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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, 1997
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 20, 1998, was $799,580,145.
As of March 20, 1998, 5,857,730 shares of Common Stock, par value of $1.00
per share, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Notice of 1998 Annual Meeting of Shareholders and
Proxy Statement dated March 30, 1998 (Part III)
Fund American
TABLE OF CONTENTS
PART I
ITEM 1. Business ......................................................... 1
a. General ....................................................... 1
b. Insurance Operations .......................................... 1
c. Mortgage Banking Operations ................................... 7
d. Investment Portfolio Management ............................... 13
e. Certain Business Conditions ................................... 13
f. Competition ................................................... 14
g. Regulation .................................................... 15
h. Employees ..................................................... 15
i. Forward-Looking Statements .................................... 16
ITEM 2. Properties ....................................................... 16
ITEM 3. Legal Proceedings ................................................ 16
ITEM 4. Submission of Matters to a Vote of Security Holders .............. 16
PART II
ITEM 5. Market for Registrant's Common Equity and Related
Stockholder Matters ............................................ 16
ITEM 6. Selected Financial Data .......................................... 17
ITEM 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations .......................................... 19
ITEM 8. Financial Statements and Supplementary Data ...................... 36
ITEM 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ............................ 36
PART III
ITEM 10. Directors and Executive Officers ................................. 36
ITEM 11. Executive Compensation ........................................... 40
ITEM 12. Security Ownership of Certain Beneficial Owners and Management ... 40
ITEM 13. Certain Relationships and Related Transactions ................... 40
PART IV
ITEM 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K .. 40
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"). White Mountains' consolidated and
unconsolidated insurance operations are conducted through its subsidiaries and
affiliates in the businesses of property and casualty insurance, reinsurance and
financial guaranty insurance. White Mountains' mortgage banking operations are
conducted through Source One Mortgage Services Corporation and its subsidiaries
("Source One"). Fund American also owns a passive investment portfolio
consisting primarily of common equity securities. 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
Consolidated Insurance Operations
Since 1995 White Mountains has been acquiring and developing various
insurance operating interests. In December 1995, White Mountains acquired Valley
Group, Inc. ("VGI") of Albany, Oregon and Charter Group, Inc. ("CGI") of
Richardson, Texas for $41.7 million in cash less $3.0 million of purchase price
adjustments. In September 1995, White Mountains formed White Mountains Insurance
Company ("WMIC") which is a New Hampshire-based mid-size commercial property and
casualty company. Since 1995 White Mountains has been active in developing,
capitalizing and reorganizing its insurance operations.
Valley. VGI, through its wholly-owned subsidiaries including Valley
Insurance Company ("VIC"), Valley Property & Casualty Insurance Company ("Valley
P&C"), Valley National Insurance Company ("Valley National") and certain related
non-insurance affiliates, collectively ("Valley"), write personal and commercial
lines as further described below:
VIC: A Northwest-based property and casualty company which writes personal
and commercial lines. In 1997 and 1996, VIC had $77.7 million and $75.1 million
of net written premiums, respectively, primarily in Oregon, California and
Washington. At December 31, 1997, VIC had $146.6 million of total admitted
assets and $61.2 million of policyholders' surplus. VIC was established in 1982
and began writing insurance policies in 1985. VIC is rated "A" or "excellent" by
A.M. Best.
Valley P&C: On December 5, 1996, Valley's parent company formed Valley P&C
to specifically write property and casualty insurance within Oregon. Valley P&C
wrote its first policies in February 1997 and had $5.2 million in net written
premiums during 1997. At December 31, 1997, Valley P&C had $7.7 million of total
admitted assets and $3.7 million of policyholders' surplus.
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 purchase of Valley National included an investment portfolio, consisting
principally of fixed maturity investments, totalling $6.7 million. Valley
National wrote its first policies in December 1996 and had $2.7 million in gross
written premiums ($.3 million of net written premiums) during 1997. Valley
National is expected to further expand its operations
1
to certain other states in which it is currently licensed. At December 31, 1997,
Valley National had $11.5 million of total admitted assets and $11.1 million of
policyholders' surplus. Valley National is a wholly-owned subsidiary of VIC and
shares its A.M. Best's "A" rating through a combination of a reinsurance
arrangement with VIC and its ownership structure.
Valley markets insurance products principally through independent agents.
Valley's primary business focus is to establish strong long-term relationships
with its agents and insured customers by focusing on providing quality insurance
products to families and family-owned businesses. This approach has resulted in
an established track record of growth:
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
----------------------------------------------------------------
Statutory Basis, in Millions 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------
Gross written premiums $ 89.2 $ 81.9 $ 73.1 $64.8 $ 52.5
Total assets at year-end 154.3 138.2 126.8 80.4 65.8
Policyholders' surplus at year-end 64.9 57.8 58.5 23.5 22.9
===================================================================================================================
In 1997 and 1996 Valley wrote $89.2 million and $81.9 million,
respectively, of gross premiums within the following states, through
approximately 285 independent agents:
- --------------------------------------------------------------------------------------
Year Ended December 31, 1997
---------------------------------------------------
Gross Written Policies
Dollars in millions Premiums In Force* Agents*
- --------------------------------------------------------------------------------------
Oregon $43.1 30,789 98
California 26.2 12,333 80
Washington 17.2 6,960 69
Arizona, Idaho, Utah and other 2.7 2,180 38
---------------------------------------------------
Totals $89.2 52,262 285
- -----------------------------------===================================================
- --------------------------------------------------------------------------------------
Year Ended December 31, 1996
---------------------------------------------------
Gross 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, Utah and other .3 222 9
---------------------------------------------------
Totals $81.9 48,804 245
======================================================================================
* Determined at year end.
Valley began to write business in the states of Arizona, Idaho and Utah
during the fourth quarter of 1996. Valley intends to increase its premium
writings in those states in the future.
2
Valley's focus on delivering insurance products to families and
family-owned businesses has resulted in a book of business which is balanced
between personal lines and commercial lines. Gross written premiums for Valley's
primary lines of business are shown below:
3
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
---------------------------------------------------------------
Millions 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------
Personal lines:
Automobile $ 29.3 $25.9 $23.9 $22.5 $ 20.5
Homeowners 13.4 12.0 10.4 8.3 6.3
Other 1.5 1.3 1.1 .8 .8
---------------------------------------------------------------
Total personal lines 44.2 39.2 35.4 31.6 27.6
---------------------------------------------------------------
Commercial lines:
Multiple peril 42.2 39.1 34.3 30.2 21.3
Other 2.8 3.6 3.4 3.0 3.6
---------------------------------------------------------------
Total commercial lines 45.0 42.7 37.7 33.2 24.9
---------------------------------------------------------------
Total gross written premiums $ 89.2 $81.9 $73.1 $64.8 $ 52.5
===================================================================================================================
The long-term relationships cultivated by Valley 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's "package" book of business. In 1997 and 1996, package
business represented approximately 79.1% and 80.0% of Valley's premium writings,
respectively, for both personal and commercial lines:
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------------------------------------
Renewal retention ratios 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------
Personal automobile/homeowners packages 91.4% 89.4% 88.2% 87.8% 89.0%
Commercial multiple peril packages 78.9% 75.5% 76.5% 84.5% 86.0%
===================================================================================================================
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
(e.g., policies written for new customers) than it does to write "seasoned"
business (e.g., policy renewals). Additionally, losses and loss adjustment
expenses are typically higher and less predictable for new business than for
seasoned business.
WMIC. WMIC is currently licensed to write insurance in Maine, New
Hampshire, Vermont, Massachusetts and New York and is expected to expand its
operations to other states as additional regulatory approvals are obtained. WMIC
markets its products principally through independent agents and had gross
written premiums during 1997 and 1996 of $5.2 million and $2.4 million ($4.7
million and $2.0 million of net written premiums), respectively. At December 31,
1997, WMIC had $31.4 million of total admitted assets and $29.1 million of
policyholders' surplus. WMIC is a wholly-owned subsidiary of VIC and shares its
A.M. Best's "A" rating through a combination of a reinsurance arrangement with
VIC and its ownership structure.
Charter. CGI, through its wholly-owned subsidiary Charter Indemnity
Company, its controlled affiliate Charter County Mutual Insurance Company and
certain related non-insurance subsidiaries (collectively "Charter"), markets and
underwrites nonstandard automobile insurance to individuals in the State of
Texas. For the years ended December 31, 1997 and 1996, Charter's net written
premiums totalled $62.9 million and $69.9 million, respectively and its
4
earned premiums totalled $62.4 million and $37.7 million, respectively. 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 and are now
fully retained, therefore, Charter's 1997 and 1996 earned premiums are not
directly comparable.
Charter writes all its business through independent agents located in
Texas. At December 31, 1997, Charter had approximately 750 agents located
throughout the State. Charter expects to write policies in Oklahoma during 1998
and is expected to expand its operations to other states.
The nonstandard automobile insurance market consists of drivers who are
unable to obtain coverage from standard carriers due to their 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 driving
while intoxicated 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
6 months or 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, 1997, Charter's net written premiums totalled $43.0 million for
liability coverages and $19.9 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 the insured. Management
believes that Charter has become a low cost provider of nonstandard automobile
insurance. 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 the insured. Management believes this database
enhances Charter's ability to analyze loss experience, and to underwrite and
price its products based on a number of variables. Charter utilizes many factors
and analyses 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 combined ratio for the years ended
December 31, 1997 and 1996 was 94.2% and 99.3%, respectively.
Investments in Unconsolidated Insurance Affiliates
White Mountains' investments in unconsolidated insurance affiliates
represent strategic operating investments in other insurers in which White
Mountains has a significant voting and economic interest but does not own
greater than 50.0% of the entity. Since 1994, Fund American has been active in
accumulating its investments in unconsolidated affiliates which are further
described below:
5
Financial Security Assurance Holdings Ltd. ("FSA"). FSA conducts its
operations principally through Financial Security Assurance Inc., a wholly-owned
monoline financial guarantee insurance subsidiary with Triple-A claims-paying
ratings from Moody's, Standard & Poor's and Fitch. FSA is principally engaged in
guaranteeing municipal bonds as well as residential mortgage and other
asset-backed securities. For 1997, 1996 and 1995 the present value of FSA's
gross written premiums totalled $250.3 million, $226.3 million and $139.1
million, respectively, and its net income was $100.5 million, $80.8 million and
$55.0 million, respectively. As of December 31, 1997 and 1996, FSA's total
assets were $1.9 billion and $1.5 billion, respectively and its shareholders'
equity was $882.4 million and $801.3 million, respectively.
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 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.
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.
All shares of and rights to FSA Common Stock owned or acquired by the
Company as described above (other than those acquired on the open market) 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,
1997, 1996 and 1995 Fund American's economic interest in FSA was approximately
26.2%, 25.1% and 21.0%, respectively, and Fund American's voting interest in FSA
was approximately 24.0%, 23.0% and 19.0%, respectively. During 1997 Fund
American transferred all of its interests in FSA to Source One.
Mr. John J. ("Jack") Byrne (Chairman of the Company) is Vice Chairman of
FSA and Mr. K. Thomas Kemp (President and CEO of the Company and Chairman and
CEO of White Mountains) and Mr. James H. Ozanne, (President of Fund American
Enterprises, Inc. ("FAE"), a wholly-owned subsidiary of the Company) are
directors of FSA. In addition to being FSA directors, Mr. Kemp is Chairman of
FSA's Human Resources Committee and Mr. Ozanne is Chairman of FSA's Underwriting
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,
1997 and 1996, as quoted on the NYSE, exceeded Fund American's carrying value of
the FSA Common Stock on the equity method. Fund American's investments in FSA
Options and Preferred Stock are 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, after tax, reported as a net amount in a separate
component of shareholders' equity and reported on the income statement as a
component of comprehensive net income.
Main Street America Holdings, Inc. ("MSA"). MSA, a subsidiary of National
Grange Mutual Insurance Company of Keene, New Hampshire ("NGM"), 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 $156.6 million, $147.2 million and
$130.9 million in 1997, 1996 and 1995, respectively, and its net income was
$11.9 million, $9.7 million and $12.4 million, respectively. MSA's year-
6
end total assets as of December 31, 1997 and 1996 were $337.2 million and $316.2
million, respectively, and its shareholders' equity was $120.6 million and
$101.4 million, respectively.
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 at December 31, 1997, 1996
and 1995 represented approximately 33.1% of the outstanding common stock of MSA
at those times.
Fund American's investment in MSA Common Stock is accounted for using the
equity method. White Mountains' President, Mr. Terry L. Baxter, and Mr. Kemp are
directors of MSA.
Folksamerica Holding Company, Inc. ("Folksamerica"). Folksamerica owns a
multi-line broker-market reinsurance company which in 1997 and 1996 had net
written premiums of $232.4 million and $171.9 million, respectively. At December
31, 1997 and 1996, Folksamerica had total assets $1.2 billion and $1.0 billion,
respectively, and shareholders' equity of $255.0 million and $167.6 million,
respectively.
In June 1996 White Mountains purchased, for $79.9 million including related
expenses, a 50.0% economic interest in Folksamerica. On November 20, 1997, White
Mountains made an additional investment in Folksamerica of $20.8 million which
served to maintain it's 50.0% economic interest. 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"), (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 and (iii) 1,563,907
shares of Folksamerica Common Stock. Folksamerica reported a book value per
share at December 31, 1997 and 1996, of $15.03 and $12.11, respectively.
White Mountains' investment in Folksamerica Common Stock is accounted for
using the equity method. White Mountains' investment in Folksamerica Preferred
Stock and Folksamerica Warrants 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, after tax,
reported as a net amount in a separate component of shareholders' equity and
reported on the income statement as a component of comprehensive net income.
Dividends earned on the Folksamerica Preferred Stock are recorded as earnings
from unconsolidated insurance affiliates on the income statement. Messrs. Baxter
and Kemp are directors of Folksamerica.
ML (Bermuda) Limited ("Murray Lawrence"). Murray Lawrence is a
Bermuda-based managing agency group in the Lloyd's insurance market. On December
8, 1997 White Mountains purchased, for $23.6 million, approximately 15.8% of the
common stock of Murray Lawrence ("Murray Lawrence Common Stock"). Mr. Kemp is a
director of Murray Lawrence.
MORTGAGE BANKING OPERATIONS
General
Source One was incorporated in 1972 and is the successor to Citizens
Mortgage Corporation which was organized in 1946. Source One's principal office
is located in Farmington Hills, Michigan. Source One is a wholly-owned
subsidiary of Fund American whereby the Company currently owns 3% of the
outstanding common stock of Source One and White Mountains owns the remaining
97% of the outstanding common stock of Source One.
7
As a mortgage banker, Source One engages primarily in the business of
producing and selling conforming and subprime residential mortgage loans and
servicing 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.
Through subsidiaries, Source One also markets credit-related insurance products
(such as life, disability, health, accidental death and property and casualty
insurance).
As of December 31, 1997 and 1996, Source One owned a mortgage loan
servicing portfolio totalling $11.6 billion and $26.4 billion, respectively, and
subserviced a portfolio of mortgage loans for others totalling $14.9 billion and
$2.8 billion, respectively. Source One services and subservices mortgage loans
on behalf of numerous institutional investors and other security holders. During
1997 and 1996, Source One originated $4.4 billion and $3.8 billion in mortgage
loans, respectively.
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 (e.g., 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
8
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.
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. 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.
Source One primarily produces fixed rate mortgage loans. Generally
speaking, fixed rate mortgages tend to capture a large share of origination
volumes in a declining interest rate environment. Additionally, fixed rate
mortgage loans are inherently less susceptible to prepayment risk than
adjustable rate mortgages. During periods of increasing interest rates, the
likely adverse effects of lower fixed rate mortgage loan originations are
mitigated by a reduction in the prepayment risk on the fixed rate mortgage loans
Source One services. During 1997 and 1996, fixed rate mortgage loan production
accounted for approximately 88% and 90%, respectively, of Source One's total
mortgage loan production.
The following table sets forth selected information regarding Source One's
mortgage loan production:
9
- ------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995 1994 1993
- ------------------------------------------------------------------------------------------------------------------
Loan production by type of loan:
FHA insured and VA guaranteed $2,985 $2,035 $1,565 $2,065 $ 3,453
Conventional 1,418 1,796 1,287 2,521 7,999
-------------------------------------------------------
Total $4,403 $3,831 $2,852 $4,586 $11,452
- -----------------------------------------------------------=======================================================
Loan production by origination source:
Correspondent network acquisitions $2,552 $1,640 $1,157 $1,081 $ 2,643
Retail branch office originations 1,339 1,590 1,347 2,005 4,922
Mortgage broker originations 390 369 196 696 1,708
Specialized marketing program originations 122 232 152 804 2,179
-------------------------------------------------------
Total $4,403 $3,831 $2,852 $4,586 $11,452
==================================================================================================================
During 1997 Source One broadened its product line by offering higher
profit margin products such as FHA home improvement ("203(k)") loans,
manufactured housing loans, subprime loans and 125% loan to value second
mortgage ("125% LTV") loans. The 203(k) loans and manufactured housing loans
produced by Source One are sold to third parties with servicing retained
whereby the subprime loans and 125% LTV loans produced by Source One are sold
to third parties on a servicing released basis. Source One is currently
planning to establish the capability to service and subservice subprime loans
and to subservice 125% LTV loans. These new products did not account for a
significant portion of Source One's total mortgage loan production during
1997 and are expected to account for less than 10% of Source One's 1998
mortgage loan production.
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,
1997, there were approximately 236 participants in Source One's correspondent
network, with no single participant or group of affiliated participants
accounting for more than 12% of Source One's total mortgage loan originations.
Retail Branch Offices. As of December 31, 1997, Source One had 129 retail
branch offices in 26 states with its highest concentration of branch offices
located in California, Washington and New York. 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.
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
10
documentation, evaluation of compliance with Source One's underwriting
conditions and closing of the loans.
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, 1997, there were
approximately 425 active participants in Source One's mortgage broker network,
with no single broker or group of affiliated brokers accounting for more than 1%
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 mortgage loans either through mortgage-backed securities
issued pursuant to programs of GNMA, FNMA and FHLMC, or to institutional
investors. Most mortgage 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 1997 approximately 65.5%, 23.3% and 6.7% of the
principal amount of Source One's loans were sold in pools through GNMA, FNMA and
FHLMC, respectively. 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. 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. 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 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 pass-thru rate from the date of the loan payoff through
the end of that calendar month without reimbursement.
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
11
mortgage-backed securities with respect to all loans which have been funded and
a substantial portion of loans in process (the "Pipeline") which it believes
will close.
Source One's risk management function closely monitors the 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 17 approved
dealers.
Loan Servicing
Source One generally retains the rights to service the mortgage loans it
produces with the exception of subprime and 125% LTV loans which are sold to
third parties on a servicing released basis. 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
purchases 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, Source One purchased the rights to service $2.8
billion of mortgage loans from third parties. There were no significant
purchases of mortgage servicing rights by Source One during 1997.
Source One also sells servicing rights when management deems it
economically advantageous. During 1997 Source One sold the rights to service a
$17.0 billion portfolio of nonrecourse mortgage loans and continues to
subservice a portion of these loans pursuant to a subservicing agreement. During
1996 Source One sold the rights to service $3.3 billion of mortgage loans and
did not retain the right to subservice the loans.
The following table summarizes the changes in Source One's mortgage loan
servicing portfolio, excluding loans sold but not transferred:
- ------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
Billions 1997 1996 1995 1994 1993
- ------------------------------------------------------------------------------------------------------------------
Servicing portfolio owned at beginning of year $ 26.4 $ 27.8 $ 35.3 $ 38.4 $ 37.3
-----------------------------------------------------
Mortgage loan production 4.4 3.8 2.9 4.6 11.4
Servicing acquisitions and other -- 2.8 4.7 3.7 6.4
-----------------------------------------------------
Total servicing in 4.4 6.6 7.6 8.3 17.8
-----------------------------------------------------
Regular payoffs 1.2 3.0 2.3 4.7 13.5
Sales of servicing 17.0 3.3 11.0 3.9 -
Principal amortization, foreclosures and other 1.0 1.7 1.8 2.8 3.2
-----------------------------------------------------
Total servicing out 19.2 8.0 15.1 11.4 16.7
-----------------------------------------------------
Servicing portfolio owned 11.6 26.4 27.8 35.3 38.4
Subservicing portfolio 14.9 2.8 4.0 4.3 -
-----------------------------------------------------
Balance at end of year $ 26.5 $ 29.2 $ 31.8 $ 39.6 $ 38.4
==================================================================================================================
Related Activities
12
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. Total fees recognized under these programs for
1997 and 1996 were $4.2 and $4.6 million, respectively.
INVESTMENT PORTFOLIO MANAGEMENT
The passive investment portfolios of the Company and White Mountains are
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 employees located in White River Junction, Vermont.
During 1997 and 1996, Fund American engaged First Manhattan Co. to provide
discretionary investment management services with respect to the disposition of
a portfolio of passive investment securities. The invested assets managed by
First Manhattan Co. included certain equity securities held by the Company, FAE,
White Mountains, Valley, Charter and WMIC. First Manhattan Co. is a registered
investment advisor.
During 1997 and 1996 Fund American also engaged affiliates of FSA and MSA
to provide discretionary investment management services with respect to the
fixed income investment portfolios of Valley, Charter and WMIC.
Fund American's philosophy is to invest all assets to maximize their after
tax 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 on a small number of quality companies
selling at reasonable prices in the marketplace. While such an approach results
in a highly concentrated portfolio, 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 its passive investment
securities 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
industry including 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
13
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 mortgage 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 servicing
rights because prepayments of mortgages decline and the average life of loan
servicing rights is lengthened. In an attempt to mitigate Source One's exposure
to changes in market interest rates, Source One utilizes various derivative
financial instruments. See "Management's Discussion and Analysis".
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 and
robust investment returns achieved in recent years. Each of White Mountains'
insurance operating affiliates strives to be a 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.
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 White Mountains' consolidated insurance companies market their products
principally through independent agents.
14
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 generally
originates 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
Valley, Charter and WMIC 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 ("RBC") standards for
property and casualty companies. The RBC ratios for Valley, Charter and WMIC, as
of December 31, 1997, were above the levels which would require regulatory
action.
Source One is subject to the rules and regulations of, and examinations by,
investors and insurers including FNMA, FHLMC, GNMA, FHA and VA with respect to
the origination and selling and servicing of mortgage loans. Lenders are
required to submit audited financial statements annually and to maintain
specified net worth levels which vary depending on the amount of loans serviced
and annual production. 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, licensing laws, usury laws, 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. 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.
EMPLOYEES
As of December 31, 1997, the Company employed 11 persons and White
Mountains employed 2,038 persons (including 281 persons at Valley, 165 persons
at Charter, 1,572 persons at Source One and 3 persons at FAE). None of Fund
American's employees are covered by a collective bargaining agreement.
Management believes that Fund American's employee relations are good.
15
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 under a lease expiring in 1998. Charter leases
56,000 square feet of office space in Richardson, Texas under a lease expiring
in 2007. Source One owns its principal office in Farmington Hills, Michigan,
which houses the majority of its employees. 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 1997.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
As of March 20, 1998, there were 506 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 Company's Board of Directors (the
"Board") reinstated and paid a $.20 regular quarterly dividend per Share. During
1997 and 1996, the Company declared and paid quarterly cash dividends of $.20
per Share and expects to pay regular quarterly cash dividends of $.40 per Share
during 1998. 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 1997 and 1996 is presented below:
- ------------------------------------------------------------------------------
1997 1996
------------------------ -----------------------
High Low High Low
- ------------------------------------------------------------------------------
Quarter ended:
December 31 $ 124 $ 105 1/4 $ 95 3/4 $ 86 3/4
September 30 108 99 1/2 93 1/2 80 1/4
June 30 110 1/2 98 82 1/4 76
March 31 109 3/4 94 79 7/8 72 1/8
==============================================================================
16
Item 6. Selected Financial Data
Selected consolidated income statement data and ending balance sheet data
for each of the five years ended December 31, 1997, follows:
- ----------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------------------------------------
Millions, except per share amounts 1997 1996 1995 1994 1993
- ----------------------------------------------------------------------------------------------------------------------
Income Statement Data:
Revenues $ 314 $ 332 $ 222 $ 229 $ 251
Expenses 336 347 226 226 234
------------------------------------------------------------------
Pretax operating earnings (loss) (22) (15) (4) 3 17
Net investment gains 97 39 39 39 124
------------------------------------------------------------------
Pretax earnings 75 24 35 42 141
Income tax provision 29 19 17 21 71
------------------------------------------------------------------
After tax earnings 46 5 18 21 70
Loss on early extinguishment of debt, after tax (6) -- -- -- --
Gain from sale of discontinued operations,
after tax -- -- 66(a) -- --
Cumulative effect of accounting change -
purchased mortgage servicing, after tax -- -- -- (44)(b) --
------------------------------------------------------------------
Net income (loss) 40 5 84 (23) 70
Change in net unrealized investment gains,
after tax 56 55 18 (55) 46
------------------------------------------------------------------
Comprehensive net income (loss) $ 96 $ 60 $ 102 $ (78) $ 116
- ----------------------------------------------------==================================================================
Basic earnings per share:
After tax earnings $ 6.89 $ .66 $ 1.88 $ 1.27 $ 6.07
Net income (loss) 5.98 .66 10.30 (3.72) 6.07
Comprehensive net income (loss) 14.55 8.01 12.64 (9.89) 10.84
Diluted earnings per share:
After tax earnings 6.22 .60 1.71 1.20 5.68
Net income (loss) 5.40 .60 9.36 (3.51) 5.68
Comprehensive net income (loss) 13.17 7.33 11.48 (9.34) 10.15
Cash dividends paid per share of common stock .80 .80 .20 -- --
- ----------------------------------------------------------------------------------------------------------------------
Ending Balance Sheet Data:
Total assets $ 2,033 $ 1,981 $ 1,872 $ 1,807 $ 3,305
Short-term debt 571 408 445 254 1,537
Long-term debt 304 424 407 547 601
Minority interest - preferred stock of subsidiary 44 44 44 100 --
Shareholders' equity 674(c) 687(c) 700(c) 661(c) 905(c)
Book value per common and equivalent share (d) 102.19 90.81 83.28 68.95 77.27
======================================================================================================================
17
(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.
(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.
(c) 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.
(d) Book value per common share as adjusted for the after tax dilutive effects
of outstanding options and warrants to acquire Shares.
18
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS: Years Ended December 31, 1997, 1996 and 1995
Consolidated Results
Fund American reported comprehensive net income (which includes the net
change in after tax unrealized investment gains) of $95.6 million for the year
ended December 31, 1997, which compares to comprehensive net income of $59.5
million and $102.3 million for 1996 and 1995, respectively. Net income for 1997
was $39.3 million versus $4.9 million and $84.1 million for 1996 and 1995,
respectively. The 1997 income statement includes pretax net realized investment
gains of $96.7 million versus $38.5 million of pretax gains recorded in 1996 and
$38.8 million recorded in 1995. The 1996 income statement includes a $32.6
million pretax, $29.4 million after tax, write-off of all Source One's existing
goodwill and certain other intangible assets. 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 items served to increase 1995 net income by a total of $41.8
million.
After tax earnings for 1997 were $45.3 million versus $4.9 million and
$18.5 million for 1996 and 1995, respectively.
Book value per common and common equivalent share was $102.19 at December
31, 1997, which compares to $90.81 at December 31, 1996. Strong operating
results at White Mountains' growing consolidated and unconsolidated insurance
operations and favorable investment portfolio results produced most of the
increase in book value per share from 1996 to 1997.
Insurance Operations
White Mountains is acquiring and developing various insurance operating
interests. Fund American acquired its investment in MSA in 1994 and assigned the
investment to White Mountains in 1995, White Mountains acquired Valley and
Charter and created WMIC in 1995, White Mountains acquired its investments in
Folksamerica Preferred Stock and Folksamerica Common Stock in June 1996 and
November 1997, respectively, and White Mountains acquired its investment in
Murray Lawrence in December 1997. White Mountains also owns approximately 97% of
Source One which owns Fund American's investments in FSA which were acquired
during 1994, 1995 and 1996.
Valley, Charter and WMIC represent Fund American's consolidated insurance
subsidiaries. Valley, Charter and WMIC's results for the years ended December
31, 1997 and 1996, included $145.3 million and $109.7 million of property and
casualty insurance premiums earned, respectively, and $97.1 million and $85.9
million of losses and loss adjustment expenses, respectively. Valley, Charter
and WMIC'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.
A summary of 1997 and 1996 underwriting results for Valley, Charter and
WMIC follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1997
Dollars in millions Valley Charter WMIC
- --------------------------------------------------------------------------------
Net written premiums $ 83.2 $ 62.9 $ 4.7
------------------------------------
Earned premiums 79.6 62.4 3.3
Losses and loss adjustment expenses 51.8 41.8 3.5
Underwriting expenses 28.3 17.1 2.0
------------------------------------
19
Underwriting (loss) profit $ (.5) $ 3.5 $ (2.2)
====================================
Statutory ratios:
Loss and loss adjustment expense 65.0% 66.9% 107.8%
Underwriting expense 34.8 27.3 53.1
------------------------------------
Combined 99.8% 94.2% 160.9%
================================================================================
- --------------------------------------------------------------------------------
Year Ended December 31, 1996
Dollars in millions Valley Charter WMIC
- --------------------------------------------------------------------------------
Net written premiums $ 75.1 $ 69.9 $ 2.0
------------------------------------
Earned premiums 70.7 37.7 1.3
Losses and loss adjustment expenses 54.3 30.3 1.2
Underwriting expenses 24.9 8.0 .9
------------------------------------
Underwriting loss $ (8.5) $ (.6) $ (.8)
====================================
Statutory ratios:
Loss and loss adjustment expense 76.8% 80.4% 95.8%
Underwriting expense 34.9 18.9 50.4
------------------------------------
Combined 111.7% 99.3% 146.2%
================================================================================
Valley and Charter's 1997 underwriting results produced satisfactory
combined ratios and an overall underwriting profit. However, premium growth at
both Valley and Charter suffered during 1997 as a result of increased
competition in the marketplace which illustrates Fund American's underwriting
discipline in a highly competitive market. WMIC's 1997 results were adversely
impacted by several large workers' compensation claims although underwriting
results on this small and growing book of business are not yet considered to be
meaningful.
Valley's 1996 underwriting results were adversely impacted by severe fourth
quarter storm-related losses and by $3.5 million in reserve strengthening for
losses and loss adjustment expenses incurred in prior years. Charter's earned
premiums trailed net written premiums during 1996 because Charter began for the
first time in 1996 to retain virtually all its written premiums. Charter's
policies written prior to 1996 were fully ceded to a former affiliate of
Charter.
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, Valley, Charter and WMIC seek to limit
losses 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. Valley,
Charter and WMIC 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 (e.g.,
higher loss frequency), the insurance premiums charged in consideration of these
additional risk characteristics are generally higher
20
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 (e.g.,
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 (e.g., medical malpractice or umbrella liability
coverages).
FSA, MSA, Folksamerica and Murray Lawrence represent Fund American's
investments in unconsolidated insurance affiliates. Fund American's investment
in FSA increased $80.1 million during 1997 which consisted of $11.4 million of
pretax earnings from FSA Common Stock, $68.0 million of pretax unrealized
investment gains from FSA Options and Preferred Stock, $2.1 million of pretax
unrealized investment gains from FSA's investment portfolio, less $1.4 million
of dividends received from FSA Common Stock. 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 pretax 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, less $1.0 million of dividends received from FSA Common
Stock.
White Mountains' investment in MSA increased $6.2 million during 1997 which
consisted of $3.8 million of pretax earnings from MSA Common Stock and $2.4
million of pretax unrealized investment gains from MSA's investment portfolio.
White Mountains' investment in MSA increased $1.0 million during 1996 which
consisted of $1.5 million of pretax earnings from MSA Common Stock offset by $.5
million of pretax unrealized investment losses from MSA's investment portfolio.
White Mountains' investment in Folksamerica increased $25.1 million during
1997 (excluding White Mountains' purchase of Folksamerica Common Stock for $20.8
million during 1997) which consisted of $.9 million of pretax earnings from
Folksamerica Common Stock, $22.4 million of pretax unrealized investment gains
from Folksamerica Preferred Stock, $1.8 million of pretax unrealized investment
gains from Folksamerica's investment portfolio. 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.
White Mountains investment in Murray Lawrence, which was acquired on
December 8, 1997, remained at its cost of $23.6 million during 1997.
Management expects that White Mountains' consolidated and unconsolidated
insurance operations will have a significantly larger impact on Fund American's
reported financial results in future years. See "Liquidity and Capital
Resources."
Mortgage Origination and Servicing Operations
For the year ended December 31, 1997 Source One had a net loss applicable
to common stock of $17.2 million versus a loss of $8.0 million for 1996. Source
One's 1997 results include the following charges: (i) a $6.0 million after tax
extraordinary loss on early extinguishment of debt, (ii) restructuring and
compensation charges of $3.1 million pretax, $2.0 after tax, associated with
Source One's plan to reduce its operating costs and improve its financial
performance, (iii) an $8.0 million pretax, $5.2 million after tax, loss on sales
of mortgage
21
servicing rights and assumption of subservicing and (iv) a $17.7 million pretax,
$11.5 million after tax, charge to Source One's valuation allowance for
impairment of their capitalized mortgage loan servicing portfolio. Source One's
1996 results include a $29.1 million pretax ($25.9 after tax) write-off of
goodwill and certain other intangible assets which was partially offset by a
$10.1 million pretax, $6.6 million after tax, gain on sales of mortgage
servicing rights. Source One had net income applicable to common shareholders of
$18.6 million for the year ended December 31, 1995 which includes a $40.0
million pretax, $26.0 million after tax, gain on mortgage servicing rights which
was partially offset by $28.0 million pretax, $18.2 million after tax, of
capitalized mortgage servicing portfolio impairment.
Gross mortgage servicing revenue was $95.0 million for the year ended
December 31, 1997 which compares to $139.6 million in 1996 and $141.9 million in
1995. The decrease in gross mortgage servicing revenue from 1995 to 1997 is
primarily the result of sales of servicing rights with respect to $17.0 billion
and $3.3 billion of mortgage loans during 1997 and 1996, respectively.
22
Source One's net mortgage servicing revenue decreased to $42.1 million for
the year ended December 31, 1997, from $77.6 in 1996 and $61.3 million in 1995.
Net mortgage servicing revenue for 1997 has been reduced by $17.7 million of
pretax impairment resulting from decreases in market interest rates during the
year versus pretax impairment of $.9 million for 1996 and $28.0 million in 1995.
Net mortgage servicing revenue for the year ended December 31, 1997 was enhanced
by $11.3 million of pretax net gains on financial instruments versus gains of
$9.9 million for 1996 and $.8 million for 1995.
Source One utilizes derivative contracts, consisting of interest rate floor
contracts and principal-only swaps, in an attempt to offset the effect on
earnings of higher amortization and impairment of the capitalized servicing
asset caused by changes in market interest rates. These financial instruments
are carried at fair value on the balance sheet with unrealized and realized
gains reported as net gains on financial instruments on the income statement.
The interest rate contracts, which were first entered into during 1995, derive
their value from differences between the floor strike rate specified in the
contract and prevailing market interest rates and are not subject to total
losses in excess of their original cost. As of December 31, 1997, 1996 and 1995,
Source One's open interest rate contracts had a fair value of $8.2 million, $4.8
million and $3.5 million and had an applicable original cost of $4.7 million,
$5.4 million and $2.6 million, respectively. As of December 31, 1997, the open
interest rate contracts had a total notional principal amount of $.7 billion and
had remaining terms ranging from 3 to 5 years. The principal-only swap
transactions, which were first entered into during 1996, derive their value from
changes in the value of referenced principal-only securities. As of December 31,
1997 and 1996, Source One's principal-only swap transactions had a fair value of
$12.5 million and $3.2 million, respectively. Source One's exposure to losses on
the principal-only swap transactions is related to changes in the market value
of the underlying principal-only securities over the life of the contract. As of
December 31, 1997, the open principal-only swap transactions had an original
notional principal amount of $98.1 million and had remaining terms of 3 to 4
years.
Net gains on sales of mortgages were $21.5 million for the year ended
December 31, 1997, versus $38.3 million in 1996 and $24.0 million in 1995. The
1997 amount includes a $3.0 million pretax charge, recorded during 1997, related
to mortgage loans held for investment which have been identified for sale and
marked down from amortized cost to current market value. The balance of the 1997
decline is due primarily to a change in Source One's loan production mix which
included a proportionately higher volume of correspondent production which
generates lower originated mortgage servicing rights income, as compared to
1996. The increased gains from 1995 to 1996 reflect increased production and
related mortgage sales volumes during the period.
During 1997 Source One sold the rights to service $17.0 billion of
nonrecourse mortgage loans for adjusted proceeds of $266.9 million, resulting in
a pretax loss of $4.3 million. As part of the servicing sale, Source One
retained the right to subservice these loans until 1998. Source One recorded an
additional pretax loss of $3.7 million during 1997 in connection with the
extension of its subservicing responsibilities for these loans for one
additional year at less favorable terms than the original agreement provided.
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.
Total mortgage loan production for the years ended December 31, 1997, 1996
and 1995, was $4.4 billion, $3.8 billion and $2.9 billion, respectively. The
increase in production from 1995 to 1997 is reflective of overall lower market
interest rates and a corresponding increase in refinancing activities during the
period. Production related to refinancing activities made up 40%, 33% and 23% of
total production during 1997, 1996 and 1995, respectively. Regular mortgage loan
payoffs due principally to refinancings on Source One's owned servicing
portfolio
23
for the years ended December 31, 1997, 1996 and 1995, were $1.2 billion, $3.0
billion and $2.3 billion, respectively.
Source One's 1997 results include $9.5 million of pretax earnings
associated with Fund American's investment in FSA which was contributed to
Source One during 1997 to provide additional credit support to Source One's
mortgage banking operations.
24
Investment Operations
The total return from Fund American's investment activities is shown below:
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------------
Net investment income:
Mortgage banking operations $ 45.8 $ 40.8 $ 37.7
Insurance operations and passive investment portfolio 19.3 16.5 17.7
---------------------------------------
Total net investment income 65.1 57.3 55.4
Net realized investment gains 96.7 38.5 38.8
Change in net unrealized investment gains, before tax (a) (10.1) 68.0 20.0
---------------------------------------
Total net investment return, before tax $151.7 $163.8 $ 114.2
===================================================================================================================
(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 (gross of related
interest expense on short-term borrowings used to finance such loans), interest
income associated with the fixed maturity investments of its consolidated
insurance operations, dividend income from its equity investments and interest
income from short-term investments. The increase in net investment income from
mortgage banking operations from 1995 to 1997 is mainly attributable to
increased interest income from mortgage loans held for sale related to higher
mortgage loan production experienced during those periods. The increase in net
investment income from insurance and other operations during from 1996 to 1997
is a result of increases in investment income from White Mountains' growing
portfolio of fixed maturity investments. The decrease in net investment income
from insurance operations and the passive investment portfolio from 1995 to 1996
was primarily the result of lower dividend income due to net sales from Fund
American's passive investment portfolio during 1995 and 1996.
Net realized investment gains during 1997 included $37.2 million of pretax
gains from the sale of 1,980,982 shares of the common stock of Travelers
Property Casualty Corp. ("Travelers P&C") for net proceeds of $69.2 million,
$24.3 million of pretax gains from the sale of 5,000,000 units of beneficial
interest of San Juan Basin Royalty Trust ("San Juan") for net proceeds of $45.7
million, $10.3 million of pretax gains from the sale of 388,140 shares of the
common stock of Mid Ocean Limited ("Mid Ocean") for net proceeds of $22.6
million and $15.5 million of pretax gains from the sale of 834,895 shares of the
common stock of Veritas DGC Inc. for net proceeds of $20.9 million. Net realized
investment gains during 1996, before tax, included $27.2 million of pretax gains
from the sale of 2,928,100 shares of the common stock of The Louisiana Land &
Exploration Company common stock for net proceeds of $125.1 million, $1.4
million of pretax gains from the sale of 2,042,572 shares of the common stock of
Zurich Reinsurance Centre Holdings, Inc. ("ZRC") for net proceeds of $61.8
million and $9.3 million of pretax gains from the sale of 600,000 of the shares
of common stock of Mid Ocean for net proceeds of $28.2 million. Net realized
investment gains during 1995 included $23.9 million of pretax gains from the
sale of 2,401,000 shares of the common stock of American Express Company for net
proceeds of $76.7 million.
A review of certain significant holdings in Fund American's portfolio of
common equity securities and other investments at December 31, 1997 follows.
Share or unit and dollar amounts refer to the aggregate number of common shares
or units of beneficial interest owned
25
and the aggregate fair value at December 31, 1997, of Fund American's holdings
of each security discussed.
26
White River Corporation (718,818 shares; "White River Shares"; $57.1
million). White River Corporation ("White River") was formerly a wholly-owned
subsidiary of Fund American. On December 22, 1993, the Company distributed
approximately 74% of the outstanding White River Shares to its shareholders.
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. Fund American owns a total of 1,014,750 White
River Shares, including 295,932 White River Shares carried in other assets which
are being held for delivery upon the exercise of existing employee stock
options. As of December 31, 1997, Fund American's total ownership position
represented approximately 20.8% of the total White River Shares. Fund American
does not account for its investment in White River Shares on the equity method
as it does not currently possess the ability to exercise significant influence
over White River.
San Juan (5,994,876 units; $55.5 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, 1997, represented approximately 12.9% of the total San Juan
units outstanding. 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 posses
the ability to exercise significant influence over the Trustee of San Juan.
Travelers P&C (1,161,924 shares; $49.2 million). Travelers P&C is one of
the largest property and casualty insurers in the United States and is an
independent agency writer of personal and commercial lines. Fund American's
investment in Travelers P&C as of December 31, 1997, represented approximately
1.7% of the total shares publicly traded. Mr. Jack Byrne is a director of
Travelers P&C.
Expenses
Compensation expense as reported totalled $101.8 million, $91.3 million and
$111.6 million for each of the years ended December 31, 1997, 1996 and 1995,
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
(which can fluctuate significantly during periods of strong mortgage loan
production), 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 $121.4 million,
$111.1 million and $82.9 million for each of the years ended December 31, 1997,
1996 and 1995, 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 increase in adjusted compensation and benefits expense from 1996
to 1997 is primarily the result of an increase in stock-based compensation
accruals associated with certain of the Company's long-term compensation plans
and its qualified and nonqualified retirement plans. During 1997 the market
value of the Company's common stock rose 26% from $95.75 to $121.00 per share.
General expenses of $87.6 million for 1997 compare to 1996 and 1995 amounts
of $87.4 million and $60.3 million, respectively. The increase in general
expenses from 1995 to 1996 is
27
primarily the result of the inclusion of a full year of Valley and Charter's
operations in the 1996 consolidated financial statements. General expenses for
1997 include $3.1 million of pretax restructuring and compensation charges at
Source One.
Source One's provision for mortgage loan losses, included in general
expenses, was $8.6 million in 1997 which compares to $10.3 million for 1996 and
$7.0 million for 1995. 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
fourth quarters of 1996 and 1995. The delinquency rates of the these portfolios
(which were acquired on favorable terms considered to be reflective of the
higher delinquency rates inherent on the portfolios) were generally higher than
those of Source One's existing portfolio resulting in a higher provision for
loan losses; however, Source One's proactive management of such delinquencies is
expected to reduce future delinquency rates on the acquired portfolios to a
level more commensurate with the balance of Source One's servicing portfolio.
The decrease in provision for loan losses from 1996 to 1997 primarily reflects a
significant reduction in the size of Source One's owned mortgage servicing
portfolio during 1997.
Source One closely monitors the rate of delinquencies and foreclosures
incidental to its servicing portfolio. The following table summarizes
delinquency and foreclosure experience with respect to the residential mortgage
loans serviced and subserviced by Source One:
- -------------------------------------------------------------------------------------------------------------------
December 31,
-----------------------------------------------------------
1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------
Percent of total residential loans serviced
and subserviced:
Past due:
31-59 days 4.77% 4.74% 3.99% 3.15% 3.41%
60-89 days .96 .95 .70 .54 .58
90 days or more .62 .55 .59 .38 .45
-----------------------------------------------------------
Total delinquencies 6.35% 6.24% 5.28% 4.07% 4.44%
- --------------------------------------------------------===========================================================
Foreclosures 1.18% .93% .80% .77% .92%
===================================================================================================================
Source One has established an allowance for mortgage loan losses which
totalled $12.8 million and $15.4 million as of December 31, 1997 and 1996,
respectively. In addition, Source One has established an $8.2 million and $7.3
million pretax reserve for estimated losses on its principal recourse portfolio
as of December 31, 1997 and 1996, respectively. Source One believes that its
total allowances are adequate to provide for estimated uninsured losses on the
mortgage servicing portfolio.
Interest expense of $49.7 million in 1997 compares to $50.0 million for
1996 and $45.8 million for 1995. The fluctuations in interest expense primarily
reflect increases and decreases in average indebtedness outstanding during each
year at Source One which is mainly driven by mortgage loan production.
Insurance losses and loss adjustment expenses for the years ended 1997 and
1996 totalled $97.1 million and $85.9 million, respectively. Loss and loss
adjustment expenses of $8.2 million for 1995 reflect only one-month of activity
due to the timing of White Mountains' acquisition of Valley and Charter.
Insurance losses and loss adjustment expenses reported for the years ended
December 31, 1996 and 1995, included $3.5 million and $3.0 million of reserve
strengthening for losses and loss adjustment expenses incurred in prior periods,
respectively. During 1997, losses and loss adjustment expenses relating to prior
years developed favorably by $2.5 million.
28
During 1996 Fund American re-assessed the recoverability of goodwill and
certain other intangible assets related to Source One and determined that it
should write-off all such assets related to Source One. This resulted in a $32.6
million pretax write-off of goodwill and other intangible assets. Factors
considered in the determination to write-off all Source One's goodwill and other
assets 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.
Fund American's consolidated affiliates are currently expected to be year
2000 compliant by the third quarter of 1998. Fund American has been identifying,
modifying and testing its internal systems and controls that will be impacted by
the year 2000 issue. Fund American estimates that its total pretax cost of
becoming internally year 2000 compliant, excluding its unconsolidated insurance
affiliates, is approximately $2.5 million of which approximately $1.3 million
has been expensed as of December 31, 1997. These figures do not include the cost
of normal software replacements and upgrades.
29
Fund American has also been closely monitoring the year 2000 issues of its
third party constituents (e.g. customers, suppliers, reinsurers, creditors,
borrowers...) and of its unconsolidated insurance affiliates. Based on
preliminary determinations, it is not expected that Fund American will be
materially adversely affected by its third party constituents. This
determination has been made as a result of an extensive interview process which
requests that constituents demonstrate an ability to become year 2000 compliant
on a timely basis. For those constituents who are deemed to be unlikely to
remedy their own year 2000 issues in a timely manner, Fund American is in the
process of either replacing that constituent or establishing similar
relationships with new parties. All of Fund American's unconsolidated insurance
affiliates are expected to be internally year 2000 compliant by the fourth
quarter of 1998 and each affiliate is in the process of determining its third
party exposures in a similar manner to that of Fund American. The total cost of
the year 2000 issue for Fund American's unconsolidated insurance affiliates has
not yet been specifically determined, however, Fund American's portion of such
costs are not expected to be material.
Income Taxes
The income tax provision related to pretax earnings for 1997, 1996 and 1995
represents an effective tax rate of 39.4%, 79.3% and 47.3%, respectively. The
primary reason for the increase in Fund American's effective tax rate from 1995
to 1996 was the 1996 write-off of goodwill and certain other intangible assets
related to Source One. The total pretax write-off of these assets was $32.6
million and the related tax benefit was $3.2 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
$27.5 million as of December 31, 1997. The deferred tax liability includes a
$79.3 million liability related to net unrealized gains on investment securities
partially offset by $51.8 million in net assets 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 1991 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
30
enhance shareholder value. As is further described below, the formation,
capitalization and ongoing development of White Mountains embodies this
strategy.
31
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 November 1996 the Company entered into a $35.0 million revolving credit
agreement with a syndicate of banks which served to replace an expiring
arrangement in the amount of $75.0 million. Under the agreement, through
November 25, 1998, 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, 1997 and 1996, the Company was in compliance with
all covenants under the facility and had no borrowings outstanding under the
agreement.
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.
During 1995 and 1994 the Company repurchased $8.8 million and $24.9 million,
respectively, in principal amount of the notes due in February 2003. At December
31, 1997, the $116.3 million of remaining outstanding notes had an average
maturity of 5.4 years and a yield to maturity of 7.82%.
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 during 1995
was 8.75%.
During 1997, 1996 and 1995 the Company repurchased 924,739 Shares, 779,077
Shares and 877,868 Shares, respectively, for $103.5 million, $66.3 million and
$65.5 million, respectively. All Shares repurchased from 1995 to 1997 have been
retired. The repurchases of Shares represent a return of excess capital to the
Company's shareholders.
In the fourth quarter of 1995 the Board reinstated and paid a $.20 regular
quarterly dividend per Share. During 1997 and 1996 the Company declared and paid
quarterly cash dividends of $.20 per Share and expects to pay regular quarterly
cash dividends of $.40 per Share during 1998.
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.
As approved by shareholders at the 1995 Annual Meeting, the Company entered
into a five year employment contract (the "Agreement") with Mr. Jack 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. 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.
Pursuant to the terms of a 1993 credit agreement among the Company and
White River, the Company provided White River with a $50.0 million term note
(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 these borrowings.
On June 29, 1995, White River repaid $35.1 million in principal amount of
the Revolver with (i) 930,000 shares of the common stock of Mid Ocean and (ii)
options to acquire an additional 388,140 shares of the common stock of Mid Ocean
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
32
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 ZRC.
33
White Mountains, Valley and Charter
In November 1996 White Mountains and Valley entered into a five year credit
facility under which they may borrow up to $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, 1997
and 1996, White Mountains and Valley were in compliance with all covenants under
the facility. During 1997 and 1996 Valley had $15.0 million of borrowings
outstanding under the facility with a weighted average interest rate of 6.09%
and 5.83%, respectively. White Mountains had no borrowings outstanding at
December 31, 1997 and 1996 under the facility.
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.
During 1997 the Company reorganized its structure in order to strengthen
Source One and make it a part of Fund American's permanent operating group under
White Mountains. Pursuant to this reorganization plan, White Mountains was
merged into FAE and the combined entity was immediately renamed White Mountains.
In addition, Source One received $139 million of capital infusions, consisting
primarily of Fund American's investments in FSA, in order to improve Source
One's debt ratings and reduce its borrowing costs. As a result of the
reorganization plan, the Company currently owns 3% of the outstanding common
stock of Source One and White Mountains owns the remaining 97% of the
outstanding common stock of Source One.
On November 20, 1997, White Mountains purchased 1,563,907 shares of
Folksamerica Common Stock for $20.8 million and on December 8, 1997 White
Mountains purchased 38,651,270 shares of Murray Lawrence Common Stock for $23.6
million. The purchase prices paid for the Folksamerica Common Stock and the
Murray Lawrence Common Stock was paid with proceeds from sales of passive
investment securities.
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 will be increased to 60% pursuant to the MSA Agreement. Also pursuant to
the MSA Agreement, NGM will contribute certain of its insurance, reinsurance and
financial services subsidiaries to MSA. The aggregate purchase price to be paid
by Fund American pursuant to the MSA Agreement is approximately $70.1 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 of passive investment securities. The closing is dependent
upon the receipt of state regulatory approvals and is expected to occur in the
first quarter of 1998.
Under the insurance laws of the various states under which Valley, Charter
and WMIC 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 Valley, Charter and WMIC in the future.
Source One
On February 28, 1997, Source One sold the rights to service $17.0 billion
of nonrecourse mortgage loans to a third party for adjusted proceeds of $266.9
million. Source One will
34
continue to service these loans pursuant to a subservicing agreement until 1999.
The proceeds were used by Source One to reduce and retire debt.
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.
In 1995 Source One sold the rights to service $11.0 billion of mortgage
loans to third parties for net cash proceeds of $199.1 million. The proceeds
were used by Source One to retire debt and to repurchase shares of its common
stock.
In July 1997 Source One amended and restated its secured revolving credit
agreement to reflect a reduction in its borrowing requirements resulting from
the 1997 servicing sale. The provisions of the amended agreement decreased
Source One's revolving credit facility from $750.0 million to $600.0 million and
reduced Source One's borrowing costs by lowering the facility fee. At December
31, 1997, Source One was in compliance with all covenants under the facility. As
of December 31, 1997, Source One had $559.0 million of borrowing outstanding
under this facility. As of December 31, 1996, Source One had no outstanding
borrowings under the previous facility.
In May 1997 Source One entered into a new unsecured revolving credit
agreement under which it can borrow up to $15.0 million through June 1, 1998. As
of December 31, 1997, there was $10.5 million outstanding under the revolving
credit agreement. As of December 31, 1996, Source One had no outstanding
borrowings under a previous facility which allowed for borrowings of up to $10.0
million.
Source One has a $650.0 million domestic commercial paper program. During
1997 Source One's commercial paper rating was downgraded by Moody's to "Not
Prime" and by Standard & Poor's to "A-3". As a result of the 1997 ratings
downgrades, Source One has not issued fresh commercial paper and has supplanted
its commercial paper borrowings with its $600.0 million committed facility. As
of December 31, 1996, there was $347.2 million of commercial paper outstanding.
The weighted average number of days to maturity of commercial paper outstanding
at December 31, 1996 was 23 days.
In 1997 Source One amended a short-term borrowing agreement which it had
entered into in 1996. The amended agreement increased Source One's facility from
$25.0 million to $50.0 million As a result of the 1997 ratings downgrade, Source
One is not able to borrow under this agreement. As of December 31, 1996, there
was $15.0 million outstanding under the original agreement.
In August 1995 Source One entered into a $60.0 million unsecured revolving
credit facility which expired in July 1997. As of December 31, 1996 there was
$45.0 million outstanding under this arrangement.
In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in
2001 of which $138.4 million remained outstanding at December 31, 1996. During
1997 Source One repurchased and retired in principal amount $119.7 million of
these notes leaving $18.7 million outstanding at December 31, 1997.
In 1992 Source One issued $100.0 million of 9% debentures due in 2012
pursuant to a $250.0 million shelf registration statement. The debentures may
not be redeemed by Source One prior to maturity. The proceeds from issuance were
used for general corporate purposes.
In December 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 in 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, $3.7 million
and $8.4 million during 1997, 1996 and 1995, respectively.
35
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 Source
One repurchased and retired the remaining $29.7 million in principal amount
outstanding of these notes.
In 1986 Source One issued $125.0 million of 8.25% debentures due November
1, 1996. During 1996 Source One repurchased and retired the remaining $74.6 in
principal amount outstanding of these debentures.
Source One is currently considering further steps to restructure its debt
including the issuance of approximately $50.0 million of additional medium-term
notes pursuant to an existing shelf registration and entering into interest rate
swaps which would enable Source One to achieve a floating rate of interest on
certain of its fixed interest obligations.
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's investments, mortgage loans held for sale and mortgage loan
servicing portfolio provide a liquidity reserve since these assets may be sold
to meet cash needs.
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 Schedule appearing on page 46 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 served
as the independent auditors of Valley through 1996. 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 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 contained herein
as Exhibits 16(a) and 16(b).
PART III
Item 10. Directors and Executive Officers
36
a. Directors (as of March 20, 1998)
Reported under the caption "Election of Directors" on pages 3 through 5 of
the Company's 1998 Proxy Statement, herein incorporated by reference.
37
b. Executive Officers (as of March 20, 1998)
- -------------------------------------------------------------------------------------------------------------------
Executive
officer
Name Position Age since
- -------------------------------------------------------------------------------------------------------------------
Raymond Barrette Executive Vice President and Chief Financial Officer 47 1997
Terry L. Baxter President of White Mountains 52 1994
Reid T. Campbell Vice President and Director of Finance 30 1996
Morgan W. Davis Executive Vice President of White Mountains 47 1994
K. Thomas Kemp President and CEO 57 1991
Michael S. Paquette Senior Vice President and Controller 34 1993
David G. Staples Vice President and Director of Taxation 37 1997
- -------------------------------------------------------------------------------------------------------------------
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. Barrette joined Fund American in November 1997 as the Company's
Executive Vice President and Chief Financial Officer. Mr. Barrette is also
Executive Vice President and Chief Financial Officer of White Mountains. He was
formerly a consultant with Tillinghast-Towers Perrin from 1994 to 1996 and was
President of the Personal Insurance Division of Fireman's Fund from 1991 to
1993. Mr. Barrette is a director of FAE, Source One, White Mountains, MSA and
WMIC.
Mr. Baxter was elected President of White Mountains in February 1997. Mr.
Baxter previously served as Chairman of Source One from May 1996 to February
1997 and as President and Secretary of FAE from 1994 to 1997. 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, Folksamerica, White Mountains, Valley, Charter, WMIC and
Sextant Underwriting Plc.
Mr. Campbell was elected Vice President and Director of Finance in February
1998 and previously served as Assistant Controller from 1996 to 1998 and
Director of Accounting from 1995 to 1996. Mr. Campbell has been with Fund
American since 1994. Mr. Campbell is also Vice President and Director of Finance
of White Mountains and is a director of WMIC and Merastar Insurance Company and
is an advisory director of Southern Heritage Insurance Company. Prior to joining
Fund American, Mr. Campbell was with KPMG Peat Marwick from 1990 to 1994.
Mr. Davis has served as White Mountains' Executive Vice President since
1997 and served as Senior Vice President since 1994. Mr. Davis is also President
and Chief Executive Officer of WMIC and Chairman and President of VGI. Prior to
joining Fund American in 1994, Mr. Davis was an independent consultant. Mr.
Davis is a director of White Mountains, WMIC, Valley, MSA, Charter and CCC
Information Services Group Inc. and is a trustee of Azusa Pacific University.
38
Mr. Kemp was appointed President and Chief Executive Officer in October
1997. Mr. Kemp previously served as Executive Vice President since 1993 and as
Vice President, Treasurer and Secretary from 1991 to 1993. Mr. Kemp also serves
as a director of the Company, Chairman and Chief Executive Officer of White
Mountains and Chairman of WMIC. He is also a director of Folksamerica, FSA, FAE,
MSA and Murray Lawrence.
Mr. Paquette was elected Vice President and Chief Accounting Officer in
1993, was appointed Vice President and Controller in February 1995 and became a
Senior Vice President in November 1997. Mr. Paquette is also Senior Vice
President and Controller of White Mountains and WMIC. Mr. Paquette has been a
member of the Fund American organization since 1989. Mr. Paquette is a director
of 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.
39
Item 11. Executive Compensation
Reported under the captions "Compensation of Executive Officers" on
pages 10 through 14, "Reports of the Compensation Committees on Executive
Compensation" on pages 15 though 18, "Shareholder Return Graph" on page 19,
and "Compensation Plans" on page 20 of the Company's 1998 Proxy Statement,
herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Reported under the caption "Voting Securities and Principal Holders
Thereof" on pages 8 through 9 of the Company's 1998 Proxy Statement, herein
incorporated by reference.
Item 13. Certain Relationships and Related Transactions
Reported under the captions "Certain Relationships and Related
Transactions" on page 14 and "Compensation Committee Interlocks and Insider
Participation in Compensation Decisions" on page 21 of the Company's 1998 Proxy
Statement, herein incorporated by reference.
PART IV
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K
a. Documents Filed as Part of the Report
The financial statements and financial statement schedule 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 Schedule appearing on page 46 of this report. A listing of exhibits
filed as part of the report appear on pages 41 and 43 of this report.
b. Reports on Form 8-K
On October 15, 1997, the Company filed a Current Report on Form 8-K
announcing the resignation of its Senior Vice President and Chief Financial
Officer, Allan L. Waters, which was effective on October 8, 1997. Mr. Waters,
who held the position of Chief Financial Officer since 1993, left the Company
for personal reasons.
40
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 November 26, 1996 among the Company, Fund
American Enterprises, Inc., the Lenders (as named therein) and The
First National Bank of Chicago (incorporated by reference to Exhibit
10(e) of the Company's 1996 Annual Report on Form 10-K)
(b) -- Credit Agreement dated November 26, 1996 among White Mountains
Holdings, Inc., the Lenders (as named therein) and The First National
Bank of Chicago (incorporated by reference to Exhibit 10(f) of the
Company's 1996 Annual Report on Form 10-K)
(c) -- Credit Agreement dated November 26, 1996 among VGI, the Lenders (as
named therein) and The First National Bank of Chicago (incorporated by
reference to Exhibit 10(g) of the Company's 1996 Annual Report on Form
10-K)
(d) -- Amended and Restated Credit Agreement dated July 31, 1997 among the
Company, Fund American Enterprises, Inc., the Lenders (as named
therein) and The First National Bank of Chicago (*)
(e) -- Amended and Restated Credit Agreement dated July 30, 1997 among
White Mountains Holdings, Inc., the Lenders (as named therein) and The
First National Bank of Chicago (*)
(f) -- Amended and Restated Credit Agreement dated July 30, 1997 among
VGI, the Lenders (as named therein) and The First National Bank of
Chicago (*)
(g) -- First Amendment dated November 20, 1997 to the Amended and Restated
Credit Agreement dated July 30, 1997 among White Mountains Holdings,
Inc., the Lenders (as named therein) and The First National Bank of
Chicago (*)
(h) -- First Amendment dated November 20, 1997 to the Amended and Restated
Credit Agreement dated July 30, 1997 among VGI, the Lenders (as named
therein) and The First National Bank of Chicago (*)
(i) -- 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)
(j) -- 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)
(k) -- Securities Purchase Agreement dated March 6, 1996 between the
Company and Folksamerica Holding Company, Inc. (incorporated by
reference to Exhibit 10(a) of the Company's Report on Form 8-K dated
June 19, 1996)
41
(l) -- Subscription Agreement dated November 6, 1997 between Folksamerica
Holding Company, Inc., the Company, White Mountains, Folksam Mutual
General Insurance Company, Folksam International Insurance Co. Ltd,
Weiner Staedtische Allgemeine Versicherung AG, P&V Assurances S.C. and
Samvirke Skadeforsikring AS (*)
(m) -- Guaranty, dated February 28, 1997, by the Company to and for the
benefit of Chemical Mortgage Company (incorporated by reference to
Exhibit 10(y) of the Company's 1996 Annual Report on Form 10-K)
(n) -- 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) (**)
(o) -- Common Stock Warrant Agreement with respect to shares of the
Company's Common stock between the Company and John J. Byrne
(incorporated by reference to Exhibit 10(v) of the Company's
Registration Statement on Form S-1 (No. 33-0199)) (**)
(p) -- 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) (**)
(q) -- The Company's Voluntary Deferred Compensation Plan, as amended on
November 15, 1996 (incorporated by reference to Exhibit 10(o) of the
Company's 1996 Annual Report on Form 10-K) (**)
(r) -- The Company's Deferred Benefit Plan, as amended on November 15,
1996 (incorporated by reference to Exhibit 10(p) of the Company's 1996
Annual Report on Form 10-K) (**)
(s) -- 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) (**)
(t) -- Valley Group Employees' 401(k) Savings Plan (incorporated by
reference to Exhibit 4(c) of the Company's Registration Statement on
Form S-8 (No. 333-30233) (**)
11 -- Statement Re Computation of Per Share Earnings (***)
16(a) -- Letter of Ernst & Young LLP dated March 27, 1997 (incorporated by
reference to Exhibit 16(a) of the Company's 1996 Annual Report on
Form 10-K)
(b) -- Letter of Coopers & Lybrand L.L.P. dated March 27, 1997
(incorporated by reference to Exhibit 16(b) of the Company's 1996
Annual Report on Form 10-K)
21 -- Subsidiaries of the Registrant (*)
23(a) -- Consent of KPMG Peat Marwick LLP dated March 27, 1998 (*)
(b) -- Consent of Ernst & Young LLP dated March 27, 1998 (*)
(c) -- Consent of Coopers & Lybrand L.L.P. dated March 27, 1998 relating
to Valley and FSA (*)
24 -- Powers of Attorney (*)
27.1 -- 1997 Financial Data Schedule (*)
27.2 -- 1995 and 1996 restated Financial Data Schedules (*)
99(a) -- Report of Coopers & Lybrand L.L.P. dated February 14, 1997
relating to VGI (incorporated by reference to Exhibit 99(a) of the
Company's 1996 Annual Report on Form 10-K)
(b) -- The Consolidated Financial Statements of FSA and the related Report
of Independent Accountants as of December 31, 1997 and 1996 and for
each of the three years in the period ended December 31, 1997 (*)
42
================================================================================
(*) Included herein.
(**) Management contracts or compensation plans/arrangements required to be
filed as an exhibit pursuant to Item 14(a)3 of Form 10-K.
(***) Not included herein as the information is contained elsewhere within
report. See Note 1 of the Notes to Consolidated Financial Statements.
d. Financial Statement Schedule
The financial statement schedule 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 Schedule appearing
on page 46 of this report.
43
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, 1998 ----------------------------------------
By: /s/ MICHAEL S. PAQUETTE
Senior 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
--------- ----- ----
RAYMOND BARRETTE* Executive Vice President and March 27, 1998
- ------------------------------------------------ Chief Financial Officer
Raymond Barrette
JOHN J. BYRNE* Chairman March 27, 1998
- ------------------------------------------------
John J. Byrne
PATRICK M. BYRNE* Director March 27, 1998
- ------------------------------------------------
Patrick M. Byrne
HOWARD L. CLARK* Director March 27, 1998
- ------------------------------------------------
Howard L. Clark
HOWARD L. CLARK, JR.* Director March 27, 1998
- ------------------------------------------------
Howard L. Clark, Jr.
ROBERT P. COCHRAN* Director March 27, 1998
- ------------------------------------------------
Robert P. Cochran
GEORGE J. GILLESPIE, III* Director March 27, 1998
- ------------------------------------------------
George J. Gillespie, III
/s/ K. THOMAS KEMP President, Chief Executive Officer and March 27, 1998
- ------------------------------------------------ Director
K. Thomas Kemp
GORDON S. MACKLIN* Director March 27, 1998
- ------------------------------------------------
Gordon S. Macklin
44
FRANK A. OLSON* Director March 27, 1998
- ------------------------------------------------
Frank A. Olson
MICHAEL S. PAQUETTE* Senior Vice President and Controller March 27, 1998
- ------------------------------------------------
Michael S. Paquette
ARTHUR ZANKEL* Director March 27, 1998
- ------------------------------------------------
Arthur Zankel
*By: /s/ K. THOMAS KEMP
- -----------------------------------------------------
K. Thomas Kemp, Attorney-in-Fact
45
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
Index to Financial Statements and Financial Statement Schedule
- --------------------------------------------------------------------------------
Form
10-K
page(s)
- --------------------------------------------------------------------------------
Financial statements:
Consolidated balance sheets as of December 31, 1997 and 1996.......... F-1
Consolidated income statements for each of the years ended
December 31, 1997, 1996 and 1995.................................. F-3
Consolidated statements of shareholders' equity for each of the
years ended December 31, 1997, 1996 and 1995...................... F-5
Consolidated statements of cash flows for each of the years ended
December 31, 1997, 1996 and 1995.................................. F-6
Notes to consolidated financial statements............................ F-7
Other financial information:
Report on management's responsibilities............................... F-42
Independent auditors' reports......................................... F-43
Selected quarterly financial data (unaudited)......................... F-47
Financial statement schedule:
I. Condensed financial information of the Registrant.......... FS-1
================================================================================
All other schedules are omitted as they are not applicable or the
information required is included in the financial statements or notes thereto.
46
CONSOLIDATED BALANCE SHEETS
- -------------------------------------------------------------------------------------------------------------------
December 31,
---------------------------
Dollars in millions 1997 1996
- -------------------------------------------------------------------------------------------------------------------
Assets
Common equity securities, at fair value (cost $64.7 and $101.1) $ 104.2 $ 160.8
Fixed maturity investments, at fair value (cost $165.4 and $154.5) 168.3 155.4
Other investments (cost $103.1 and $119.7) 167.9 176.5
Short-term investments, at amortized cost (which approximated fair value) 62.8 67.5
---------------------------
Total investments 503.2 560.2
Cash 7.0 4.8
Mortgage loans held for sale 519.3 314.9
Capitalized mortgage servicing, net of accumulated amortization 181.0 410.9
Pool loan purchases 149.8 131.5
Mortgage claims receivable and real estate acquired,
less allowance for mortgage loan losses of $12.8 and $15.4 41.2 57.1
Receivable from sale of mortgage servicing 27.3 --
Insurance premiums receivable 56.1 52.2
Reinsurance recoverable on paid and unpaid losses 9.6 40.0
Investments in unconsolidated insurance affiliates 382.7 226.9
Other assets 155.7 182.1
---------------------------
Total assets $ 2,032.9 $ 1,980.6
===================================================================================================================
Liabilities
Short-term debt $ 571.4 $ 407.9
Long-term debt 304.3 424.2
Unearned insurance premiums 78.0 72.6
Loss and loss adjustment expense reserves 71.9 65.4
Accounts payable and other liabilities 289.7 279.5
---------------------------
Total liabilities 1,315.3 1,249.6
- -------------------------------------------------------------------------------------------------------------------
Minority interest - preferred stock of subsidiary 44.0 44.0
- -------------------------------------------------------------------------------------------------------------------
Shareholders' equity
Common stock - authorized 125,000,000 shares,
issued 31,015,463 and 31,940,202 shares 31.0 31.9
Paid-in surplus 355.9 366.5
Retained earnings 1,008.9 1,067.1
Common stock in treasury, at cost: 25,034,939 shares (871.0) (871.0)
Net unrealized investment gains, after tax 148.8 92.5
---------------------------
Total shareholders' equity 673.6 687.0
- -------------------------------------------------------------------------------------------------------------------
Total liabilities, minority interest and shareholders' equity $ 2,032.9 $ 1,980.6
===================================================================================================================
F-1
See Notes to Consolidated Financial Statements.
F-2
CONSOLIDATED INCOME STATEMENTS
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
---------------------------------------
Millions, except per share amounts 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------------
Revenues:
Gross mortgage servicing revenue $ 95.0 $139.6 $ 141.9
Amortization and impairment of capitalized mortgage servicing (64.2) (71.9) (81.4)
Net gain on financial instruments 11.3 9.9 .8
---------------------------------------
Net mortgage servicing revenue 42.1 77.6 61.3
Net gain on sales of mortgages 21.5 38.3 24.0
Gain (loss) on sales of mortgage servicing rights and assumption
of subservicing (8.0) 10.1 40.0
Other mortgage operations revenue 19.1 18.1 15.6
Earned property and casualty insurance premiums 145.3 109.7 5.8
Earnings from unconsolidated insurance affiliates 21.3 12.0 9.4
Other insurance operations revenue 7.8 9.4 10.8
Net investment income 65.1 57.3 55.4
---------------------------------------
Total revenues 314.2 332.5 222.3
- -------------------------------------------------------------------------------------------------------------------
Expenses:
Compensation and benefits 101.8 91.3 111.6
General expenses 87.6 87.4 60.3
Interest expense 49.7 50.0 45.8
Insurance losses and loss adjustment expenses 97.1 85.9 8.2
Write-off of goodwill and other intangible assets -- 32.6 --
---------------------------------------
Total expenses 336.2 347.2 225.9
- -------------------------------------------------------------------------------------------------------------------
Pretax operating loss (22.0) (14.7) (3.6)
Net realized investment gains 96.7 38.5 38.8
---------------------------------------
Pretax earnings 74.7 23.8 35.2
Income tax provision 29.4 18.9 16.7
---------------------------------------
After tax earnings 45.3 4.9 18.5
Tax benefit from sale of discontinued operations -- -- 66.0
Loss on early extinguishment of debt, after tax (6.0) -- (.4)
---------------------------------------
Net income 39.3 4.9 84.1
Change in net unrealized investment gains, after tax 56.3 54.6 18.2
---------------------------------------
Comprehensive net income 95.6 59.5 102.3
Dividends on preferred stock -- -- (3.8)
---------------------------------------
Comprehensive net income applicable to common stock $ 95.6 $ 59.5 $ 98.5
- ----------------------------------------------------------------------------=======================================
Basic earnings per share:
After tax earnings $ 6.89 $ .66 $ 1.88
Tax benefit from sale of discontinued operations -- -- 8.47
Loss on early extinguishment of debt, after tax (.91) -- (.05)
---------------------------------------
Net income $ 5.98 $ .66 $ 10.30
=======================================
Comprehensive net income $ 14.55 $ 8.01 $ 12.64
=======================================
F-3
Diluted earnings per share:
After tax earnings $ 6.22 $ .60 $ 1.71
Tax benefit from sale of discontinued operations -- -- 7.70
Loss on early extinguishment of debt, after tax (.82) -- (.05)
---------------------------------------
Net income $ 5.40 $ .60 $ 9.36
=======================================
Comprehensive net income $ 13.17 $ 7.33 $ 11.48
===================================================================================================================
See Notes to Consolidated Financial Statements.
F-4
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- ---------------------------------------------------------------------------------------------------------------------
Common Net Loan for
stock and Common unrealized common
Preferred paid-in Retained stock in investment stock
Millions Total stock surplus earnings treasury gains issued
- ---------------------------------------------------------------------------------------------------------------------
Balances at January 1, 1995 $661.1 $75.0 $371.7 $1,098.2 $(878.5) $ 19.7 $(25.0)
- ---------------------------------------------------------------------------------------------------------------------
Net income 84.1 -- -- 84.1 -- -- --
Dividends to shareholders (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 shareholders (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 --
- ---------------------------------------------------------------------------------------------------------------------
Net income 39.3 -- -- 39.3 -- -- --
Dividends to shareholders (5.3) -- -- (5.3) -- -- --
Purchases of common stock retired (103.7) -- (11.5) (92.2) -- -- --
Change in net unrealized investment
gains and losses, after tax 56.3 -- -- -- -- 56.3 --
- ---------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $673.6 $ -- $386.9 $1,008.9 $(871.0) $148.8 $ --
=====================================================================================================================
See Notes to Consolidated Financial Statements.
F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------
Year Ended December 31,
----------------------------------
Millions 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------
Net income $ 39.3 $ 4.9 $ 84.1
Charges (credits) to reconcile net income (loss) to cash flows from
operations:
Undistributed earnings from unconsolidated insurance affiliates (14.7) (8.2) (8.6)
Net realized investment gains (96.7) (38.5) (38.8)
Net unrealized gain on financial instruments (13.3) (1.8) (.8)
Mortgage loan production (4,403.3) (3,831.6) (2,852.0)
Mortgage loan sales and amortization 4,198.9 3,897.7 2,681.5
Loss (gain) on sales of mortgage servicing rights 8.0 (10.1) (40.0)
Increase in unearned insurance premiums 5.4 37.6 2.7
Increase in insurance premiums receivable (3.9) (6.9) (1.3)
(Decrease) increase in deferred insurance policy acquisition costs (1.1) (6.5) .2
Net increase in insurance loss reserves 6.5 21.2 12.3
Depreciation and amortization of servicing assets, goodwill and other 67.1 85.4 86.4
Net change in current and deferred income taxes receivable and payable 4.5 11.8 14.9
Change in other assets 55.9 (29.3) (4.9)
Change in accounts payable and other liabilities 11.1 33.7 35.9
Tax benefit from sale of discontinued operations -- -- (66.0)
Compensation expense resulting from warrant extension -- -- 46.2
Write-off of goodwill and other intangible assets -- 32.6 --
Other, net 23.5 6.1 (5.8)
---------------------------------------
Net cash (used for) provided from operating activities (112.8) 198.1 (54.0)
- --------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Net decrease in short-term investments 4.7 36.1 15.6
Sales of common stocks and other investments 207.9 231.6 208.3
Sales of fixed maturity investments 92.5 131.7 62.1
Purchases of common stocks and other investments (54.8) (85.0) (63.7)
Purchases of fixed maturity investments (102.6) (180.8) (48.8)
Acquisitions of consolidated insurance affiliates -- (13.2) (42.2)
Investments in unconsolidated insurance affiliates (44.4) (107.6) (33.0)
Collections on other mortgage origination and servicing assets 274.2 175.3 210.9
Additions to capitalized mortgage servicing rights (139.5) (88.6) (120.8)
Proceeds from sales of mortgage servicing rights 242.6 11.7 181.1
Additions to other mortgage origination and servicing assets (285.1) (205.7) (172.7)
Net (purchases) sales of fixed assets (2.9) (7.3) .4
---------------------------------------
Net cash provided from (used for) investing activities 192.6 (101.8) 197.2
- --------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Net issuances (repayments) of short-term debt 162.4 (36.2) 96.5
Issuances of long-term debt -- 15.0 --
Repayments of long-term debt (131.0) -- (93.7)
Purchases of common stock retired (103.7) (66.3) (65.5)
Cash dividends paid to shareholders (5.3) (5.9) (6.4)
Redemptions of preferred stock -- -- (75.0)
Other -- (.8) 2.1
---------------------------------------
Net cash used for financing activities (77.6) (94.2) (142.0)
- --------------------------------------------------------------------------------------------------------------
Net increase in cash during year 2.2 2.1 1.2
Cash balance at beginning of year 4.8 2.7 1.5
---------------------------------------
Cash balance at end of year $ 7.0 $ 4.8 $ 2.7
==============================================================================================================
See Notes to Consolidated Financial Statements
F-6
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 and 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 restated to conform with the current year presentation.
The Company adopted the provisions of SFAS No. 130, "Reporting
Comprehensive Income" as of December 31, 1997. SFAS No. 130 establishes
standards for the reporting and display of comprehensive income and its
components (such as changes in net unrealized investment gains and losses) in a
financial statement that is displayed with the same prominence as other
financial statements. In accordance with the adoption of SFAS No. 130, the
Company now reports comprehensive net income on its income statement. All prior
period income statements have been restated to reflect application of this
statement. Additionally, the Company has provided supplemental comprehensive
earnings per share computations.
Investment securities
Fund American's portfolio of common equity securities, fixed maturity
investments and other investments are mainly classified as available for sale
and are reported at fair value as of the balance sheet date. Net unrealized
investment gains and losses, after tax, associated with such investments are
reported as a net amount in a separate component of shareholders' equity.
Changes in net unrealized investment gains and losses, after tax, are reported
on the income statement as a component of comprehensive net income.
Premiums and discounts on fixed maturity investments are accreted to income
over the anticipated life of the investment.
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 or otherwise; mortgage loans held for investment; REMICs; 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. 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 classified as trading securities and are carried at fair value
with realized and unrealized gains and losses reported in net gain on financial
instruments.
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.
Short-term investments consist primarily of money market instruments and
mortgage-backed securities with remaining maturities of up to one year. Money
market instruments are carried at amortized cost which approximated fair
value as of December 31, 1997 and 1996. Short-term mortgage-
F-7
backed securities are classified as trading securities and are stated at fair
value with unrealized gains and losses, if any, reported in income.
Fund American's consolidated insurance operations are required to maintain
deposits with insurance regulators of certain states in order to maintain their
insurance licenses. The total fair value of such deposits totalled $11.3 million
and $10.7 million as of December 31, 1997 and 1996, respectively.
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, 1997, White Mountains' insurance subsidiaries insured commercial
and personal property and casualty risks in Arizona, California, Idaho, New
Hampshire, Massachusetts, Oregon, Texas, Utah, Vermont and Washington.
Policy acquisition costs include commissions, premium taxes 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. Deferred acquisition costs are reviewed to
determine if they are recoverable from future income, and if not, are charged to
expense.
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 limit losses 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, (e.g., 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.
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
F-8
allocated to goodwill. Prior to December 1996 Source One's goodwill was being
amortized over 20 years. During 1996 Fund American re-assessed the
recoverability of goodwill and certain other intangible assets related to Source
One and determined that it should write-off all such assets related to Source
One. This resulted in a $32.6 million pretax write-off of goodwill and other
intangible assets. Factors considered in the determination to write-off all
Source One's goodwill and other assets 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.
Mortgage loans held for sale are stated at the lower of aggregate cost or
fair value, including the fair value of commitments to originate and sell
mortgage loans. 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, are
deferred and 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 net 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
capitalized mortgage servicing 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. The valuation allowance for
Source One's principal recourse portfolio includes a reserve for estimated
losses on the corresponding loans.
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. 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 fair value less estimated
selling costs or the recorded balance satisfied at the date of acquisition, as
determined on an individual property basis. Costs related to maintaining the
properties are charged to expense as incurred.
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.
Earnings per share
The Company adopted the provisions of SFAS No. 128, "Earnings Per Share" in
December 1997. SFAS No. 128 simplified the computation of earnings per share and
is intended to make
F-9
the U.S. standard more compatible with existing international standards. The
adoption of SFAS No. 128 did not materially change the method by which the
Company computes its earnings per share but replaces the Company's historic
presentation of "primary earnings per share" and "fully diluted earnings per
share" with a presentation of "basic earnings per share" and "diluted earnings
per share".
Basic earnings per share amounts are based on the weighted average number
of Shares outstanding. In the basic earnings per share calculation, net income
is reduced by preferred stock dividends to arrive at earnings applicable to
common stock.
Diluted earnings per share amounts are based on the weighted average number
of Shares and potential dilutive Shares outstanding. Potential dilutive Shares
include stock options, warrants and preferred stock redeemable for Shares. In
the diluted earnings per share calculation, net income is reduced by preferred
stock dividends when the assumed redemption of preferred stock is anti-dilutive.
The following table outlines the Company's computation of earnings per
share for the years ended December 31, 1997, 1996 and 1995:
F-10
- ---------------------------------------------------------------------------------------------------------
Year Ended December 31,
-------------------------
1997 1996 1995
- ---------------------------------------------------------------------------------------------------------
Basic earnings per share numerators (in millions):
After tax earnings $45.3 $ 4.9 $18.5
Dividends on preferred stock -- -- (3.8)
----------------------
After tax earnings applicable to common stock 45.3 4.9 14.7
Tax benefit from sale of discontinued operations -- -- 66.0
Loss on early extinguishment of debt, after tax (6.0) -- (.4)
----------------------
Net income available applicable to common stock $39.3 $ 4.9 $80.3
======================
Comprehensive net income applicable to common stock $95.6 $59.5 $98.5
- ----------------------------------------------------------------------------------=======================
Diluted earnings per share numerators (in million):
After tax earnings applicable to common stock $45.3 $ 4.9 $14.7
After tax dilution to earnings from unconsolidated insurance affiliates (.2) -- --
----------------------
Diluted after tax earnings available applicable to common stock 45.1 4.9 14.7
Tax benefit from sale of discontinued operations -- -- 66.0
Loss on early extinguishment of debt, after tax (6.0) -- (.4)
----------------------
Diluted net income available applicable to common stock $39.1 $ 4.9 $80.3
======================
Diluted comprehensive net income applicable to common stock $95.4 $59.5 $98.5
- ----------------------------------------------------------------------------------=======================
Earnings per share denominators (in thousands):
Basic earnings per share numerator (average common shares outstanding) 6,570 7,429 7,794
Dilutive stock options and warrants to acquire common stock (a) 674 681 788
----------------------
Diluted earnings per share denominator 7,244 8,110 8,582
- ----------------------------------------------------------------------------------=======================
Basic earnings per share (in dollars):
After tax earnings $6.89 $ .66 $1.88
Tax benefit from sale of discontinued operations -- -- 8.47
Loss on early extinguishment of debt, after tax (.91) -- (.05)
----------------------
Net income applicable to common stock $5.98 $ .66 $10.30
======================
Comprehensive net income $14.55 $8.01 $12.64
- ----------------------------------------------------------------------------------=======================
Diluted earnings per share (in dollars):
After tax earnings $6.22 $ .60 $1.71
Tax benefit from sale of discontinued operations -- -- 7.70
Loss on early extinguishment of debt, after tax (.82) -- (.05)
----------------------
Net income applicable to common stock and assumed conversions $5.40 $ .60 $9.36
======================
Comprehensive net income $13.17 $7.33 $11.48
=========================================================================================================
(a) See Note 11 for detailed information concerning the Company's outstanding
dilutive stock options and warrants to acquire common stock.
Future application of accounting standards
In December 1996 the Financial Accounting Standards Board (the "FASB")
issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of
SFAS No. 125" which has further deferred the adoption of certain other
provisions of SFAS No. 125 to periods beginning
F-11
after December 31, 1997. Fund American does not expect that the adoption of SFAS
No. 127 will have a material effect on its financial position or results of
operations.
In December 1997 the American Institute of Certified Public Accountants
(the "AICPA") issued Statement of Position ("SOP") 97-3 "Accounting by Insurance
and Other Enterprises for Insurance-Related Assessments", which provides
guidance for determining when an insurance or other enterprise should recognize
a liability for guaranty-fund and other insurance related assessments and
guidance for measuring the liability. The statement becomes effective in 1999
and allows for early application. Fund American does not expect the adoption of
this statement to have a material effect on its financial position or results of
operation.
In March 1998 the AICPA issued SOP 98-1 "Accounting for Internal Use
Software", which provides guidance for determining when internal use software
costs (whether acquired or internally developed) are expensed as incurred or
capitalized. The statement becomes effective in 1999 and allows for early
application. Fund American does not expect the adoption of this statement to
have a material effect on its financial position or results of operation.
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 of short-term
investments. Valley's wholly-owned subsidiary, VIC, is a Northwest-based
property and casualty company which writes personal and commercial lines through
independent agents. In 1997 and 1996, VIC had $77.7 million and $75.1 million of
net written premiums, respectively, primarily in Oregon, Washington and
California. Charter wrote $62.9 million and $69.9 million of non-standard
automobile insurance premiums in Texas during 1997 and 1996, respectively. 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 is currently licensed to write insurance in Maine, New Hampshire,
Vermont, Massachusetts and New York and is expected to expand its operations to
other states as additional regulatory approvals are obtained. WMIC had gross
written premiums during 1997 and 1996 of $5.2 million and $2.4 million ($4.7
million and $2.0 million of net written premiums), respectively. At December 31,
1997, WMIC had $31.4 million of total admitted assets and $29.1 million of
policyholders' surplus. WMIC is a wholly-owned subsidiary of VIC.
On January 19, 1996, VIC 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 had $2.7 million in gross written premiums ($.3
million of net written premiums) during 1997. Valley National is expected to
further expand its operations to certain other states in which it is currently
licensed. 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. Valley National is a wholly-owned subsidiary
of VIC.
On December 5, 1996, Valley's parent company formed Valley P&C to
specifically write property and casualty insurance within Oregon. Valley P&C
wrote its first policies in February
F-12
1997 and had $5.2 million in net written premiums during 1997. At December 31,
1997, Valley P&C had $7.7 million of total admitted assets and $3.7 million of
policyholders' surplus.
F-13
Loss and loss adjustment expense reserve activity
The following table summarizes Valley, Charter and WMIC's loss and loss
adjustment expense reserve activity for the years ended December 31, 1997 and
1996:
- -----------------------------------------------------------------------------------------------
Millions Year Ended December 31,
- -----------------------------------------------------------------------------------------------
1997 1996 1995
----------------------------
Beginning balance $ 65.4 $ 44.1 $ --
Reserves acquired through the purchase of Valley and Charter -- -- 39.9
Losses and loss adjustment expenses incurred relating to:
Current year losses 99.6 82.4 5.2
Prior year losses (2.5) 3.5 3.0
Loss and loss adjustment expenses paid relating to:
Current year losses (58.7) (47.8) (4.0)
Prior year losses (30.0) (18.5) --
Changes in reinsurance and other (1.9) 1.7 --
----------------------------
Ending balance $ 71.9 $ 65.4 $ 44.1
===============================================================================================
Additional insurance operations information
Total policyholders' surplus of Valley, Charter and WMIC, as reported to
various regulatory authorities, as of December 31, 1997 and 1996, was $93.8
million and $81.4 million, respectively. Statutory net income for the year ended
December 31, 1997 for Valley, Charter and WMIC totalled $11.0 million. For the
year ended December 31, 1996 and the one-month period ended December 31, 1995,
Valley, Charter and WMIC had a statutory net loss of $6.4 million and $2.3
million, respectively. The principal differences between Valley, Charter and
WMIC's statutory amounts and the amounts reported in accordance with GAAP are
not material and include deferred taxes, surplus debentures and deferred
acquisition costs. Valley, Charter and WMIC's statutory policyholders' surplus
at December 31, 1997 and 1996, was in excess of the minimum requirements of
relevant state insurance regulations.
Under the insurance laws of the various states under which Valley, Charter
and WMIC 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 Valley, Charter and WMIC in the future. At
December 31, 1997 and 1996, $87.9 million and $75.6 million, respectively, of
Valley, Charter and WMIC's 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
F-14
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 1991 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
Fund American's net investment income is comprised primarily of interest
income earned on mortgage loans originated by Source One (gross of related
interest expense on short-term borrowings used to finance such loans), interest
income associated with the fixed maturity investments of its consolidated
insurance operations, dividend income from its equity investments and interest
income from short-term investments. Net investment income consisted of the
following:
- --------------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995
- -------------------------------------------------------------------------------
Investment income:
Mortgage loans held for sale $43.1 $39.3 $35.9
Fixed maturity investments 11.3 10.4 9.0
Common equity securities 7.3 4.3 2.5
Short-term investments 3.9 6.6 6.6
Other -- (2.3) 1.7
------------------------------
Total investment income 65.6 58.3 55.7
Less investment expenses and other charges (.5) (1.0) (.3)
------------------------------
Net investment income, before tax $65.1 $57.3 $55.4
===============================================================================
Total net investment gains, before tax, associated with Fund American's
investment portfolio consisted of the following:
- -------------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995
- -------------------------------------------------------------------------------
Gross realized investment gains $ 98.6 $ 43.3 $46.3
Gross realized investment losses (1.9) (4.8) (7.5)
------------------------------
Net realized investment gains 96.7 38.5 38.8
Net unrealized investment (losses) gains (a) (10.1) 68.0 20.0
------------------------------
Total net investment gains, before tax $ 86.6 $106.5 $58.8
===============================================================================
(a) Excludes net unrealized investment gains and losses recorded from Fund
American's investments in unconsolidated insurance affiliates.
The components of Fund American's ending net unrealized investment gains
and losses on its investment portfolio and its investments in unconsolidated
insurance affiliates were as follows:
F-15
- -------------------------------------------------------------------------------
December 31,
Millions 1997 1996
- -------------------------------------------------------------------------------
Investment securities:
Gross unrealized investment gains $112.1 $121.0
Gross unrealized investment losses (2.0) (.8)
--------------------
Net unrealized gains from investment securities 110.1 120.2
Net unrealized gains from investments in
unconsolidated insurance affiliates 118.8 22.1
--------------------
Total net unrealized investment gains, before tax $228.9 $142.3
===============================================================================
F-16
The cost or amortized cost, gross unrealized investment gains and losses,
and carrying values of Fund American's fixed maturity investments as of December
31, 1997 and 1996, were as follows:
- -------------------------------------------------------------------------------------------------------------------
December 31, 1997
-----------------------------------------------------------
Cost or Gross Gross
amortized unrealized unrealized Carrying
Millions cost gains losses value
- -------------------------------------------------------------------------------------------------------------------
U S WEST, Inc. redeemable preferred stock $ 49.4 $ -- $ -- $ 49.4
Municipal obligations 33.3 .6 -- 33.9
Debt securities issued by industrial corporations 32.4 1.0 (.7) 32.7
U. S. Government and agency obligations 32.3 .9 -- 33.2
GNMA Mortgage-backed securities 15.4 1.0 -- 16.4
Aggregate of holdings less than $10 million 2.6 .1 -- 2.7
-----------------------------------------------------------
Total fixed maturity investments $165.4 $3.6 $ (.7) $168.3
===================================================================================================================
- -------------------------------------------------------------------------------------------------------------------
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
===================================================================================================================
The cost or amortized cost and carrying value of Fund American's fixed
maturity investments at December 31, 1997 and 1996, are presented 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,
-----------------------------------------------------------
1997 1996
---------------------------- -------------------------
Cost or Cost or
amortized Carrying amortized Carrying
Millions cost value cost value
- -------------------------------------------------------------------------------------------------------------------
Due in one year or less $ -- $ -- $ 7.1 $ 7.1
Due after one year through five years 6.8 7.0 6.6 6.6
Due after five years through ten years 93.1 93.7 98.2 98.5
Due after ten years 50.1 51.2 33.5 34.1
GNMA Mortgage-backed securities 15.4 16.4 9.1 9.1
------------------------- ------------------------
Total $165.4 $168.3 $154.5 $155.4
===================================================================================================================
Sales of investments, excluding short-term investments, totalled $300.4
million, $363.3 million and $270.4 million for the years ended December 31,
1997, 1996 and 1995, respectively. Non-cash exchanges of investment securities
totalling $2.3 million and $90.4 million during 1996
F-17
and 1995, respectively, are not reflected in the Consolidated Statements of Cash
Flows. There were no non-cash exchanges of investment securities during 1997.
Fund American adopted the provisions of SFAS No. 130 during 1997 and now
reports the change in net unrealized investment gains, after tax, on its income
statement to arrive at comprehensive net income. All prior period income
statements have been restated to reflect application of this statement. The
components of the change in net unrealized investment gains, after tax, are as
follows:
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------------
Net realized investment gains $ 96.7 $38.5 $38.8
Income tax expense applicable to net realized investment gains (33.8) (13.5) (13.6)
---------------------------------------
Net realized investment gains, after tax 62.9 25.0 25.2
---------------------------------------
Net unrealized investment gains arising during the year, after tax (a) 119.2 79.6 43.4
Net unrealized gains reclassed to realized gains for investments sold (62.9) (25.0) (25.2)
---------------------------------------
Change in net unrealized investment gains, after tax $ 56.3 $54.6 $18.2
===================================================================================================================
(a) Net of income tax expense of $64.2 million, $42.9 million and $23.4
million for the years ended December 31, 1997, 1996 and 1995, respectively.
NOTE 5. Capitalized Mortgage Servicing
Source One estimates the fair values of its mortgage servicing rights by
calculating the present value of the expected future net 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 capitalized mortgage servicing rights, Source One
stratifies its owned mortgage loan servicing portfolio based on the portfolio's
predominant risk characteristics which have been determined to be prepayment,
default and operational risks. Accordingly, Source One has stratified its owned
mortgage loan servicing portfolio by interest rate, loan type (investor),
original term to maturity and principal recourse. In estimating the fair value
of its owned mortgage loan servicing portfolio, Source One uses market consensus
prepayment rates and discounts future net cash flows using representative market
interest rates which were 10.5% for conventional loans, 12.0% for insured loans,
and for 1997 and 1996, 21.0% for recourse loans. The fair value of each stratum
is computed and compared to its recorded book value to determine if an
impairment valuation allowance, or recovery of a previously established
valuation allowance, is required. In 1996, as a result of the contracted sale of
$17.0 billion of nonrecourse mortgage servicing rights, Source One valued the
portfolio to be sold as one stratum using the contract price.
After the 1997 servicing sale, Source One's recourse portfolio became a
more significant component of its total remaining owned servicing portfolio.
Included in Source One's calculation for measuring impairment of its capitalized
servicing asset is an $8.2 million and $7.3 million pretax reserve for estimated
recourse losses on the corresponding loans in determining the fair value of its
principal recourse portfolio as of December 31, 1997 and 1996, respectively.
The discount rate and prepayment assumptions are significant factors used
in estimating the fair value of Source One's mortgage servicing rights.
Accordingly, the value of mortgage servicing rights can be significantly
impacted by changes in interest rates.
Source One adopted certain provisions of SFAS No. 125, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities"
in the 1997 first quarter. SFAS
F-18
No. 125 served to eliminate the distinction between "normal" servicing rights
and excess servicing receivables. Source One estimated the fair value of its
portfolio during 1997 in accordance with SFAS No. 125 which did not materially
effect Source One's 1997 results.
Prior to the adoption of SFAS No. 125, Source One estimated 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 strip" interest rates to determine the appropriate discount rates
and prepayment speed assumption rates that are based on interest rates, loan
types (investor) 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% and was 12.0% for the year ended December 31, 1995. For the years
ended December 31, 1996 and 1995, the weighted average discount rates inherent
in the carrying amount of the capitalized excess servicing asset were 10.4% and
10.0%, respectively.
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, 1997:
- -------------------------------------------------------------------------------------------------------------------
Fair value Principal Weighted Weighted Weighted
of mortgage balance average average average
servicing rights serviced (a) interest maturity service
(millions) (millions) rate (months) fee
- -------------------------------------------------------------------------------------------------------------------
Loan Type:
Insured $ 102.2 $ 5,314 8.85% 291 .46%
Conventional 44.9 2,515 8.13 273 .39
Recourse 28.7 2,413 8.60 205 .49
Adjustable 12.4 418 7.09 326 .53
--------------------------------
Total servicing portfolio $188.2 $10,660 8.56% 269 .46%
===================================================================================================================
(a) Excludes $773 million of principal balance of mortgage servicing rights not
capitalized prior to the adoption of an accounting standard implemented by
Source One as of January 1, 1995.
The following table summarizes changes in Source One's capitalized
servicing asset:
- -------------------------------------------------------------------------------------------------------------------
Deferred
gain on Total
Mortgage Valuation sale of capitalized
Millions servicing allowance Subservicing servicing servicing
- -------------------------------------------------------------------------------------------------------------------
Balances at January 1, 1995 $ 547.7 $ -- $ -- $ (17.2) $ 530.5
Additions 102.8 -- -- -- 102.8
Scheduled amortization (52.8) -- -- -- (52.8)
Impairment/unscheduled amortization (.5) (28.0) -- -- (28.5)
Amortization of deferred gain -- -- -- 4.2 4.2
Sales (159.1) -- -- -- (159.1)
- -------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995 438.1 (28.0) -- (13.0) 397.1
Additions 125.5 -- -- -- 125.5
F-19
Scheduled amortization (69.9) -- -- -- (69.9)
Impairment/unscheduled amortization (1.1) (.9) -- -- (2.0)
Amortization of deferred gain -- -- -- 6.1 6.1
Sales (45.9) -- -- -- (45.9)
- -------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 446.7 (28.9) -- (6.9) 410.9
Additions 90.4 (1.2) -- -- 89.2
Scheduled amortization (37.5) -- (8.9) -- (46.4)
Impairment/unscheduled amortization -- (17.3) (.5) -- (17.8)
Amortization of deferred gain -- -- -- 6.9 6.9
Sales (273.7) 2.3 9.6 -- (261.8)
- -------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $ 225.9 $ (45.1) $ .2 $ -- $ 181.0
===================================================================================================================
F-20
During 1997 Source One sold the rights to service $17.0 billion of
nonrecourse mortgage loans for adjusted proceeds of $266.9 million, resulting in
a pretax loss of $4.3 million. As part of the servicing sale, Source One
retained the right to subservice these loans until 1998. Source One recorded an
additional pretax loss of $3.7 million during 1997 in connection with the
extension of its subservicing responsibilities for these loans for one
additional year at less favorable terms than the original agreement provided.
The subservicing asset associated with Source One's subservicing
responsibilities is being amortized on a straight-line basis over the
subservicing period and is tested for impairment. 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 to a third party and retained the rights to subservice those loans
pursuant to a subservicing agreement. In connection with the servicing sale, a
pretax gain of $19.9 million was deferred in 1994 and was to be recognized as
income over the five-year life of the subservicing agreement. In 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. In 1997, the third party sold the
remainder of the loans subserviced by Source One which resulted in Source One
recognizing the remaining balance of the deferred gain during 1997.
NOTE 6. 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 $26.5 billion and $29.2 billion as of
December 31, 1997 and 1996, respectively. The following table summarizes the
mortgage loan servicing portfolio as of December 31, 1997:
- -------------------------------------------------------------------------------------------------------------------
Weighted average
--------------------------------------------------------------
Principal Remaining
balance Loan Net contractual
serviced balance Interest servicing fee life
Loan type (millions) (thousands) rate rate (months)
- -------------------------------------------------------------------------------------------------------------------
Residential
Conventional $ 5,521 $ 68 8.37% .424% 240
FHA 3,916 57 8.80 .427 297
VA 2,124 62 8.42 .403 298
Commercial 66 889 7.45 .176 163
-------------
Owned servicing portfolio $11,627 $ 63 8.52% .420% 269
Subservicing portfolio 14,919
-------------
Total mortgage servicing portfolio $26,546 $ 61 8.45% n/m 249
===================================================================================================================
n/m - not meaningful
The servicing fee rates in the preceding table are shown after deducting
applicable guarantee fees. Guarantee fees, when applicable, range from 6 basis
points for governmental loans to approximately 30 basis points for certain
conventional loans. Certain loans sold to private investors have no guarantee
fees.
The following tables summarize Source One's owned mortgage loan servicing
portfolio by interest rate range and by location of property:
F-21
- -------------------------------------------------------------------------------------------------------------------
December 31, 1997 December 31, 1996
------------------------------------------- -------------------------------------------
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 843 $ 66 5.41% 1,239 $ 87 5.50%
6.00% - 6.49% 1,823 159 6.13 5,449 288 6.22
6.50% - 6.99% 4,166 319 6.66 15,369 1,111 6.68
7.00% - 7.49% 12,968 729 7.17 42,363 2,395 7.11
7.50% - 7.99% 29,240 2,455 7.63 58,622 4,104 7.60
8.00% - 8.49% 27,989 2,280 8.13 60,852 4,337 8.10
8.50% - 8.99% 32,178 1,867 8.59 77,061 4,047 8.58
9.00% - 9.49% 13,452 722 9.07 37,714 2,052 9.06
9.50% - 9.99% 29,142 1,420 9.55 69,548 3,618 9.57
10% and above 32,488 1,610 10.49 83,585 4,371 10.49
------------------------------------------- -------------------------------------------
Total 184,289 $11,627 8.52% 451,802 $26,410 8.59%
===================================================================================================================
- -------------------------------------------------------------------------------------------------------------------
December 31, 1997 December 31, 1996
------------------------------------------- -------------------------------------------
Aggregate Aggregate
Number principal Percentage Number principal Percentage
of balance of servicing of balance of servicing
State loans (millions) portfolio loans (millions) portfolio
- --------------------- ------------------------------------------ --------------------------------------------
California 20,459 $ 1,889 16.3% 60,547 $ 4,955 18.7%
New York 22,118 1,162 10.0 42,195 2,441 9.2
Texas 15,655 736 6.3 29,851 1,513 5.7
Washington 7,889 690 5.9 23,048 1,692 6.4
Florida 12,894 663 5.7 28,361 1,408 5.3
Michigan 10,773 520 4.5 25,553 1,019 3.9
New Jersey 7,088 503 4.3 13,689 895 3.4
Illinois 6,335 420 3.6 16,704 1,036 3.9
Maryland 5,020 362 3.1 8,966 534 2.0
Ohio 6,658 357 3.1 15,772 656 2.5
Other 69,400 4,325 37.2 187,116 10,261 39.0
------------------------------------------ --------------------------------------------
Total 184,289 $11,627 100.0% 451,802 $26,410 100.0%
===================================================================================================================
Escrow funds of approximately $196.8 million, $207.8 million and $236.0
million as of December 31, 1997, 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.
F-22
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 1997 1996
- ------------------------------------------------------------------------------
Adjustable rate mortgage loans, weighted average
interest rates of 6.36% and 6.60% $ 51.6 $ 35.1
Fixed rate 5 year through 25 year mortgage loans,
weighted average interest rates of 7.68% and 7.73% 60.4 51.2
Fixed rate 30 year mortgage loans, weighted average
interest rates of 7.76% and 8.19% 405.0 228.0
---------------------
Total principal amount 517.0 314.3
Net premiums 2.3 .6
---------------------
Total mortgage loans held for sale $519.3 $314.9
==============================================================================
- --------------------------------------------------------------------------------
December 31,
---------------------------------------------
Principal balance Number of loans
--------------------- --------------------
Dollars in Millions 1997 1996 1997 1996
- -------------------------------------------------------- --------------------
Loan type: FHA $103.1 $ 89.9 1,781 1,621
VA 43.3 35.3 669 592
Conventional 3.4 6.3 45 75
--------------------- --------------------
Total pool loan purchases $149.8 $131.5 2,495 2,288
================================================================================
NOTE 8. Debt
Short-term debt
Short-term debt outstanding consisted of the following:
- -------------------------------------------------------------------------------
December 31,
Millions 1997 1996
- -------------------------------------------------------------------------------
Charter: Notes payable and lease obligations $ 2.0 $ 1.7
-------------------------
Source One:
Credit agreement borrowings 569.5 45.0
Commercial paper and short-term borrowings -- 362.2
Less net discounts (.1) (1.0)
-------------------------
Total Source One 569.4 406.2
-------------------------
Total short-term debt $ 571.4 $ 407.9
===============================================================================
The weighted average interest rates of short-term debt outstanding during
the year ended December 31, 1997 and 1996 were as follows:
F-23
- --------------------------------------------------------------------------------
Year Ended December 31,
1997 1996
- --------------------------------------------------------------------------------
White Mountains: Credit facility 6.04% --
Parent Company: Revolving credit facility -- 5.82%
Charter: Notes payable 6.50% 6.50%
Source One:
Credit agreements borrowings 6.34% 6.19%
Commercial paper and short-term borrowings 5.81% 5.69%
================================================================================
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 July 1997 Source One amended and restated its secured revolving credit
agreement to reflect a reduction in its borrowing requirements resulting from
the 1997 servicing sale. The provisions of the amended agreement decreased
Source One's revolving credit facility from $750.0 million to $600.0 million and
reduced Source One's borrowing costs by lowering the facility fee. At December
31, 1997, Source One was in compliance with all covenants under the facility. As
of December 31, 1997, Source One had $559.0 million of borrowing outstanding
under this facility. As of December 31, 1996, Source One had no outstanding
borrowings under the previous facility.
In May 1997 Source One entered into a new unsecured revolving credit
agreement under which it can borrow up to $15.0 million through June 1, 1998. As
of December 31, 1997, there was $10.5 million outstanding under the revolving
credit agreement. As of December 31, 1996, Source One had no outstanding
borrowings under a previous facility which allowed for borrowings of up to $10.0
million.
In August 1995 Source One entered into a $60.0 million unsecured revolving
credit facility which expired in July 1997. As of December 31, 1996 there was
$45.0 million outstanding under this arrangement.
Source One has a $650.0 million domestic commercial paper program. In
November 1997 Source One's commercial paper rating was downgraded by Moody's to
"Not Prime" and by Standard & Poor's to "A-3". As a result of the 1997 ratings
downgrades, Source One has not issued fresh commercial paper and has supplanted
its commercial paper borrowings with its $600.0 million credit agreement
facility. As of December 31, 1996, there was $347.2 million of commercial paper
outstanding. The weighted average number of days to maturity of commercial paper
outstanding at December 31, 1996 was 23 days.
In 1997 Source One amended a short-term borrowing agreement which it had
entered into in 1996. The amended agreement increased Source One's facility from
$25.0 million to $50.0 million As a result of the 1997 ratings downgrade, Source
One is not able to borrow under this agreement. As of December 31, 1996, there
was $15.0 million outstanding under the original agreement.
In 1986 Source One issued $125.0 million of 8.25% debentures due November
1, 1996. During 1996 Source One repurchased and retired the remaining $74.6 in
principal amount outstanding of these debentures.
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 Source
One repurchased and retired the remaining $29.7 million in principal amount
outstanding of these notes.
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
F-24
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.
F-25
In November 1996 the Company entered into a $35.0 million revolving credit
agreement with a syndicate of banks which served to replace an expiring
arrangement in the amount of $75.0 million. Under the agreement, through
November 25, 1998, 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, 1997 and 1996, the Company was in compliance with
all covenants under the facility and had no borrowings outstanding under the
agreement.
Long-term debt
Long-term debt outstanding consisted of the following:
- -------------------------------------------------------------------------------
December 31,
Millions 1997 1996
- -------------------------------------------------------------------------------
Parent Company:
Medium-term notes $116.3 $116.2
Less net discounts (.7) (.8)
----------------------------
Total Parent Company 115.6 115.4
----------------------------
Source One:
Medium-term notes, 8.875% due in 2001 18.7 138.4
Debentures, 9.0% due in 2012 100.0 100.0
Subordinate debentures, 9.375% due in 2025 56.0 56.0
Less net discounts (2.1) (2.8)
----------------------------
Total Source One 172.6 291.6
----------------------------
Valley: Medium-term notes 15.0 15.0
Charter: Notes payable in 1998 and 1999 1.1 2.2
----------------------------
Total long-term debt $304.3 $424.2
===============================================================================
In 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.
During 1995 and 1994 the Company repurchased $8.8 million and $24.9 million,
respectively, in principal amount of the notes due in February 2003. At December
31, 1997, the $116.3 million of remaining outstanding notes had an average
maturity of 5.4 years and a yield to maturity of 7.82%.
In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in
2001 of which $138.4 million remained outstanding at December 31, 1996. During
1997 Source One repurchased and retired in principal amount $119.7 million of
these notes which resulted in a $6.0 million after tax extraordinary loss on
early extinguishment of debt.
In 1992 Source One issued $100.0 million of 9% debentures due in 2012
pursuant to a $250.0 million shelf registration statement. The debentures may
not be redeemed by Source One prior to maturity. The proceeds from issuance were
used for general corporate purposes.
In December 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 in 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.
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 Source
One repurchased and retired the remaining $29.7 million in principal amount
outstanding of these notes.
F-26
Source One is currently considering further steps to restructure its debt
including the issuance of approximately $50.0 million of additional medium-term
notes pursuant to an existing shelf registration and entering into interest rate
swaps which would enable Source One to achieve a floating rate of interest on
certain of its fixed interest obligations.
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.
Total interest paid by Fund American for both short-term and long-term debt
was $51.9 million, $51.5 million and $47.9 million in 1997, 1996 and 1995,
respectively.
Fund American's long-term debt maturities, including current portion of
long-term debt, for 1998, 1999, 2000, 2001, 2002 and beyond are $1.1 million,
$1.1 million, $4.0 million, $18.7 million, $15.0 million and $268.3 million,
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 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------------
Tax on pretax earnings:
Federal $ 26.7 $ 18.1 $ 16.6
State and local 2.7 .8 .1
----------------------------------------------
Income tax provision on pretax earnings 29.4 18.9 16.7
Tax benefit from sale of discontinued operations -- -- (66.0)
Tax benefit from loss on early extinguishment of debt 3.2 -- (.2)
----------------------------------------------
Total income tax provision (benefit) $ 32.6 $ 18.9 $ (49.5)
- ---------------------------------------------------------------------==============================================
Net income tax payments $ 24.9 $ 7.0 $ 2.6
- ---------------------------------------------------------------------==============================================
Tax provision recorded directly to shareholders' equity related to:
Exercises of employee stock options and warrants $ -- $ -- $ .2
Changes in net unrealized investment gains and losses $ 30.3 $ 29.4 $ 9.8
===================================================================================================================
The components of the income tax provision (benefit) on pretax earnings
follow:
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
--------------------------------------------
Millions 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------------
Current provision $ 33.5 $22.5 $ 26.4
Deferred benefit (4.1) (3.6) (9.7)
--------------------------------------------
Total income tax provision on pretax earnings $ 29.4 $18.9 $ 16.7
===================================================================================================================
F-27
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 1997 1996
- -------------------------------------------------------------------------------
Deferred tax assets related to:
Employee compensation and benefit accruals $ 39.1 $ 32.8
Capitalized mortgage servicing 26.2 18.4
Unearned insurance premiums 5.3 4.9
Allowance for mortgage loan losses 4.8 4.8
Discounting of loss reserves 2.9 2.7
Other items 10.1 10.1
------------------------
Total deferred tax assets 88.4 73.7
- -------------------------------------------------------------------------------
Deferred tax liabilities related to:
Net unrealized investment gains 79.3 49.0
Earnings from insurance affiliates 11.8 6.7
Purchase accounting adjustments 5.5 6.2
Deferred acquisition costs 5.0 4.6
Unrealized gains on financial instruments 4.6 .9
Other items 9.7 7.6
------------------------
Total deferred tax liabilities 115.9 75.0
- -------------------------------------------------------------------------------
Net deferred Federal income tax liability $ (27.5) $ (1.3)
===============================================================================
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 1997 1996 1995
- ---------------------------------------------------------------------------------------
Tax provision at Federal statutory rate $ 26.1 $ 8.3 $ 12.3
Differences in taxes resulting from:
Dividends received deduction (3.1) (2.3) (1.9)
Nonconventional fuel source tax credits (2.4) -- --
Tax reserve adjustments 5.1 4.2 2.3
State income taxes 1.8 .5 --
Minority interest dividends 1.3 1.3 2.7
Write-off of goodwill and other intangible assets -- 8.1 --
F-28
Other, net .6 (1.2) 1.3
-------------------------------
Total income tax provision on pretax earnings $ 29.4 $ 18.9 $ 16.7
=======================================================================================
The Company believes that it is more likely than not that results of future
operations will generate sufficient taxable income to realize the deferred tax
asset balances carried as of December 31, 1997 and 1996.
NOTE 10. Retirement and Post-Retirement Plans
In 1993 the Company and certain of its subsidiaries established an
unfunded, 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, 1997 and 1996, Fund American's
liability to participants pursuant to the Deferred Benefit Plans was $3.9
million and $2.9 million, respectively.
In 1993 the Company and certain of its subsidiaries also established an
unfunded, nonqualified plans for a select group of management employees for the
purpose of deferring current compensation for retirement savings (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, 1997
and 1996, Fund American's liability to participants pursuant to the Deferred
Compensation Plans was $37.6 million and $21.8 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.
Source One established a 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, 1997, 1996 and 1995, totalled
$.6 million, $1.3 million and $1.7 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.
Total accrued postretirement benefit costs included in accounts payable and
other liabilities for Source One employees was $3.7 million and $3.5 million at
December 31, 1997 and 1996, respectively.
NOTE 11. Employee Stock Plans
F-29
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, 1997, 377,000 Shares remained available for grants under the
Incentive Plan.
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.
Pursuant to the Incentive Plan 50,000, 73,000 and 56,429 performance shares
were granted in 1997, 1996 and 1995, respectively, of which 400, 3,000 and 1,800
of the performance shares granted, respectively, remain unallocated to
participants as of December 31, 1997 and are not deemed to be outstanding.
During 1997, 1996 and 1995, 22,944, 0, and 0 performance shares were canceled,
respectively, and 86,156, 10,650 and 0 performance shares were paid in cash,
respectively. At December 31, 1997, 174,229 performance shares were outstanding.
The financial goal for full payment of the performance shares is the achievement
of a 13% to 15% annual return on equity as measured over the applicable
performance periods.
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. As of December 31, 1997, 1996
and 1995 there were 2,000, 3,000 and 7,000 stock options outstanding,
respectively, which had exercise prices ranging from $24.82 to $32.60 per Share.
All Fund American stock options outstanding during the three year period ended
December 31, 1997, were fully vested and exercisable. No new stock options have
been issued to Fund American employees since 1991.
In 1985 the Company's Chairman purchased warrants (the "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
was extended from January 2, 1996, to January 2, 2002. In accordance with APB
No. 25, the extension of the Warrants 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 1997 and 1996. Pursuant to
certain anti-dilution adjustments related to the distribution of White River
Shares to the Company's shareholders, the exercise price for the Warrants to
purchase Fund American Shares was reduced to $21.66 per Share.
All employees (other than employees of Source One and FAE) 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 including 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 became eligible to participate in
the Valley 401(k) Plan beginning January 1, 1997. Fund American added Shares to
the investment options offered under the Valley 401(k) Plan as of July 1, 1997.
As of December 31, 1997 participants of the Valley 401(k) Plan owned a total of
1,825 Shares.
F-30
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 (the "Source One 401(k)
Plan"). Contributions to the plan can be invested in various investments
including Shares. In 1997, Source One added a matching contribution feature to
the Source One 401(k) Plan which is equal to a certain percentage of employee
contributions, up to a maximum of 5%, dependent upon Source One's return on
equity. As of December 31, 1997 participants of the Source One 401(k) Plan owned
a total of 44,502 Shares.
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.
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 1997, 1996 and 1995, as
follows:
- -------------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------
Millions, except per share amounts 1997 1996 1995
- -------------------------------------------------------------------------------
Net income:
As reported $ 39.3 $ 4.9 $ 84.1
Pro forma 39.4 - 108.6
- -------------------------------------------------------------------------------
Basic net income per share:
As reported $ 5.98 $ .66 $ 10.30
Pro forma 5.99 - 13.44
- -------------------------------------------------------------------------------
Diluted net income per share:
As reported $ 5.40 $ .60 $ 9.36
Pro forma 5.41 - 12.21
===============================================================================
SFAS No. 123 provides for the expense of Warrants, stock options and
performance shares over the life of the award. In determining the pro forma
effects of SFAS No. 123, the Company recognizes the pro forma expense of the
Warrants over time and assumes that the $46.2 million pretax charge associated
with the extension of the Warrants recognized in 1995 did not occur. The pro
forma net income figures disclosed above may not be representative of the
effects on reported net income to be reported in future years.
NOTE 12. Minority Interest - Preferred Stock of Subsidiary
In 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 $96.8 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
F-31
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 preferred stock
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 1997, 1996 and 1995 the Company repurchased 924,739 Shares, 779,077
Shares and 877,868 Shares, respectively, for $103.7 million, $66.3 million and
$65.4 million, respectively. All such Shares repurchased from 1995 to 1997 have
been retired. At December 31, 1997, the Company had outstanding authorization to
purchase an additional 193,417 Shares.
Loan for common stock issued
On December 30, 1992, pursuant to a request from the Board, the Company's
Chairman 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 the Chairman. The loan was fully
repaid on its maturity date, October 23, 1995.
Common stock dividends
In the fourth quarter of 1995 the Board of Directors reinstated and paid a
$.20 regular quarterly dividend per Share. During 1996 and 1997 the Company
declared and paid regular quarterly cash dividends of $.20 per Share.
F-32
NOTE 14. Industry Segments
Revenues, pretax earnings (loss) and ending identifiable assets for Fund
American's industry segments are shown below:
- -----------------------------------------------------------------------------
Year Ended December 31,
Millions 1997 1996 1995
- -----------------------------------------------------------------------------
Revenues:
Mortgage banking operations $ 118.2 $ 184.9 $ 178.6
Insurance operations 188.0 140.1 32.6
Other 8.0 7.5 11.1
-------------------------------------------
Total $ 314.2 $ 332.5 $ 222.3
- ----------------------------------===========================================
Pretax earnings (loss):
Mortgage banking operations $ (26.6) $ (2.1) $ 35.3
Insurance operations 32.6 .2 18.9
Other 68.7 25.7 (19.0)
-------------------------------------------
Total $ 74.7 $ 23.8 $ 35.2
- ----------------------------------===========================================
Ending assets:
Mortgage banking operations $1,084.9 $1,131.1 $1,138.5
Insurance operations 748.3 586.2 373.7
Other 199.7 263.3 359.7
-------------------------------------------
Total $2,032.9 $1,980.6 $1,871.9
=============================================================================
NOTE 15. Investments in Unconsolidated Affiliates
Investment in FSA
Fund American owned 3,460,200, 3,460,200 and 2,460,200 shares of FSA Common
Stock at December 31, 1997, 1996 and 1995. This represented approximately 12.1%,
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, 1997, 1996 and 1995,
raising Fund American's voting control of FSA to approximately 24.0%, 23.0% and
19.0%, respectively. At December 31, 1997, 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, 1997, 1996 and
1995, Fund American's economic interest in FSA was 26.2%, 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, 1997 and 1996, as quoted on the NYSE,
exceeded Fund American's carrying value of the FSA Common Stock on the equity
method. Fund American's investments in FSA Options and Preferred Stock 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, after tax, reported as a net amount in a separate
component of shareholders' equity and reported on the income statement as a
component of comprehensive net income.
F-33
The following table summarizes financial information for FSA:
- --------------------------------------------------------------------------------
Millions 1997 1996 1995
- --------------------------------------------------------------------------------
FSA balance sheet data:
Total investments $1,431.6 $1,154.4 $1,110.7
Total assets 1,900.6 1,537.7 1,490.3
Deferred premium revenue 595.2 511.2 463.9
Loss and loss adjustment expense reserve 75.4 72.1 111.8
Preferred shareholder's equity .7 .7 .7
Common shareholders' equity 881.7 800.6 777.2
FSA income statement data:
Gross premiums written $ 236.4 $ 177.0 $ 110.7
Net premiums written 172.9 121.0 77.6
Net premiums earned 109.5 90.4 69.3
Net investment income 72.1 65.1 49.0
Net income 100.5 80.8 55.0
- --------------------------------------------------------------------------------
Amounts recorded by Fund American:
Investment in FSA Common Stock $ 104.3 $ 92.3 $ 60.0
Investment in FSA Options and Preferred Stock 87.8 19.8 2.5
-------- -------- --------
Total Investment in FSA $ 192.1 $ 112.1 $ 62.5
======== ======== ========
Equity in earnings from FSA Common Stock (a) $ 11.4 $ 7.8 $ 5.4
Equity in net unrealized investment gains
(losses) from FSA's investment
portfolio, before tax (b) 2.1 (1.0) 4.5
Unrealized investment gains on FSA Options and
Preferred Stock, before tax (b) 68.0 17.3 .3
================================================================================
(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to shareholders' equity (after tax) with related changes
in net unrealized investment gains and losses (after tax) reported on the
income statement as a component of comprehensive net income.
At December 31, 1997 and 1996, Fund American's consolidated retained
earnings included $24.1 million and $13.8 million, respectively, of
undistributed earnings of FSA.
Investment in MSA
At December 31, 1997, 1996 and 1995, Fund American owned 90,606 shares of
MSA Common Stock. This represented approximately and 33.1% 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.
F-34
The following tables summarize financial information for MSA:
- ------------------------------------------------------------------------------
Millions 1997 1996 1995
- ------------------------------------------------------------------------------
MSA balance sheet data:
Total investments $280.1 $249.4 $240.8
Total assets 337.2 316.2 309.6
Unearned premium reserve 71.8 64.0 58.4
Loss and loss adjustment expense reserves 123.7 120.1 116.2
Shareholders' equity 120.6 101.4 92.0
MSA income statement data:
Net premiums written $156.6 $147.2 $130.9
Net premiums earned 148.7 141.6 127.7
Net investment income 15.4 14.9 15.0
Net income 11.9 9.7 12.4
- ------------------------------------------------------------------------------
Amounts recorded by Fund American:
Investment in MSA Common Stock $ 40.9 $ 34.7 $ 33.7
Equity in earnings from MSA Common Stock (a) 3.8 1.5 4.0
Equity in net unrealized investment gains (losses)
from MSA's investment portfolio, before tax (b) 2.4 (.5) 3.2
==============================================================================
(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to shareholders' equity (after tax) with related changes
in net unrealized investment gains and losses (after tax) reported on the
income statement as a component of comprehensive net income.
At December 31, 1997 and 1996, Fund American's consolidated retained
earnings included $10.9 million and $6.5 million, respectively, of undistributed
earnings of MSA.
Investment in Folksamerica
White Mountains owned 6,920,000 shares of Folksamerica Preferred Stock at
December 31, 1997 and 1996. White Mountains owned 1,563,907 shares of
Folksamerica Common Stock at December 31, 1997. White Mountains ownership
percentage of Folksamerica at December 31, 1997 and 1996 represented 50.0% of
the total Folksamerica voting shares outstanding at that time. At December 31,
1997 and 1996, White Mountains 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 investment in
Folksamerica Preferred Stock and Folksamerica Warrants on June 19, 1996. White
Mountains acquired its investment in Folksamerica Common Stock on November 20,
1997.
White Mountains' investment in Folksamerica Common Stock is accounted for
using the equity method. Fund American's investment in Folksamerica Preferred
Stock and Folksamerica Warrants 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, after tax,
reported as a net amount in a separate component of shareholders' equity and
reported on the income statement as a component of comprehensive net income.
Dividends earned on the Folksamerica Preferred Stock are recorded as earnings
from unconsolidated insurance affiliates on the income statement.
F-35
The following table summarizes financial information for Folksamerica:
- --------------------------------------------------------------------------------
Millions 1997 1996
- --------------------------------------------------------------------------------
Folksamerica balance sheet data:
Total investments $ 926.2 $711.4
Total assets 1,213.6 994.8
Unearned premium reserve 96.5 61.5
Loss and loss adjustment expense reserve 739.1 628.9
Preferred shareholder's equity 79.4 79.4
Common shareholders' equity 175.6 88.2
Folksamerica income statement data:
Gross premiums written $ 251.0 $187.2
Net premiums written 232.4 171.9
Net premiums earned 238.0 181.4
Net investment income 46.7 32.4
Net income 35.9 17.1
- --------------------------------------------------------------------------------
Amounts recorded by Fund American:
Investment in Folksamerica Common Stock $ 23.5 $ --
Investment in Folksamerica Preferred Stock 78.0 77.9
Investment in Folksamerica Warrants 24.6 2.2
-------- ------
Total Investment in Folksamerica $ 126.1 $ 80.1
-------- ------
Equity in earnings from Folksamerica Common Stock (a) $ .9 $ --
Dividends from Folksamerica Preferred Stock (a) 5.2 2.7
Equity in net unrealized investment gains from
Folksamerica's investment portfolio, before tax (b) 1.8 --
Unrealized investment gains on Folksamerica Warrants
and Preferred Stock, before tax (b) 22.4 .2
================================================================================
(a) Recorded net of related amortization of goodwill and accretion of discount.
(b) Recorded directly to shareholders' equity (after tax) with related changes
in net unrealized investment gains and losses (after tax) reported on the
income statement as a component of comprehensive net income.
At December 31, 1997 and 1996, Fund American's consolidated retained
earnings included $1.0 million and $0 million of undistributed earnings of
Folksamerica.
Investment in Murray Lawrence
At December 31, 1997 White Mountains owned 38,651,270 shares of Murray
Lawrence Common Stock which it had acquired on December 8, 1997 for $23.6
million. This represented approximately 15.8% of the total shares of Murray
Lawrence Common Stock outstanding at that time. White Mountains' carrying value
of the Murray Lawrence investment was equal to its cost of $23.6 million at
December 31, 1997.
NOTE 16. Financial Instruments With Off-Balance-Sheet Risk
Source One utilizes derivative financial instruments in the management of
interest rate risk. Source One's use of derivative financial instruments is
primarily limited to (i) commitments to extend credit, (ii) mandatory forward
commitments and (iii) interest rate floor contracts and principal-only swap
agreements. Although SFAS No. 115 requires that these financial instruments be
classified as held for trading purposes, Fund American does not consider these
investments to be speculative holdings.
F-36
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 is represented by the contractual
notional amount of those commitments. Source One's locked mortgage loan
commitments expected to close totalled $284.5 million and $175.7 million at
December 31, 1997 and 1996, respectively. Fixed rate commitments result in
Source One having market interest rate risk as well as credit risk. Variable
rate commitments result primarily in 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 a substantial portion of the Pipeline that is expected to close and all
mortgage loans receivable. At December 31, 1997 and 1996, Source One had $776.8
million and $454.6 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 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 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 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 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
F-37
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 pass-thru rate from the date of
loan payoff through the end of the calendar month without reimbursement.
At December 31, 1997 and 1996, Source One serviced approximately $5.4
billion and $13.5 billion of GNMA loans (without substantial recourse),
respectively, and $2.5 billion and $2.9 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 $12.8
million and $15.4 million at December 31, 1997 and 1996, respectively. In
addition, the valuation allowance for Source One's capitalized servicing asset
related to its principal recourse portfolio includes an $8.2 million and $7.3
million reserve for estimated losses at December 31, 1997 and 1996,
respectively. Source One's management believes the allowance for loan losses is
adequate to cover unreimbursed foreclosure advances and principal losses,
including losses on loans with recourse.
In order to offset changes in the value of Source One's capitalized
servicing asset 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 capitalized
servicing asset, while the value of the financial instrument increases.
Conversely, as interest rates increase, the value of the capitalized servicing
asset 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 strike rates range from 4.00% to 6.14%. 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 net gain on financial instruments on the consolidated
income statements. As of December 31, 1997 and 1996, the carrying value of
Source One's open interest rate floor contracts totalled $8.2 million and $4.8
million, respectively, with a total notional principal amount of $.7 billion and
$1.0 billion, respectively. The floors have terms ranging from 3 to 5 years.
The value of the principal-only swaps is determined by changes in the value
of referenced principal-only strips. As of December 31, 1997 and 1996, the
carrying value of Source One's principal-only swap transactions totalled $12.5
million and $3.2 million, respectively, with an original notional principal
amount of $98.1 million and $50.0 million, respectively. The principal-only
swaps have remaining terms of 3 to 4 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 17. Fair Value of Financial Instruments
The estimated fair values of 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 realized in a current market exchange.
F-38
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. For 1997, mortgage loans held for investment were
carried at fair value. For 1996, the fair value of mortgage loans held for
investment were estimated using quoted market prices for securities backed by
similar loans. Fair values of REMICs are estimated using discounted cash flow
analyses reflecting interest only 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. Prior to 1997, the fair value of
Source One's excess mortgage servicing asset was 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 interest only strip
interest rates.
Mortgage Loans Held for Sale. Fair values are estimated using quoted market
prices for securities backed by similar loans.
Pool Loan Purchases. Fair values are estimated based on discounted cash
flow analyses using Source One's short-term incremental borrowing rate, quoted
market prices for securities backed by similar loans or actual prices at which
the loans were subsequently sold..
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 or
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, net
of the face amounts of the commitments. Fair value for commitments to extend
credit is based on current quoted market prices for securities backed by similar
loans, net of the principal amounts of the commitments.
The carrying amounts and estimated fair values of Fund American's financial
instruments were as follows:
- -------------------------------------------------------------------------------------------------------------------
December 31, 1997 December 31, 1996
------------------------- ------------------------
Carrying Fair Carrying Fair
Millions amount value amount value
- -------------------------------------------------------------------------------------------------------------------
Financial assets:
Common equity securities $104.2 $104.2 $160.8 $160.8
Fixed maturity investments 168.3 168.3 155.4 155.4
Other investments (excluding derivative instruments) 151.1 160.6 168.5 168.4
Derivative instruments:
Interest rate floor contracts 8.2 8.2 4.8 4.8
Principal-only swaps 12.5 12.5 3.2 3.2
Short-term investments 62.8 62.8 67.5 67.5
Cash 7.0 7.0 4.8 4.8
Capitalized excess mortgage servicing (a) - - 38.7 39.6
Mortgage loans held for sale 519.3 529.3 314.9 315.9
Pool loan purchases 149.8 150.2 131.5 135.8
Mortgage claims receivable, net (b) 35.6 34.9 38.4 37.7
Other financial assets 43.4 43.4 35.9 35.9
F-39
Financial liabilities:
Short-term debt 571.4 571.4 407.9 407.9
Long-term debt 304.3 326.5 424.2 460.2
Other financial liabilities 22.3 22.3 18.3 18.3
Off-balance-sheet financial instruments:
Mandatory forward commitments - 1.6 - (.2)
Commitments to extend credit expected to close - 6.5 - 1.9
===================================================================================================================
(a) Not applicable for 1997 due to the adoption of SFAS No. 125. See Note 5.
(b) Excludes $5.6 million and $13.1 million of real estate owned in 1997 and
1996, 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.
Fund American's investments in FSA Options and Preferred Stock,
Folksamerica Preferred Stock and Folksamerica Warrants are not presented in the
table above. These financial instruments are accounted for under the provisions
of SFAS No. 115 and are carried on the balance sheet at fair value. See Note 15.
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.
NOTE 18. Related Party Transactions
For corporate travel purposes Fund American jointly owns two short-range
aircraft with Haverford Utah, LLC ("Haverford"). Messrs. Jack Byrne, Patrick
M. Byrne, a director of the Company and White Mountains, 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.
Jack Byrne and Kemp are the sole shareholders of HTI. During 1996 and 1995 Fund
American paid HTI a total of $279,739 and $183,563, respectively, pursuant to
the dry lease arrangement. The terms of the 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 pursuant to the HTI dry lease are
considered to be representative of the actual hourly costs of operating HTI's
aircraft.
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.
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.
Mr. Gordon S. Macklin, a director of the Company, is Chairman, President and
Chief
F-40
Executive Officer of White River. Mr. Patrick M. Byrne is also a director 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 Chairman and 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-41
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.
KPMG Peat Marwick LLP have audited the consolidated financial statements of
Fund American as of December 31, 1997 and for the year then ended, and issued
their unqualified report thereon dated January 29, 1998, which appears on page
F-43. Ernst & Young LLP served as Fund American's independent auditors as of
December 31, 1996 and 1995, and for the years then ended, and issued their
unqualified report thereon dated March 21, 1997, which appears on page F-45.
Coopers & Lybrand L.L.P. served as independent auditors of Valley as of December
31, 1996 and for the year then ended. Their unqualified report thereon, dated
February 14, 1997, has been included as an exhibit to this annual report.
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, which is comprised solely of
non-management directors, 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.
F-42
K. Thomas Kemp
Director, President
and Chief Executive Officer
Raymond Barrette
Executive Vice President
and Chief Financial Officer
Michael S. Paquette
Senior Vice President
and Controller
INDEPENDENT AUDITORS' REPORT
Board of Directors and Shareholders
Fund American Enterprises Holdings, Inc.
We have audited the accompanying consolidated balance sheet of Fund American
Enterprises Holdings, Inc. and Subsidiaries (the "Company") as of December 31,
1997 and the related consolidated income statement, and consolidated statements
of shareholders' equity and cash flows for the year then ended (collectively the
"consolidated financial statements"). In connection with our audit of the
consolidated financial statements, we also have audited the 1997 financial
information in Schedule I Condensed Financial Information of the Registrant (the
"financial statement schedule"). These consolidated financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audit. We did not audit
the consolidated financial statements of Financial Security Assurance Holdings
Ltd. ("FSA") (a 12.1 percent owned equity investee company). The Company's
equity investment in FSA at December 31, 1997 was $104.3 million and its equity
in earnings of FSA was $11.4 million for the year ended 1997. The consolidated
financial statements of FSA were audited by other auditors, Coopers and Lybrand
L.L.P., whose report has been furnished to us, and, our opinion, insofar as it
relates to the amounts included for FSA is based solely on the report of the
other auditors.
We conducted our audit 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 audit and the report of the other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audit and the report of the other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Fund American Enterprises Holdings,
Inc. and Subsidiaries as of December 31, 1997, and the results of their
operations and their cash flows for the year then ended in conformity with
generally accepted accounting principles. Also in our opinion, the 1997
information in the related financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
F-43
KPMG Peat Marwick LLP
Hartford, Connecticut
January 29, 1998
F-44
INDEPENDENT AUDITORS' REPORT
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 the related
consolidated income statements and statements of shareholders' equity and
cash flows for each of the two 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 schedule listed
at Item 14(d). Our responsibility is to express an opinion on these financial
statements and schedule 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 preceding 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 the consolidated results of its
operations and its cash flows for each of the two years in the period ended
December 31, 1996, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statements schedule
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.
F-45
Ernst & Young LLP
New York, New York
March 21, 1997
F-46
SELECTED QUARTERLY FINANCIAL DATA (Unaudited)
Selected quarterly financial data for 1997 and 1996 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.
- --------------------------------------------------------------------------------------------------------------------
1997 Three Months Ended (a) 1996 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 $ 82.8 $ 79.4 $ 70.3 $81.7 $ 72.8 $89.9 $ 82.6 $ 87.2
Expenses 92.8 78.7 82.7 82.0 120.1 81.2 76.9 69.0
--------------------------------------------------------------------------
Pretax operating earnings (loss) (10.0) .7 (12.4) (.3) (47.3) 8.7 5.7 18.2
Net realized investment gains (losses) 49.1 21.8 16.2 9.6 10.4 (1.6) 1.4 28.3
--------------------------------------------------------------------------
Pretax earnings (loss) 39.1 22.5 3.8 9.3 (36.9) 7.1 7.1 46.5
Income tax provision (benefit) 14.7 7.1 3.2 4.4 (5.8) 3.4 3.6 17.7
--------------------------------------------------------------------------
After tax earnings (loss) 24.4 15.4 .6 4.9 (31.1) 3.7 3.5 28.8
Loss on early extinguishment of debt,
after tax -- -- (6.0) -- -- -- -- --
--------------------------------------------------------------------------
Net income (loss) 24.4 15.4 (5.4) 4.9 (31.1) 3.7 3.5 28.8
Change in net unrealized gains,
after tax (18.1) 36.3 44.5 (6.4) 36.5 18.5 16.5 (16.9)
--------------------------------------------------------------------------
Comprehensive net income (loss) $ 6.3 $ 51.7 $ 39.1 $(1.5) $ 5.4 $22.2 $ 20.0 $ 11.9
==========================================================================
Basic earnings per share:
After tax earnings (loss) $ 3.89 $ 2.41 $ .09 $ .71 $(4.37) $ .50 $ .45 $ 3.75
Net income (loss) 3.89 2.41 (.80) .71 (4.37) .50 .45 3.75
Comprehensive net income (loss) 1.01 8.09 5.82 (.22) .76 3.05 2.61 1.55
Diluted earnings per share:
After tax earnings (loss) 3.50 2.18 .08 .65 (4.37) .46 .42 3.45
Net income (loss) 3.50 2.18 (.73) .65 (4.37) .46 .42 3.45
Comprehensive net income (loss) .90 7.31 5.29 (.20) .76 2.79 2.40 1.42
====================================================================================================================
(a) The quarterly amounts for the three month period ended June 30, 1997
include a $9.2 million pretax loss on early extinguishment of Source One's
debt which served to decrease second quarter 1997 net income by $6.0
million. The quarterly amounts for the three month period ended December
31, 1997 include $49.1 million of pretax realized investment gains which
served to increase fourth quarter 1997 net income by $31.9 million.
(b) The quarterly amounts for the three month period ended March 31, 1996
include a $20.0 million pretax recovery of the valuation allowance for the
impairment of Source One's capitalized mortgage servicing rights which
served to
F-47
increase first quarter 1996 net income by $13.0 million. The quarterly
amounts for the three month period ended December 31, 1996 include a $32.6
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.
SCHEDULE I
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
(Parent Company Only)
CONDENSED BALANCE SHEETS
- --------------------------------------------------------------------------------
December 31,
-----------------------
Millions 1997 1996
- --------------------------------------------------------------------------------
Assets:
Fixed maturity investments $ -- $ 46.0
Common equity securities and other investments 49.2 100.1
Short-term investments, at amortized cost 2.3 .3
Other assets 40.4 18.1
Investments in unconsolidated insurance affiliates -- 27.7
Investments in consolidated affiliates 857.8 725.2
-----------------------
Total assets $949.7 $ 917.4
- ---------------------------------------------------------=======================
Liabilities:
Long-term debt with third parties $115.6 $ 115.4
Intercompany borrowings 30.0 --
Accounts payable and other liabilities 130.5 115.0
-----------------------
Total liabilities 276.1 230.4
Shareholders' equity 673.6 687.0
-----------------------
Total liabilities and shareholders' equity $949.7 $ 917.4
================================================================================
CONDENSED INCOME STATEMENTS
- -------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------
Millions 1997 1996 1995
- -------------------------------------------------------------------------------
Revenues $ 8.5 $ 11.7 $ 28.7
FS-1
Expenses 21.2 15.5 68.9
-----------------------------
Pretax operating loss (12.7) (3.8) (40.2)
Net realized investment gains (losses) 44.2 (3.1) 12.6
-----------------------------
Pretax earnings (loss) 31.5 (6.9) (27.6)
Income tax provision (benefit) 16.3 .5 (8.7)
-----------------------------
Parent company only operating income (loss) 15.2 (7.4) (18.9)
Earnings from consolidated affiliates 24.1 12.3 37.4
Tax benefit from sale of discontinued operations -- -- 66.0
Loss on early extinguishment of debt, after tax -- -- (.4)
-----------------------------
Consolidated net income $ 39.3 $ 4.9 $ 84.1
Consolidated change in net unrealized
investment gains, after tax 56.3 54.6 18.2
-----------------------------
Consolidated comprehensive net income $ 95.6 $ 59.5 $ 102.3
===============================================================================
FS-2
SCHEDULE I
(continued)
FUND AMERICAN ENTERPRISES HOLDINGS, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF CASH FLOWS
- ----------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------
Millions 1997 1996 1995
- ----------------------------------------------------------------------------------------------------------
Net income $ 39.3 $ 4.9 $ 84.1
Charges (credits) to reconcile net income to net cash from operations:
Net realized investment (gains) losses (44.2) 3.1 (12.6)
Earnings from consolidated subsidiaries (24.1) (12.3) (37.4)
Undistributed earnings from unconsolidated insurance affiliates (.4) (1.1) (9.0)
Changes in current income taxes receivable and payable 5.1 28.4 2.9
Deferred income tax (benefit) provision (3.7) .1 (13.5)
Dividends and return of capital distributions received from subsidiaries -- 65.0 233.3
Tax benefit from sale of discontinued operations -- -- (66.0)
Compensation expense resulting from warrant extension -- -- 46.2
Other, net 2.4 (15.9) (3.7)
-----------------------------
Net cash (used for) provided from operations (25.6) 72.2 224.3
- ----------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Net (increase) decrease in short-term investments (2.0) 28.2 34.3
Sales of investment securities 119.4 134.4 45.1
Purchases of investment securities -- (108.9) (41.3)
Investments in consolidated affiliates (12.7) (25.2) (77.2)
Investments in unconsolidated affiliates -- (27.7) (33.8)
Purchases of fixed assets -- (.8) --
-----------------------------
Net cash provided from (used for) investing activities 104.7 -- (72.9)
- ----------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Purchases of common stock retired (103.8) (66.3) (65.5)
Proceeds from issuances of common stock from treasury -- -- 3.3
Intercompany borrowings from subsidiaries 30.0 -- --
Repayments of long-term debt -- -- (7.9)
Redemption of preferred stock -- -- (75.0)
Dividends paid to shareholders (5.3) (5.9) (6.4)
-----------------------------
Net cash used for financing activities (79.1) (72.2) (151.5)
- ----------------------------------------------------------------------------------------------------------
Net decrease in cash during year -- -- (.1)
Cash balance at beginning of year -- -- .1
- ----------------------------------------------------------------------------------------------------------
Cash balance at end of year $ -- $ -- $ --
==========================================================================================================
FS-3