (loss) $ (31.1) $ 3.7 $ 3.5 $ 28.8 $ 2.4 $ 6.6 $ 43.3 $ 31.8
- ----------------------------------=======================================================================================
Primary earnings per share:
After tax earnings (loss) $ (3.99) $ .46 $ .42 $ 3.45 $ .29 $ .75 $ (2.95) $ 3.43
Net income (loss) (3.99) .46 .42 3.45 .29 .75 5.08 3.41
Fully diluted earnings per share:
After tax earnings (loss) (3.99) .46 .42 3.45 .29 .75 (2.44) 3.23
Net income (loss) (3.99) .46 .42 3.45 .29 .75 4.68 3.22
=========================================================================================================================
(a) The quarterly amounts for the three month period ended December 31, 1996,
include a $33.6 million pretax write-off of all Source One's existing
goodwill and certain other intangible assets and $28.4 million of pretax
impairment of Source One's capitalized mortgage servicing asset. These two
items served to decrease fourth quarter 1996 net income by $48.5 million.
(b) The quarterly amounts for the three month periods ended June 30 and March
31, 1995, have been restated to reflect the adoption as of January 1, 1995,
of SFAS No. 122. Prior to restatement, net income for the three month
periods ended June 30 and March 31, 1995, was $48.2 million and $28.9
million, respectively.
F-33
FUND AMERICAN
REPORT ON MANAGEMENT'S RESPONSIBILITIES
The financial information included in this annual report, including the
audited consolidated financial statements, has been prepared by the management
of Fund American. The consolidated financial statements have been prepared in
accordance with generally accepted accounting principles and, where necessary,
include amounts based on informed estimates and judgments. In those instances
where there is no single specified accounting principle or standard, management
makes a choice from reasonable, accepted alternatives which are believed to be
most appropriate under the circumstances. Financial information presented
elsewhere in this annual report is consistent with that shown in the financial
statements.
Fund American maintains internal financial and accounting controls designed to
provide reasonable and cost effective assurance that assets are safeguarded from
loss or unauthorized use, that transactions are recorded in accordance with
management's policies and that financial records are reliable for preparing
financial statements. The internal controls structure is documented by written
policies and procedures which are communicated to all appropriate personnel and
is updated as necessary. Fund American's business ethics policies require
adherence to the highest ethical standards in the conduct of its business.
Compliance with these controls, policies and procedures is continuously
maintained and monitored by management.
Ernst & Young LLP are Fund American's independent auditors and have audited
the consolidated financial statements of Fund American as of December 31, 1996
and 1995, and for each of the three years in the period ended December 31, 1996,
and issued their report thereon dated March 21, 1997, which appears on page F-35
herein. Coopers & Lybrand L.L.P. serves as independent auditors of Valley. Their
report, dated February 14, 1997 on their audit of Valley as of and for the year
ended December 31, 1996, has been included as Exhibit 99(a).
In connection with their audits, the independent auditors provide an
objective, independent review and evaluation of the structure of internal
controls to the extent they consider necessary. Management reviews all
recommendations of the independent auditors concerning the structure of internal
controls and responds to such recommendations with corrective actions, as
appropriate.
The Audit Committee of the Board is comprised of all non-management directors
and has general responsibility for the oversight and surveillance of the
accounting, reporting and financial control practices of Fund American. The
Audit Committee, which reports to the full Board, annually reviews the
effectiveness of the independent auditors, Fund American's internal auditors and
management with respect to the financial reporting process and the adequacy of
internal controls. Both the internal auditors and the independent auditors
have, at all times, free access to the Audit Committee, without members of
management present, to discuss the results of their audits, the adequacy of
internal controls and any other matter that they believe should be brought to
the attention of the Audit Committee.
John J. Byrne Allan L. Waters Michael S. Paquette
Chairman of the Board, President Senior Vice President Vice President and
and Chief Executive Officer and Chief Financial Officer Controller
F-34
FUND AMERICAN
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
Fund American Enterprises Holdings, Inc.
We have audited the accompanying consolidated balance sheets of Fund American
Enterprises Holdings, Inc., as of December 31, 1996 and 1995, and the related
consolidated income statements and statements of shareholders' equity and cash
flows for each of the three years in the period ended December 31, 1996. These
financial statements are the responsibility of the Company's management. Our
audits also included the financial statement schedules listed at Item 14(d).
Our responsibility is to express an opinion on these financial statements and
schedules based on our audits. We did not audit the consolidated financial
statements of Valley Group, Inc., a wholly-owned subsidiary, representing
substantially all of the Company's consolidated insurance operations, which
statements reflect total assets of $288.0 million as of December 31, 1996 and
total revenues of $126.9 million for the year then ended, and the consolidated
financial statements of Financial Security Assurance Holdings Ltd. ("FSA"), an
equity method investee. The Company's equity method investment in FSA
represents $92.3 million of assets at December 31, 1996 and its equity in FSA's
earnings represents $7.8 million of total revenues for the year then ended.
Those statements were audited by other auditors, Coopers and Lybrand L.L.P.,
whose reports have been furnished to us, and our opinion, insofar as it relates
to data included for Valley Group, Inc. and FSA, with respect to the amounts in
the preceeding sentence, is based solely on the reports of the other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, based on our audits and the reports of other auditors, the
financial statements referred to above present fairly, in all material respects,
the consolidated financial position of Fund American Enterprises Holdings, Inc.
at December 31, 1996 and 1995, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
1996, in conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statements schedules when considered in relation
to the basic financial statements taken as a whole present fairly in all
material respects the information set forth therein.
As discussed in the Notes to Consolidated Financial Statements, in 1995 the
Company changed its method of accounting for originated mortgage servicing
rights and in 1994 the Company changed its methodology used to measure
impairment of purchased mortgage servicing rights.
Ernst & Young LLP
New York, New York
March 21, 1997
F-35
FUND AMERICAN
SCHEDULE I
MARKETABLE SECURITIES AND OTHER INVESTMENTS
COMMON EQUITY SECURITIES
-----------------------------------------------------------------------------------------------------
December 31, 1996
--------------------------------------------------------------
Percent
of total
Shares Fair fair
Shares and units in thousands, dollars in millions or units Cost value value
- ------------------------------------------------------------------------------------------------------
Energy, natural resources and related industries:
San Juan Basin Royalty Trust 10,995 $ 50.4 $ 90.7 56.4%
Veritas DGC Inc. 835 5.4 14.7 9.1
Aggregate of holdings less than $10.0 million 5.0 5.9 3.7
------------------------------------
Total energy, natural resources and related
industries 60.8 111.3 69.2
All other:
Mid Ocean Limited 388 12.2 20.4 12.7
Vanguard Institutional Index Fund 183 12.8 12.6 7.8
Aggregate of holdings less than $10.0 million 15.3 16.5 10.3
------------------------------------
Total common equity securities $101.1 $160.8 100.0%
======================================================================================================
FIXED MATURITY INVESTMENTS
- --------------------------------------------------------------------------------------------
December 31, 1996
---------------------------------------
Cost or
amortized Fair
Millions cost value
- --------------------------------------------------------------------------------------------
U. S. Government and agency obligations $ 63.6 $ 64.3
U S WEST, Inc. redeemable preferred stock 49.1 49.1
Debt securities issued by industrial corporations 31.3 31.5
GNMA mortgage-backed securities 9.1 9.1
Aggregate of holdings less than $10.0 million 1.4 1.4
----------------------------------------
Total fixed maturity investments $ 154.5 $ 155.4
============================================================================================
OTHER INVESTMENTS
- --------------------------------------------------------------------------------------------
December 31, 1996
----------------------------------------
Cost or
amortized Carrying
Millions cost value
- --------------------------------------------------------------------------------------------
Travelers Property Casualty Corp. restricted
common shares $ 50.8 $ 90.3
White River Corporation restricted common shares 21.1 39.2
Mortgage loans held for investment 23.4 23.4
Aggregate of holdings less than $10.0 million 24.4 23.6
----------------------------------------
Total other investments $ 119.7 $ 176.5
============================================================================================
FS-1
FUND AMERICAN
SCHEDULE III
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
(PARENT COMPANY ONLY)
CONDENSED BALANCE SHEETS
- -------------------------------------------------------------------------------------------------------
December 31,
-----------------------------
Millions 1996 1995
- -------------------------------------------------------------------------------------------------------
Assets:
Fixed maturity investments $ 46.0 $ -
Common equity securities and other investments 100.1 8.0
Short-term investments, at amortized cost .3 23.9
Cash - -
Other assets 18.1 18.9
Investments in unconsolidated insurance affiliates 27.7 2.5
Investments in consolidated affiliates 725.2 825.4
-----------------------------
Total assets $ 917.4 $ 878.7
- --------------------------------------------------------------------------=============================
Liabilities:
Debt $ 115.4 $ 115.3
Accounts payable and other liabilities 115.0 63.7
-----------------------------
Total liabilities 230.4 179.0
Shareholders' equity 687.0 699.7
-----------------------------
Total liabilities and shareholders' equity $ 917.4 $ 878.7
=======================================================================================================
CONDENSED INCOME STATEMENTS
- -------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------------
Millions 1996 1995 1994
- -------------------------------------------------------------------------------------------------------
Revenues $ 11.7 $ 28.7 $ 14.2
Expenses 15.5 68.9 21.2
-----------------------------------
Pretax operating loss (3.8) (40.2) (7.0)
Net realized investment gains (losses) (3.1) 12.6 22.7
-----------------------------------
Pretax earnings (loss) (6.9) (27.6) 15.7
Income tax provision (benefit) .5 (8.7) 7.6
-----------------------------------
Parent company only operating income (loss) (7.4) (18.9) 8.1
Earnings from consolidated affiliates 12.3 37.4 13.0
Tax benefit from sale of discontinued operations - 66.0 -
Loss on early extinguishment of debt, after tax - (.4) -
Cumulative effect of accounting change - purchased mortgage
servicing, after tax - - (44.3)
-----------------------------------
Consolidated net income (loss) $ 4.9 $ 84.1 $ (23.2)
=======================================================================================================
FS-2
FUND AMERICAN
SCHEDULE III
(CONTINUED)
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
(PARENT COMPANY ONLY)
CONDENSED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------
Millions 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 4.9 $ 84.1 $ (23.2)
Charges (credits) to reconcile net income to net cash from operations:
Tax benefit from sale of discontinued operations - (66.0) -
Cumulative effect of accounting change - purchased mortgage servicing, after tax - - 44.3
Compensation expense resulting from warrant extension - 46.2 -
Net realized investment losses (gains) 3.1 (12.6) (22.7)
Earnings from consolidated subsidiaries (12.3) (37.4) (13.0)
Undistributed earnings from unconsolidated insurance affiliates (1.1) (9.0) (2.5)
Dividends and return of capital distributions received from subsidiaries 65.0 233.3 121.3
Changes in current income taxes receivable and payable 28.4 2.9 35.1
Deferred income tax provision (benefit) .1 (13.5) 2.8
Other, net (15.9) (3.7) 10.0
-------------------------------------
Net cash provided from operations 72.2 224.3 152.1
- --------------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Net decrease in short-term investments 28.2 34.3 69.6
Sales and maturities of common equity securities and other investments 134.4 45.1 73.3
Purchases of common equity securities and other investments (108.9) (41.3) (60.3)
Investments in consolidated affiliates (25.2) (77.2) -
Investments in unconsolidated affiliates (27.7) (33.8) (44.0)
Purchases of fixed assets (.8) - -
-------------------------------------
Net cash (used for) provided from investing activities - (72.9) 38.6
- --------------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Repayments of long-term debt - (7.9) (23.9)
Redemption of preferred stock - (75.0) (82.0)
Proceeds from issuances of common stock from treasury - 3.3 2.8
Purchases of common stock retired (66.3) (65.5) (78.8)
Dividends paid to shareholders (5.9) (6.4) (10.8)
-------------------------------------
Net cash used for financing activities (72.2) (151.5) (192.7)
- --------------------------------------------------------------------------------------------------------------------------
Net decrease in cash during year - (.1) (2.0)
Cash balance at beginning of year - .1 2.1
- --------------------------------------------------------------------------------------------------------------------------
Cash balance at end of year $ - $ - $ .1
==========================================================================================================================
FS-3