<PAGE>   1
                                    TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS

     The consolidation in the mortgage banking business continued to gain speed
     in 1998. The largest originator produced over $100 billion of mortgage
     loans. Over 15 consolidating acquisitions were completed during the year.
     This consolidation activity has contributed to intense price competition.
     Smaller independent mortgage banks such as Source One Mortgage Services
     Corporation will survive in this environment by focusing on high quality
     service, tightly defined niches and entrepreneurial origination structures
     such as Central Pacific Mortgage (CPM), our net branch subsidiary.

     With those business factors in mind, Source One had a very successful 1998.
     Not only did we follow a closely structured business plan, but we
     implemented a number of successful changes. Due to those efforts, we are
     pleased to report record results in 1998.

OPERATING RESULTS

     Source One achieved new loan production of $12 billion, making it a record
     year. Further, we achieved our highest return on equity in the 13 years of
     Fund American ownership. The mortgage operation's GAAP ROE for 1998 was
     25%. Net income applicable to common stock was $42.2 million, also a
     record. The residential mortgage loan business was fueled by a very strong
     economy and declining interest rates. These external factors coupled with
     our strategic initiatives in 1997 and 1998 produced an outstanding result
     for Source One.

     We reached the #5 position in GNMA market share in a market dominated by
     highly capitalized banks. We reduced our common equity base by sending $104
     million of capital to Fund American. We squeezed our costs in the face of
     record volume and found $4 million of cost savings.

HIGH QUALITY SERVICE

     Source One has been one of the most efficient servicers and subservicers in
     the mortgage banking industry over the past decade while, at the same time,
     continually focusing on the specific needs of our customers (mortgagors,
     investors and servicers). For example, Source One has been recognized in
     annual cost surveys as one of the lowest cost servicers of all loan types.
     We have also been a pioneer in such areas as the use of voice response
     units and power dialers, a payoff imaging system, totally automated fax
     response capabilities, behavioral scoring, and loss mitigation.
     Consequently, Source One has been able to provide quality service at a low
     cost.

     Standard & Poor's and Fitch IBCA performed detailed servicing evaluations
     of our servicing operations in 1998. Both independent organizations issued
     reports concluding that Source One is a superior mortgage loan servicer. 

     In fact, the Chase subservicing agreement was extended for two additional
     years, due in part to the excellent service Source One provides. We also
     added seven new subservicing customers. These favorable evaluations are a
     credit not only to our experienced servicing team, but also to the
     excellent automation systems that support this group.

PRODUCTION

     The strong production market resulted in a volume of $12 billion. We
     continued with our plan of concentrating on higher margin government
     production, bringing our product mix up to 70% government.

     All of our production areas have focused on selling niche products in 1998.
     In addition, Source One opened 34 new branch offices in 1998 reaching a
     total of 163 offices at year end (up 26% from year end 1997).

     Early in 1998 Source One recognized a unique opportunity within the
     high-margin mortgage marketplace and quickly capitalized by creating an
     independent subprime (B-C) operation located in Lagrangeville, NY. This
     state-of-the-art facility is fully staffed with mortgage professionals who
     are responsible for the origination, sales, and subservicing of subprime
     loans.

     We felt the need to bolster our existing product lines with some
     high-margin niche programs including subprime in order to augment our
     conventional production during economic shifts and market downturns. Based
     upon our solid name recognition and dedicated effort, the up-start Subprime
     Division has quickly established itself as a formidable contender in the
     often volatile B-C marketplace.

     Our overall goal of increasing our niche and high margin products proved
     successful. Source One produced $374 million of new product volume in 1998,
     up from $65 million in 1997.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report   1



<PAGE>   2


TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS

TECHNOLOGICAL ADVANCEMENTS

     Source One purchased the Empower Loan Origination System from Eastern
     Software in the fall. This product is a state-of-the art client/server
     system that handles the full scope of origination activities, from lead
     management through setup on the servicing system to post-closing. The
     system is an "open architecture" format that allows the individual
     production units to customize their workflows for both sales and operations
     to increase productivity and reduce expense.  

     The system is unique in that it is designed to support different lines of 
     the mortgage business, including broker, retail, subprime, telemarketing 
     and correspondent.

     The system was rolled out in our New York Subprime Division late in 1998.
     Further rollout of the system to the remainder of the Source One production
     units should be complete in 1999.

     Amid our system upgrades we have paid detailed attention to the Year 2000
     Compliance issue. We are confident in reporting that Source One's computer
     system is at 100% compliance. In fact, a review by independent consultants
     in November of 1998 revealed all of our systems are prepared to handle
     business as usual on January 1, 2000.

SENIOR MANAGEMENT

     Melinda Cain was promoted to Senior Vice President in 1998 and is
     responsible for overseeing Capital Markets, Portfolio Management and
     backroom operations.

     Thomas Marshall was promoted to Senior Vice President in 1998 and is
     responsible for aspects of Secondary Marketing. This includes pipeline
     hedging, pool delivery, loan pricing and gestation repo programs.

     Mike Muldoon joined the Company in 1998 as a Senior Vice President
     responsible for the Subprime Subservicing Unit in Lagrangeville, NY.

     John Jansen, Senior Vice President of Human Resources, retired in January
     1999. He was replaced by Greg Ghilardi, Senior Vice President.

SUBSEQUENT EVENTS

     In late March 1999, Source One and Citicorp Mortgage, Inc. reached an
     agreement under which Citicorp Mortgage, Inc. will purchase substantially
     all of the mortgage-banking-related assets, assume certain liabilities, and
     employ substantially all of the employees of Source One. Closing is
     contingent upon receipt of various regulatory and agency approvals. The
     successful execution of our strategic plan and our operational success in
     1998 have been material contributors to the successful positioning of
     Source One. We are very pleased with this transaction and look forward to
     watching our small part of the largest financial institution in the world
     grow in the years to come.


Sincerely,

Frank Mohan                                 James Ozanne
-----------------                           ------------
Frank Mohan                                 James Ozanne
President and CEO                           Chairman

March 29, 1999



2   Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   3


                   SELECTED CONSOLIDATED FINANCIAL DATA & CORPORATE INFORMATION*

<TABLE>
<CAPTION>
===================================================================================================================================
INCOME STATEMENT DATA
-----------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,                                    1998            1997             1996             1995             1994
(in thousands, except per share amounts)
-----------------------------------------------------------------------------------------------------------------------------------

<S>                                                 <C>             <C>              <C>              <C>              <C>        
Total revenue                                       $   208,368     $    89,993      $   141,423      $   148,595      $   142,493
Total expenses                                          138,215         101,140          136,296          105,313          137,215
Income (loss) before income taxes,
   extraordinary loss and cumulative
   effect of accounting change                           70,153         (11,147)           5,127           43,282            5,278
Income tax expense (benefit)                             24,243          (3,617)           9,453           16,132            4,474
-----------------------------------------------------------------------------------------------------------------------------------
Income (loss) before extraordinary
   loss and cumulative effect
   of accounting change                                  45,910          (7,530)          (4,326)          27,150              804
Extraordinary loss on retirement of debt                   --            (5,975)            --               (902)            --
Cumulative effect of accounting change (a)                 --              --               --               --            (44,296)
-----------------------------------------------------------------------------------------------------------------------------------
Net income (loss)                                   $    45,910     $   (13,505)     $    (4,326)     $    26,248      $   (43,492)
Less dividends on preferred stock                         3,707           3,707            3,707            7,634            6,642
-----------------------------------------------------------------------------------------------------------------------------------
Net income (loss) applicable to
   common stock                                     $    42,203     $   (17,212)     $    (8,033)     $    18,614      $   (50,134)
-----------------------------------------------------------------------------------------------------------------------------------
Basic net income (loss) per common share: (b)
Before extraordinary loss and cumulative
   effect of accounting change                      $     13.14     $     (3.78)     $     (3.57)     $      7.55      $     (1.65)
Basic net income (loss) per common share                  13.14           (5.79)           (3.57)            7.20           (14.21)
-----------------------------------------------------------------------------------------------------------------------------------
Cash dividends per common share (c)                 $     32.39     $      --        $      --        $      --        $      --
Cash dividends declared on common shares                104,033            --               --               --               --
Payment for common shares repurchased                      --             2,638             --            120,000          122,000
Issuance of common shares                                  --           119,040             --               --               --
===================================================================================================================================
COMPREHENSIVE INCOME STATEMENT DATA (d)
-----------------------------------------------------------------------------------------------------------------------------------
Net income (loss)                                   $    45,910         (13,505)     $    (4,326)     $    26,248      $   (43,492)
Other comprehensive income (loss)                        19,294          41,102              546            3,519           (3,779)
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss)                         $    65,204          27,597      $    (3,780)     $    29,767      $   (47,271)
-----------------------------------------------------------------------------------------------------------------------------------
Basic comprehensive income
   (loss) per common share (b)                      $     19.15            8.03      $     (3.33)     $      8.57      $    (15.28)
===================================================================================================================================
OPERATING DATA
-----------------------------------------------------------------------------------------------------------------------------------
Total mortgage loan production (e) (in millions)    $    10,866           4,403      $     3,831      $     2,852      $     4,586
Servicing portfolio at end of year: (f)
   Balance (in millions)                            $    25,112          26,546      $    29,201      $    31,831      $    39,568
   Number of loans serviced (g)                         384,466         438,261          478,779          494,051          543,428
   Weighted average interest rate (g)                      7.99%           8.45%            8.48%            8.33%            8.14%
   Weighted average net servicing fee (g)(h)               .397%           .420%            .422%            .419%            .410%
   Percent delinquent (g)                                  7.07%           6.35%            6.24%            5.28%            4.07%
   Percent in process of foreclosure                       1.50%           1.18%             .93%             .80%             .77%
Servicing rights acquisitions (in millions)         $      --                36      $     2,789      $     4,674      $     3,707
Sale of servicing rights (in millions)              $    10,647          17,018      $     3,302      $    10,973      $     3,868
Number of employees at end of year                        2,212           1,572            1,682            1,680            2,055
-----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA
December 31, (in thousands)
-----------------------------------------------------------------------------------------------------------------------------------
Mortgage loans receivable                           $   676,317         519,247      $   314,937      $   381,028      $   210,472
Capitalized servicing (net) (i)                         169,688         181,025          410,939          397,071          530,450
Total assets                                          1,517,977       1,304,690        1,131,054        1,135,029        1,210,012
Senior debt                                             814,593         686,906          643,262          661,846          647,251
Subordinated debt                                        55,771          55,153           54,535           54,786             --
Total liabilities                                     1,105,464         849,641          816,297          812,785          733,925
Total stockholders' equity                              412,513         455,049          314,757          322,244          476,087
===================================================================================================================================
</TABLE>

* See accompanying notes to selected consolidated financial data.



Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report   3



<PAGE>   4


NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA & CORPORATE INFORMATION

(a)  The 1994 amount reflects the cumulative after tax effect, as of January 1,
     1994, of a change in the methodology used to measure impairment of the
     purchased mortgage servicing rights asset.
(b)  Basic net income (loss) and basic comprehensive income (loss) per common
     share amounts for all years presented are based on the weighted average
     number of common shares outstanding.
(c)  Cash dividends per common share were computed based on the total number of
     common shares outstanding as of the dividend record dates.
(d)  Comprehensive income (loss) includes net income (loss) and the net change
     in after tax unrealized investment gains (refer to Note 1 to the
     consolidated financial statements for further discussion).
(e)  Excludes mortgage loan production originated by the Company's retail
     branches that is sold directly to third parties on a whole loan basis
     totaling $1,201 million, $680 million, $496 million and $390 million for
     the years ended December 31, 1998, 1997, 1996 and 1995, respectively.
(f)  Includes loans subserviced for others having a principal balance of $15.9
     billion, $14.9 billion, $2.8 billion, and $4.0 billion as of December 31,
     1998, 1997, 1996, and 1995, respectively, except as noted.
(g)  Excludes interim servicing of loans having a principal balance of $1.7
     billion as of December 31, 1994.
(h)  Excludes loans subserviced for others as noted in (e) above.
(i)  Reflects a $68.1 million cumulative pretax adjustment to the purchased
     mortgage servicing rights asset as of January 1, 1994 relating to a change
     in the methodology used to measure its impairment.

FORM 10-K
--------------------------------------------------------------------------------

     The financial information contained in this report substantially conforms
     with the information required in the "Form 10-K" Annual Report filed by the
     Company with the Securities and Exchange Commission at the end of March
     1999. Certain supplemental information appears in such Form 10-K that is
     not necessarily disclosed within this document. Copies of such Form 10-K
     (without exhibits) are available, without charge, upon request to the
     Corporate Secretary's Office, Source One Mortgage Services Corporation,
     27555 Farmington Road, Farmington Hills, Michigan 48334-3357 (telephone:
     (248) 488-7000).

BUSINESS
--------------------------------------------------------------------------------

     The Company primarily engages in the business of producing and selling
     conforming and subprime residential mortgage loans, servicing conforming
     residential mortgage loans and subservicing residential mortgage loans for
     third parties. In response to increased industry competition for producing
     and servicing conforming mortgage loans, the Company decided to broaden its
     product line by offering higher margin products. The Company began to
     produce 203(k) (FHA home improvement) loans, manufactured housing loans,
     subprime loans and high loan-to-value ("high LTV") second mortgage loans in
     late 1997. The 203(k) loans and the manufactured housing loans are being
     sold into agency pools with servicing retained. The subprime and high LTV
     loans are being originated for a fee and sold to third parties on a
     servicing released basis. The Company is currently subservicing subprime
     loans and has the capability to service and subservice subprime and high
     LTV loans. Although these higher margin products are a new focus for the
     Company, they accounted for less than 4% of total production in 1998 and
     are currently expected to account for approximately 8% of total production
     in 1999. The Company's primary sources of revenue are net servicing
     revenue, net interest revenue, net gain on sale of mortgages, net gain on
     sale of servicing, earnings from unconsolidated affiliate and other
     revenue.

     The Company is also engaged, through certain of its subsidiaries, in the
     sale of credit-related insurance products (such as life, disability,
     health, accidental death and property and casualty insurance).

MARKET FOR STOCK AND RELATED MATTERS
--------------------------------------------------------------------------------

     There is no established public trading market for the Company's common
     stock. As of March 31, 1999, there were two holders of the 3,211,881 shares
     of the Company's issued and outstanding common stock, White Mountains
     Holdings, Inc. ("White Mountains") (formerly Fund American Enterprises,
     Inc.), and its parent Fund American Enterprises Holdings, Inc. ("Fund
     American").

     During the year ended December 31, 1998, the Company declared and paid cash
     dividends on its common stock totaling $104.0 million. The Company did not
     declare or pay cash dividends on its common stock during the years ended
     December 31, 1997 or 1996. The Company's secured revolving credit
     facilities contain covenants which limit its ability to pay dividends or
     make distributions on its capital to holders of its common stock. In
     addition, the Company must comply with certain financial covenants provided
     in its secured revolving credit facilities, including restrictions relating
     to tangible net worth and leverage. The Company is currently in compliance
     with all such covenants.

4   Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   5


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

YEAR ENDED DECEMBER 31, 1998 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1997
--------------------------------------------------------------------------------

     SUMMARY - The Company reported net income of $45.9 million for the year
     ended December 31, 1998 compared to a net loss of $13.5 million for the
     year ended December 31, 1997. The 1998 results include a $15.2 million
     pretax gain on sale of servicing, $13.8 million pretax equity in earnings
     of an unconsolidated affiliate and a $14.8 million pretax charge for
     impairment of the Company's capitalized servicing asset, which was offset
     by a $20.4 million pretax net gain on financial instruments. The 1997
     results include an $8.0 million pretax loss on the sale of servicing to a
     third party and the related assumption of subservicing, $9.5 million pretax
     equity in earnings of an unconsolidated affiliate and a $21.2 million
     pretax charge for impairment of the Company's capitalized servicing asset,
     which was partially offset by a $11.3 million net gain on financial
     instruments. The 1997 results also include the following one-time charges:
     a $9.2 million pretax extraordinary loss on the early retirement of debt, a
     $3.0 million pretax charge related to loans held for investment which were
     identified for sale and marked down from amortized cost to current market
     value, $3.1 million of pretax restructuring and compensation charges and
     $2.1 million of other miscellaneous charges.

     The Company reported comprehensive income (which includes the net change in
     after tax unrealized investment gains) of $65.2 million for the year ended
     December 31, 1998 compared to $27.6 million in 1997. The Company's
     unrealized investment gains are associated with its investment in Financial
     Security Assurance Holdings Ltd. ("FSA"), which it acquired during 1997
     (refer to Note 2 to the consolidated financial statements for further
     discussion).

     Total mortgage loan production for the years ended December 31, 1998 and
     1997 was $10.9 billion and $4.4 billion, respectively. The significant
     increase in 1998 mortgage loan production reflects lower market interest
     rates and a corresponding increase in refinance activity throughout 1998 as
     compared to 1997. Production related to refinancing activity made up
     approximately 61% of the Company's total production for 1998 as compared to
     approximately 40% for 1997.

     During the first quarter of 1999, interest rates increased from year end
     1998 levels. The increase in interest rates has resulted in a slight
     decrease in the Company's 1999 first quarter mortgage loan production
     volume from the fourth quarter of 1998. There can be no assurance that
     these results will continue, however, since management cannot predict the
     interest rate environment for the remainder of 1999.

     Although 1998 production increased significantly, the Company's total
     mortgage servicing portfolio decreased to $25.1 billion as of December 31,
     1998 from $26.5 billion as of December 31, 1997. Consistent with its goal
     to minimize exposure to interest rate risk inherent in its capitalized
     servicing asset, the Company sold the rights to service $10.6 billion of
     its nonrecourse mortgage servicing portfolio to third parties during 1998.
     The Company continues to service $4.1 billion of these loans pursuant to
     the subservicing agreement discussed below. During 1997, the Company sold
     the rights to service $17.0 billion of its nonrecourse mortgage servicing
     portfolio to a third party ("the 1997 Servicing Sale") and continues to
     service the loans pursuant to a subservicing agreement ("the 1997
     Subservicing Agreement"). In December 1997, the 1997 Subservicing Agreement
     was amended to extend the Company's subservicing responsibilities for one
     additional year at less favorable terms than the original agreement
     provided. In early November 1998, the Company amended the 1997 Subservicing
     Agreement again to extend its subservicing responsibilities for two
     additional years at slightly more favorable terms than the first amendment
     provided. As a result, the Company will continue to service these loans at
     least until March 2001, June 2001 and August 2001 for Federal Home Loan
     Mortgage Corporation ("FHLMC" or "Freddie Mac"), Government National
     Mortgage Association ("GNMA" or "Ginnie Mae"), and Federal National
     Mortgage Association ("FNMA" or "Fannie Mae") loans, respectively.

     The following table summarizes the Company's portfolio of mortgage loans
     serviced as of December 31, 1998 and 1997:

<TABLE>
<CAPTION>
========================================================================================================================
December 31, (in millions)                                                               1998                     1997
------------------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>                        <C>      
Mortgage servicing portfolio owned                                                $     9,197                $  11,627
Mortgage servicing portfolio serviced for others                                       15,915                   14,919
------------------------------------------------------------------------------------------------------------------------
Total mortgage servicing portfolio                                                $    25,112                $  26,546
========================================================================================================================
</TABLE>

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report   5



<PAGE>   6


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     Mortgage loan payoffs for the years ended December 31, 1998 and 1997 were
     $4.9 billion and $3.0 billion, respectively. The average prepayment rate of
     the Company's total servicing portfolio was 21.2% for 1998 as compared to
     10.5% for 1997. The increase in payoffs also reflects lower market interest
     rates and the corresponding increase in refinance activity in 1998 as
     compared to 1997, the effects of which were offset by a smaller average
     owned servicing portfolio.

     REVENUE- Mortgage servicing revenue decreased to $78.1 million in 1998 from
     $95.0 million in 1997. The decrease in mortgage servicing revenue is
     primarily the result of (i) the 1998 and 1997 servicing sales; (ii) lower
     subservicing revenue resulting from the first amendment to the 1997
     Subservicing Agreement and (iii) the recognition of the remaining deferred
     gain on the Company's 1994 sale of servicing in 1997 as discussed below.
     Amortization of capitalized servicing was $55.2 million and $68.0 million
     for the years ended December 31, 1998 and 1997, respectively. Amortization
     includes the change in the valuation allowances for impairment of the
     Company's capitalized servicing asset as indicated in the following table:

<TABLE>
<CAPTION>
=========================================================================================================================
Year ended December 31, (in thousands)                                                         1998                  1997
-------------------------------------------------------------------------------------------------------------------------
<S>                                                                                     <C>                    <C>       
Scheduled amortization of capitalized servicing                                         $    40,420            $   46,417
Increase in valuation allowances for impairment                                              14,759                21,614
-------------------------------------------------------------------------------------------------------------------------
Total amortization of capitalized servicing                                             $    55,179            $   68,031
=========================================================================================================================
</TABLE>

     The impairment charge in 1998 is primarily the result of increased market
     consensus prepayment rates and a corresponding decrease in the fair value
     of the Company's capitalized servicing asset during 1998. The impairment
     charge in 1997 is primarily the result of increased market consensus
     prepayment rates and a corresponding decrease in the fair value of the
     Company's capitalized servicing asset during 1997. Excluding the effects of
     these charges, 1998 amortization expense decreased by $6.0 million from
     1997. This decrease is primarily due to the reduction in amortization of
     the Company's subservicing asset. The net carrying value of the
     subservicing asset, which relates to the 1997 Servicing Sale, was reduced
     in connection with the first amendment to the 1997 Subservicing Agreement.
     The remaining balance is being amortized on a straight-line basis over the
     subservicing period and tested for impairment.

     In 1994, the Company sold the rights to service $3.9 billion of mortgage
     loans to a third party and continued to service these loans pursuant to a
     subservicing agreement. The gain of $19.9 million was deferred and was
     being recognized over the five-year life of the subservicing agreement. In
     the fourth quarter of 1997, the third party sold the rights to service the
     remaining portfolio of loans subserviced by the Company. As a result, the
     Company recognized the remaining $4.4 million balance of the deferred gain.
     The Company recognized deferred gain totaling $6.9 million in 1997 which
     was included in mortgage servicing revenue in the 1997 consolidated
     statement of income.

     In order to offset changes in the value of its capitalized servicing asset
     and to mitigate the effect on earnings of higher amortization and
     impairment of the asset which results from increased prepayment activity,
     the Company invests in various financial instruments. As interest rates
     decline, prepayment activity generally increases, thereby reducing the
     value of the capitalized servicing asset, while the value of the financial
     instruments increases. Conversely, as interest rates increase, the value of
     the capitalized servicing asset increases, while the value of the financial
     instruments decreases. The financial instruments utilized by the Company
     include interest rate floor contracts, interest rate swap agreements and
     principal-only swap agreements.

     The Company recognized a net gain on its financial instruments of $20.4
     million for the year ended December 31, 1998. The 1998 net gain includes a
     net realized gain of $3.6 on the sales of financial instruments, realized
     gains of $4.7 million from net cash flows received and $12.1 million in
     unrealized gains due to a net increase in the fair value of the various
     financial instruments. The Company recognized a net gain on its financial
     instruments of $11.3 million for the year ended December 31, 1997. The 1997
     net gain includes a net realized gain of $.1 million on the sales of
     financial instruments, realized gains of $.1 million from net cash flows
     received and $11.1 million in unrealized gains due to a net increase in the
     fair value of the various financial instruments (refer to Note 10 to the
     consolidated financial statements for further discussion).

     Interest income increased to $85.4 million in 1998 from $45.8 million in
     1997. The increase in interest income is primarily the result of the
     increase in mortgage loan production and the corresponding increase in the
     average mortgage loans receivable inventory. Interest expense was $70.2
     million and $35.4 million for the years ended

6   Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   7


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     December 31, 1998 and 1997, respectively. This increase is primarily the
     result of increased short-term borrowings necessary to fund the increase in
     1998 production and an increase in cost of borrowings due to the Company's
     inability to issue commercial paper, slightly offset by the effect of the
     early retirement of medium-term notes in the second quarter of 1997.

     The Company realized a net investment gain of $2.2 million for the year
     ended December 31, 1998 compared to a net investment loss of $1.0 million
     for the year ended December 31, 1997. The 1998 gain is primarily the result
     of a realized gain from a distribution received on a partnership
     investment. The 1997 loss is primarily the result of the write-down of
     certain investments to realizable value.

     In mid-March 1997, the Board of Directors of Fund American and several of
     its subsidiaries approved a corporate restructuring plan that strengthened
     the Company by increasing its stockholders' equity. The most significant
     part of the plan was the contribution by White Mountains of its investment
     in FSA to the Company in exchange for shares of the Company's common stock.
     The Company recognized $13.8 million and $9.5 million of equity in earnings
     of FSA as a result of its investment for the years ended December 31, 1998
     and 1997, respectively (refer to Notes 2 and 9 to the consolidated
     financial statements for further discussion).

     Net gain on mortgage sales increased to $86.8 million in 1998 from $21.5
     million in 1997. This increase is primarily the result of increased
     mortgage loan sales volumes and the related increase in capitalized
     originated mortgage servicing rights ("OMSR") income and gains on mortgage
     sales. The 1997 net gain on sale of mortgages also includes a $3.0 million
     pretax charge in the second quarter of 1997 relating to the Company's
     mortgage loans held for investment which were identified for sale and
     marked down from amortized cost to current market value (refer to Note 7 to
     the consolidated financial statements for further discussion).

     The Company recorded a $15.2 million pretax gain on sale of servicing
     during 1998, which reflects the sales of the rights to service
     approximately $10.6 billion of the Company's nonrecourse mortgage servicing
     portfolio to third parties and adjustments to previous sales. During the
     fourth quarter of 1998, the Company recorded a $4.9 million pretax gain on
     sale of servicing, which included adjustments of approximately $2.6 million
     primarily related to servicing sales prior to the fourth quarter. The
     Company recorded a $4.3 million pretax loss from the sale of the right to
     service $17.0 billion of its nonrecourse mortgage servicing portfolio and
     the related assumption of subservicing in the first half of 1997. The
     Company recorded an additional loss of $3.7 million in the fourth quarter
     of 1997 in connection with the first amendment to the 1997 Subservicing
     Agreement.

     Other revenue was $31.9 million and $19.1 million for the years ended
     December 31, 1998 and 1997, respectively. The increase in other revenue
     primarily reflects an increase in ancillary production income associated
     with the increase in production volumes in 1998.  

     EXPENSES - Salaries and employee benefits expense was $78.7 million and 
     $54.8 million for the years ended December 31, 1998 and 1997, respectively.
     Generally accepted accounting principles ("GAAP") require certain loan 
     origination revenues to be netted against direct loan origination costs. 
     Since salaries and employee benefits expense is the largest component of 
     loan origination costs, approximately 90% of loan origination revenues are 
     accounted for as a reduction to salaries and benefits expense as indicated 
     in the following table:

<TABLE>
<CAPTION>
==========================================================================================================================
Year ended December 31, (in thousands)                                                          1998                 1997
--------------------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>                  <C>        
Unadjusted salaries and employee benefits expense                                        $   115,854          $    74,405
GAAP net origination revenues                                                                (37,162)             (19,611)
--------------------------------------------------------------------------------------------------------------------------
GAAP salaries and employee benefits expense                                              $    78,692          $    54,794
==========================================================================================================================
</TABLE>

     An increase in loan origination revenues, reflecting the significant
     increase in retail mortgage loan production during 1998 as compared to
     1997, partially offset the increase in unadjusted salaries and employee
     benefits expense. Excluding the effects of loan origination revenue,
     unadjusted salaries and benefits expense increased 56%. This increase is
     primarily due to the increase in loan officer commissions associated with
     the significant increase in 1998 mortgage loan production and increased
     headcount due to an expansion of the production network.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report   7



<PAGE>   8


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     The provision for loan losses was $3.8 million and $4.7 million for the
     years ended December 31, 1998 and 1997, respectively. The 1997 provision
     includes a $.4 million charge related to the sale of a commercial real
     estate owned property in the second quarter of 1997. A valuation allowance
     of $2.6 million was included in the December 31, 1996 allowance for loan
     losses for this property.

     In April 1997, the Company's management approved and implemented a
     restructuring plan designed to reduce its operating costs in order to
     improve its financial performance. As part of this plan, the Company
     reduced its work force, primarily in overhead areas, by approximately 100
     employees during the second quarter of 1997 to bring its overhead costs in
     line with its production and servicing operations. As a result, the Company
     recognized restructuring charges totaling $1.7 million during the second
     quarter of 1997 (refer to Note 12 to the consolidated financial statements
     for further discussion).

     Other operating expenses were $42.5 million and $26.6 million for the years
     ended December 31, 1998 and 1997, respectively. The increase in 1998 is
     primarily due to increased loan processing and general office expenses
     related to the increased production volumes and additional travel,
     advertising and promotional expenses incurred in 1998 related to the
     Company's subprime and high loan-to-value business entered into in the
     third quarter of 1997.

     The Company recognized an extraordinary loss of $6.0 million, net of income
     tax benefit, on the early retirement of $119.6 million of its outstanding
     8.875% medium-term notes due October 15, 2001 in the second quarter of
     1997.

YEAR ENDED DECEMBER 31, 1997 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1996
--------------------------------------------------------------------------------

     SUMMARY - The Company reported a net loss of $13.5 million for the year
     ended December 31, 1997 compared to a net loss of $4.3 million for the year
     ended December 31, 1996. The 1997 results include an $8.0 million pretax
     loss on the sale of servicing to a third party and the related assumption
     of subservicing, $9.5 million pretax equity in earnings of an
     unconsolidated affiliate and a $21.2 million pretax charge for impairment
     of the Company's capitalized servicing asset, which was partially offset by
     a $11.3 million net gain on financial instruments. The 1997 results also
     include the following one-time charges: a $9.2 million pretax extraordinary
     loss on the early retirement of debt, a $3.0 million pretax charge related
     to loans held for investment which were identified for sale and marked down
     from amortized cost to current market value, $3.1 million of pretax
     restructuring and compensation charges and $2.1 million of other
     miscellaneous charges. The 1996 results include a $10.1 million pretax gain
     on the sale of servicing, a $29.1 million pretax charge for the write-off
     of the Company's goodwill and other intangible assets and a $8.2 million
     pretax charge for impairment of its capitalized servicing asset, which was
     offset by a $9.9 million pretax net gain on financial instruments.

     The Company reported comprehensive income (which includes the net change in
     after tax unrealized gains and losses) of $27.6 million for the year ended
     December 31, 1997. The Company's 1997 unrealized investment gains are
     associated primarily with its investment in FSA, which it acquired during
     1997. For the year ended December 31, 1996, the Company reported a
     comprehensive loss of $3.8 million. The Company's 1996 unrealized
     investment gains are associated with its investment in common equity
     securities.

     Total mortgage production for the years ended December 31, 1997 and 1996
     was $4.4 billion and $3.8 billion, respectively. Production related to
     refinancing activity made up 40% of total production for 1997 as compared
     to 33% for 1996. The increase in mortgage loan production in 1997 reflects
     overall lower market interest rates during 1997 and a corresponding
     increase in refinance activity from 1996.

8   Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   9


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS


     The Company's total mortgage servicing portfolio decreased to $26.5 billion
     as of December 31, 1997 from $29.2 billion as of December 31, 1996. During
     the year ended December 31, 1997, the Company purchased the rights to
     service $.04 billion of mortgage loans from third parties. In addition, the
     Company sold the rights to service $17.0 billion of its nonrecourse
     mortgage servicing portfolio to a third party ("the 1997 Servicing Sale")
     during 1997 and continues to service these loans pursuant to a subservicing
     agreement. The following table illustrates the change in the Company's
     mortgage servicing portfolio mix primarily as a result of the sale:

<TABLE>
<CAPTION>
======================================================================================================================
December 31, (in millions)                                                                        1997            1996
----------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>             <C>       
Mortgage servicing portfolio owned                                                          $   11,627      $   26,410
Mortgage servicing portfolio subserviced for others                                             14,919           2,791
----------------------------------------------------------------------------------------------------------------------
Total mortgage servicing portfolio                                                          $   26,546      $   29,201
======================================================================================================================
</TABLE>

     During the year ended December 31, 1996, the Company purchased the rights
     to service $2.8 billion of mortgage loans from third parties and sold the
     rights to service $3.3 billion of its mortgage servicing portfolio to third
     parties.

     Mortgage loan payoffs for each of the years ended December 31, 1997 and
     1996 were $3.0 billion. The average prepayment rate of the Company's total
     servicing portfolio was 10.5% for each of the years ended December 31, 1997
     and 1996. The Company's prepayment experience is significantly influenced
     by fluctuations in mortgage interest rates, although the effect is not
     immediate. While overall, mortgage interest rates were lower during 1997
     than in 1996, there was a significant decline in rates in December of 1997.
     Therefore, the average prepayment rates for 1997 do not fully reflect the
     decrease in interest rates as of year end 1997. The average prepayment
     rates for the months of January and February 1998 were 11.6% and 21.9%,
     respectively.

     REVENUE- Mortgage servicing revenue decreased to $95.0 million in 1997 from
     $139.6 million in 1996. The decrease in mortgage servicing revenue is
     primarily due to the 1997 Servicing Sale, slightly offset by increased
     subservicing revenue generated as a result of the sale. The subservicing
     fees, however, are significantly lower than the servicing fees earned on
     the Company's owned servicing portfolio. Amortization of capitalized
     servicing was $68.0 million and $79.1 million for the years ended December
     31, 1997 and 1996, respectively. Amortization includes the change in the
     valuation allowances for impairment of the Company's capitalized servicing
     asset as indicated in the following table:

<TABLE>
<CAPTION>
================================================================================================================================
Year ended December 31, (in thousands)                                                                1997              1996
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                           <C>               <C>       
Scheduled amortization of capitalized servicing                                               $     46,417      $     69,932
Increase in valuation allowances for impairment                                                     21,614             9,261
--------------------------------------------------------------------------------------------------------------------------------
Total amortization of capitalized servicing                                                   $     68,031      $     79,193
================================================================================================================================
</TABLE>

     The 1997 impairment charge is primarily a result of increased market
     consensus prepayment rates and a corresponding decrease in the fair value
     of the Company's capitalized servicing asset during 1997. Excluding the
     effects of these charges, 1997 amortization expense decreased by $23.5
     million from 1996. This decrease in amortization expense is primarily the
     result of a smaller servicing asset due to the 1997 Servicing Sale.

     In 1994, the Company sold the rights to service $3.9 billion of mortgage
     loans to a third party and continued to service these loans pursuant to a
     subservicing agreement. The gain of $19.9 million was deferred and was
     being recognized over the five-year life of the subservicing agreement. In
     the fourth quarter of 1996, the third party sold the rights to service
     approximately $1.0 billion of these mortgage loans, representing
     approximately 25% of the total loans subserviced by the Company for this
     third party. Accordingly, the Company recognized an additional $2.4 million
     of the deferred gain in 1996, representing approximately 25% of the
     deferred balance at the time of sale. In the fourth quarter of 1997, the
     third party sold the rights to service the remaining portfolio of loans. As
     a result, the Company recognized the $4.4 million remaining balance of the
     deferred gain. In 1997 and 1996, the Company recognized deferred gains
     totaling $6.9 million and $6.1 million, respectively, as part of mortgage
     servicing revenue in the consolidated statements of income.

     The Company recognized a net gain on its financial instruments of $11.3
     million for the year ended December 31, 1997. The 1997 net gain includes a
     net realized gain of $.1 million on the sale of financial instruments,
     realized gains of $.1 million from net cash flows received and $11.1
     million in unrealized gains due to a net increase in the fair value of the
     various financial instruments. The Company recognized a net gain on its
     financial instruments of $9.9 million for the year ended December 31, 1996.
     The 1996 net gain includes $8.2 million in realized gains from

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report   9



<PAGE>   10


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     net cash flows received and $1.7 million in unrealized gains due to a net
     increase in the fair value of the various financial instruments.  
     
     Interest income increased to $45.8 million in 1997 from $40.8 million in 
     1996. The increase in interest income is primarily the result of interest 
     income earned on the outstanding receivable balance from the 1997 Servicing
     Sale and an increase in interest income from pool loan purchases due to a 
     higher average asset balance. Interest expense was $35.4 million and $36.0 
     million for the years ended December 31, 1997 and 1996, respectively.

     In 1997, the Company realized a $.3 million gain from the transfer of its
     remaining common equity securities to White Mountains in exchange for
     shares of the Company's common stock held by White Mountains, which were
     then retired by the Company. The 1996 realized loss of $.9 million was a
     result of the Company selling certain common equity securities to White
     Mountains for cash. All of the equity securities involved in such
     transactions were actively traded, readily marketable, listed on a national
     exchange and, for purposes of such transactions, were valued at their
     closing prices on the day preceding the date of each transaction.

     The Company realized a net investment loss of $1.0 million for the year
     ended December 31, 1997 compared to a net investment gain of $.6 million
     for the year ended December 31, 1996. The 1997 loss is primarily the result
     of the write-down of certain investments to realizable value. The 1996 gain
     reflects realized gains related to a partnership investment, offset by the
     write-down of certain investments to realizable value.

     The Company recognized $9.5 million of equity in earnings of FSA as a
     result of its investment for the year ended December 31, 1997 (refer to
     Notes 2 and 9 to the consolidated financial statements for further
     discussion).

     Net gain on mortgage sales decreased to $21.5 million in 1997 from $38.3
     million in 1996. This decrease is primarily due to decreased capitalized
     originated mortgage servicing rights ("OMSR") income as a result of a
     change in the Company's mortgage loan production mix which included a
     proportionately higher volume of correspondent production, which generates
     lower OMSR income. The decrease in the 1997 gain also reflects a $3.0
     million pretax charge relating to mortgage loans held for investment which
     were identified for sale and marked down from amortized cost to current
     market value during the second quarter of 1997.

     The Company recorded a $4.3 million pretax loss from the sale of the rights
     to service $17.0 billion of its nonrecourse mortgage servicing portfolio
     and the related assumption of subservicing in the first half of 1997. The
     Company recorded an additional loss of $3.7 million in the fourth quarter
     of 1997 in connection with the first amendment to the 1997 Subservicing
     Agreement. During 1996, the Company recorded a pretax gain of $10.1 million
     from the sales of the rights to service $3.3 billion of the Company's
     mortgage servicing portfolio.
     
     EXPENSES - Salaries and employee benefits expense was $54.8 million and 
     $56.3 million for the years ended December 31, 1997 and 1996, respectively.
     Generally accepted accounting principles ("GAAP") require certain loan 
     origination revenues to be netted against direct loan origination costs. 
     Since salaries and employee benefits expense is the largest component of 
     loan origination costs, approximately 90% of loan origination revenues are 
     accounted for as a reduction to salaries and benefits expense as indicated 
     in the following table:

<TABLE>
<CAPTION>
===========================================================================================================================
Year ended December 31, (in thousands)                                                         1997               1996
---------------------------------------------------------------------------------------------------------------------------
<S>                                                                                   <C>                <C>          
Unadjusted salaries and employee benefits expense                                     $      74,405      $      76,114
GAAP net origination revenues                                                               (19,611)           (19,820)
---------------------------------------------------------------------------------------------------------------------------
GAAP salaries and employee benefits expense                                           $      54,794      $      56,294
===========================================================================================================================
</TABLE>

     The slight decrease in loan origination revenues, reflecting lower retail
     mortgage loan production during 1997 as compared to 1996, slightly offset
     the decrease in unadjusted salaries and employee benefits expense. The
     decrease in unadjusted salaries and employee benefits expense primarily
     reflects decreased headcount as a result of the Company's restructuring
     plan implemented in the second quarter of 1997, partially offset by an
     increase in the long term incentive plan accrual.

10  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   11


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     The provision for loan losses was $4.7 million and $3.0 million for the
     years ended December 31, 1997 and 1996, respectively. The 1997 provision
     includes a $.4 million charge related to the sale of a commercial real
     estate owned property in the second quarter of 1997. A valuation allowance
     of $2.6 million was included in the December 31, 1996 allowance for loan
     losses and $.9 million was charged to the 1996 provision for this property.
     The 1996 provision also includes $.3 million of gain on the disposition of
     a commercial real estate owned property during 1996.

     In the fourth quarter of 1996, the Company wrote off the remaining carrying
     value of goodwill and certain other intangible assets totaling $29.1
     million. It is the Company's policy to account for goodwill and other
     intangible assets at the lower of amortized cost or fair value. On an
     ongoing basis, management reviews the valuation and amortization of these
     assets. As a part of its ongoing review, management estimates the fair
     value of the Company's intangible assets, taking into consideration any
     events and circumstances which might have diminished their value. During
     1996, the Company had been re-evaluating the recoverability of goodwill and
     certain other intangible assets and considered the impact of the following
     factors on its forecast of future operations (i) increased competition and
     industry consolidation which had adversely impacted the value of the
     Company's mortgage loan production and servicing operation; (ii) the
     attainment of a definitive agreement in the fourth quarter of 1996 to sell
     approximately $17.0 billion of the Company's mortgage servicing portfolio
     at essentially book value and (iii) a reduction in interest rates in the
     fourth quarter of 1996. Based on such valuation, the Company had determined
     that its projected results would not support the future amortization of the
     Company's remaining goodwill and certain other intangible assets of $29.1
     million at December 31, 1996 and, therefore, wrote-off such assets.

     The Company recorded $1.7 million in restructuring charges during the
     second quarter of 1997 as a result of a restructuring plan implemented in
     the second quarter of 1997.

     Other operating expenses were $26.6 million and $34.3 million for the year
     ended December 31, 1997 and 1996, respectively. The decrease in 1997 is
     primarily due to the elimination of amortization expense related to
     goodwill and certain other intangible assets, which were written off at
     year end 1996.

     The Company's income tax provision for the year ended December 31, 1996 was
     adversely impacted by the write-off of goodwill and other intangible assets
     at year end 1996. The total pretax write-off of these assets was $29.1
     million and the related tax benefit was $3.2 million.
     
     The Company recognized an extraordinary loss of $6.0 million, net of income
     tax benefit, on the early retirement of $119.6 million of its outstanding
     8.875% medium-term notes due October 15, 2001 in the second quarter of
     1997.

LIQUIDITY AND CAPITAL RESOURCES
--------------------------------------------------------------------------------

     The Company's primary cash flow requirements relate to funding mortgage
     loan production and investing in mortgage servicing rights. To meet these
     financing needs, the Company relies on short-term credit facilities, medium
     and long-term debt, early funding programs, cash flow from operations and
     cash from the sale of servicing. Management believes capital resources will
     be sufficient to meet the Company's operating needs as well as to fund
     maturing medium and long-term debt.

     The Company amended and restated its $701.0 million secured revolving
     credit agreement in July 1998, to increase its borrowing capacity and
     flexibility. The provisions of the amended agreement increased its
     borrowing capacity from $701.0 million to $800.0 million, which allows the
     Company to meet higher borrowing requirements resulting from increased
     production volumes. The provisions also allow the Company to more fully
     utilize the facility by easing its restrictions with respect to the
     Company's use of its high LTV mortgage loans and non-conforming second
     mortgage loans as collateral and increasing the collateral value of the
     Company's mortgage-backed-security ("MBS") pools. Borrowings under the
     facility are secured primarily by the Company's mortgage loans receivable
     and pool loan purchases. The revolving credit facility expires on July 9,
     1999. As of December 31, 1998, there was $650.5 million outstanding under
     this facility. As of December 31, 1997, there was $559.0 million
     outstanding under the previous facility.

     The Company entered into a new secured credit agreement in May 1998, to
     fund the origination or acquisition of subprime and high LTV loans. Under
     this agreement, the Company may borrow up to $175.0 million through April
     29, 1999. Borrowings under this facility are secured by the underlying
     loans. As of December 31, 1998, there was $21.6 million outstanding under
     this facility.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  11



<PAGE>   12


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     The Company entered into an additional secured credit agreement in July
     1998, to be used for working capital and general corporate purposes,
     including the funding of mortgage loans. Under this agreement, the Company
     may borrow up to $35.0 million through July 9, 1999. Borrowings under this
     facility are secured by the Company's investment in FSA common stock. As of
     December 31, 1998, there were no outstanding borrowings under this
     facility.

     The Company must comply with certain financial covenants provided in its
     secured revolving credit facilities, including restrictions relating to
     tangible net worth and leverage. In addition, there are certain covenants
     which limit the Company's ability to pay dividends or make distributions of
     its capital to holders of its common stock. The limits do not apply to
     preferred stock dividend and subordinated debt interest requirements each
     year. The Company is currently in compliance with all such covenants.

     Central Pacific replaced its existing $15.0 million unsecured revolving
     credit agreement with a new mortgage warehousing agreement in April 1998,
     to fund the origination or acquisition of mortgage loans. Under this
     agreement, Central Pacific could borrow up to $25.0 million through April
     15, 1999. Borrowings under this new facility are secured by the underlying
     loans. In July 1998, Central Pacific amended this new agreement to increase
     its borrowing capacity to $40.0 million. In February 1999, the agreement
     was extended to June 1, 1999. As of December 31, 1998, there was $25.1
     million outstanding under this agreement. As of December 31, 1997, there
     was $10.5 million outstanding under the previous agreement.

     Central Pacific must comply with certain financial covenants provided in
     its secured credit agreement, including restrictions relating to tangible
     net worth and leverage. Central Pacific is currently in compliance with all
     such covenants.

     Effective December 8, 1995, the Company exchanged and retired 2,239,061
     shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million
     in principal amount of 9.375% subordinated interest deferrable debentures
     ("subordinated debentures"), due December 31, 2025. Interest on the
     subordinated debentures is paid quarterly in arrears at the annual rate of
     9.375% on the last business day of each March, June, September and
     December. The purpose for the exchange was to improve the Company's
     after-tax cash flow since the interest payable on the subordinated
     debentures is deductible for federal income tax purposes, whereas dividends
     payable on the preferred stock are not.

     The subordinated debentures are redeemable at the option of the Company, in
     whole or in part, at any time on or after May 1, 1999. On or after such
     date, the subordinated debentures may be redeemed at the option of the
     Company at a price equal to 100% of the principal amount redeemed ($25 for
     each $25 principal amount of subordinated debenture), plus accrued and
     unpaid interest to the date fixed for redemption.

     In June 1992, the Company issued $100.0 million of 9% debentures due June
     2012 under terms of a $250.0 million shelf registration statement filed
     with the Securities and Exchange Commission ("SEC") in April 1992. The
     debentures may not be redeemed by the Company prior to maturity. The
     proceeds were used for general corporate purposes. In January, 1999 the
     Company repurchased and retired $8.0 million of these debentures.

     In October 1991, the Company issued $160.0 million of 8.875% medium-term
     notes due October 2001. During 1995 and 1997, the Company repurchased and
     retired $21.6 million and $119.6 million in principal amount, respectively
     of these notes.

     The Company has a dividend policy which may result in the payment of
     dividends on the Company's common stock, dependent upon the earnings, cash
     position and capital needs of the Company, limitations in credit
     agreements, general business conditions and other factors deemed relevant
     by the Company's Board of Directors. During 1998, the Company declared and
     paid cash dividends on its common stock totaling $104.0 million which have
     been reflected as reductions in paid-in capital. The Company did not
     declare any dividends on its common stock during 1997.

     Quarterly cash dividends are paid on preferred stock at an annual rate of
     8.42% or $2.105 per share, if declared by the Board of Directors, in
     arrears on the first day of each February, May, August and November. During
     1998, 1997 and 1996, the Company declared and paid annual cash dividends of
     $3.7 million on its preferred stock.

12  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   13


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     The preferred stock is not redeemable prior to May 1, 1999. On or after
     such date, the preferred stock may be redeemed at the option of the Company
     at a price of $25 per share, plus accrued and unpaid dividends to the
     redemption date.

     In January 1997, the Company transferred its remaining common equity
     securities with a market value of $2.6 million to White Mountains in
     exchange for 21,239 shares of the Company's common stock held by White
     Mountains, which were retired by the Company.

     During 1998, the Company sold the rights to service approximately $10.6
     billion of its nonrecourse mortgage servicing portfolio to third parties
     for net proceeds of $227.9 million. During 1997, the Company sold the
     rights to service $17.0 billion of its nonrecourse mortgage servicing
     portfolio to a third party for net proceeds of $266.9 million. The Company
     has used the proceeds of $425.4 million received from the 1997 and 1998
     sales to reduce outstanding short-term debt, retire medium-term notes, pay
     dividends on its common stock and for general corporate purposes. The
     remaining balance of $73.8 million, including $4.4 million of accrued
     interest, is included in other assets in the consolidated statement of
     condition as of December 31, 1998. Under circumstances deemed appropriate
     by management, additional sales transactions may occur in the future.
     Although there have been continuing sales in 1999, there can be no
     assurance that additional sales will occur.

     During 1996, the Company sold the rights to service a total of $3.3 billion
     of mortgage loans to a third party for net proceeds of $55.9 million, which
     were used for general corporate purposes.

     In March 1997, the Board of Directors of Fund American approved a corporate
     restructuring plan involving several of its subsidiaries including the
     Company. In accordance with this plan, the Company contracted to receive
     capital infusions from White Mountains of approximately $139 million
     (approximately $119 million net of associated tax liabilities and other
     adjustments) consisting primarily of common stock, convertible redeemable
     preferred stock and options to acquire common stock of FSA. Subsequently,
     the Company issued 881,120 shares of its common stock to White Mountains in
     exchange for 3.5 million shares of FSA common stock, 2.0 million shares of
     FSA convertible redeemable preferred stock and options to acquire 2.6
     million shares of FSA common. In addition, the Company issued 105,000
     shares of its common stock to Fund American for cash proceeds of $12.7
     million. The capital infusions were undertaken to improve the Company's
     debt ratings and reduce the Company's borrowing costs.

YEAR 2000 COMPLIANCE
--------------------------------------------------------------------------------

     During the fourth quarter of 1996, the Company established a team to
     coordinate the identification, evaluation and implementation of changes to
     computer systems and applications that the Company currently believes are
     necessary to achieve a year 2000 date conversion with no material adverse
     effects to its customers or disruption to business operations. These
     actions are necessary to ensure that the systems and applications will
     recognize and process the year 2000 and beyond. The Company has
     substantially completed the testing phase for all information technology
     ("IT") systems and is currently concentrating efforts on testing outside
     constituents. Additionally, non-IT systems have also been reviewed for
     affects of the Year 2000 dilemma. Non-IT systems influenced by Year 2000
     date conversion will be upgraded or replaced by the second quarter of 1999.

     During 1998, the Company engaged an independent consultant to perform an
     assessment of the Company's Year 2000 readiness. The assessment confirmed
     that the Company was in the final stages of completion and that the Company
     was a low risk entity for adverse Year 2000 incidents.

     The total pretax cost of achieving Year 2000 compliance, including $1.0
     million for hardware and software upgrades, is approximately $2.5 million.
     To date, the Company has incurred approximately $2.4 million in costs.
     These costs have been expensed as incurred, with the exception of hardware
     costs, which were capitalized in accordance with GAAP. The Year 2000
     project has accounted for less than 15% of the total IT budget for the
     years ended December 31, 1998, 1997 and 1996.

     The Company has been closely monitoring the Year 2000 issues of its third
     party constituents with whom it voluntarily interacts (e.g. customers,
     suppliers, reinsurers, creditors, borrowers). These third party
     constituents were requested to demonstrate their ability to become Year
     2000 compliant by year-end 1998. For those constituents who either failed
     to respond to this inquiry or were deemed to be unlikely to remedy their
     own Year 2000 issues in a timely manner, the Company is in the process of
     establishing similar relationships with new parties that expect to be Year
     2000 compliant.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  13



<PAGE>   14


MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

     The failure to identify or correct significant Year 2000 issues could
     result in an interruption in, or a failure of, certain normal business
     activities or operations concerning the Company. Such failure could
     adversely affect the Company's results of operations, liquidity and
     financial condition. Due to general uncertainties inherent in the Year 2000
     problem, resulting in part from uncertainty of potential business
     interruptions caused by third party constituents in which the Company must
     interact (including but not limited to the suppliers of electric power,
     various private and public markets for equity and debt securities, certain
     agencies of the Federal government and states in which the Company conducts
     business), the Company is unable to determine at this time whether the
     consequences of any Year 2000 failures will have a material impact on its
     results of operations, liquidity or financial condition. However, the
     Company currently believes that, with the implementation of its Year 2000
     plan (which is in the final stages of completion), the possibility of
     significant interruptions of normal business activities due to Year 2000
     issues should be reduced. In addition, the Company is currently in the
     process of developing and updating Business Continuance Plans, to
     facilitate continued operations in the event of adverse Year 2000
     incidents.

INFLATION
--------------------------------------------------------------------------------
  
     Inflation and changes in interest rates can have differing effects on
     various aspects of the Company's business, particularly with respect to
     marketing gains and losses from the sale of mortgage loans, mortgage loan
     production, the value of the Company's servicing portfolio and net interest
     revenue. Historically, the Company's loan originations and loan production
     income have increased in response to falling interest rates and 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 the Company's mortgage loan servicing portfolio because prepayments of
     mortgages increase and the average life of loan servicing rights is
     shortened. Conversely, periods of increasing inflation and rising interest
     rates tend to increase loan servicing income and the value of the Company's
     mortgage loan servicing portfolio because prepayments of mortgages decline
     and the average life of loan servicing rights is lengthened. In an attempt
     to mitigate the Company's exposure to changes in market interest rates, the
     Company utilizes various derivative financial instruments (refer to Note 10
     to the consolidated financial statements).




Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  14



<PAGE>   15
                                                  REPORT OF INDEPENDENT AUDITORS

THE BOARD OF DIRECTORS
SOURCE ONE MORTGAGE SERVICES CORPORATION

     We have audited the accompanying consolidated statements of condition of
     Source One Mortgage Services Corporation and subsidiaries ("the Company")
     as of December 31, 1998 and 1997, and the related consolidated statements
     of income, comprehensive income, stockholders' equity, and cash flows for
     each of the years then ended. These financial statements are the
     responsibility of the Company's management. Our responsibility is to
     express an opinion on these financial statements based on our audits. We
     did not audit the financial statements of Financial Security Assurance
     Holdings Ltd. ("FSA") (a 11.6 percent owned equity investee company). The
     Company's investment in FSA at December 31, 1998 and 1997, was $120 million
     and $104 million, and its equity in earnings of FSA was $13.8 million and
     $9.5 million for the years ended December 31, 1998 and 1997, respectively.
     The financial statements of FSA were audited by other auditors,
     PricewaterhouseCoopers LLP, 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. The accompanying consolidated
     financial statements of the Company for the year ended December 31, 1996,
     were audited by other auditors whose report thereon dated January 30, 1997,
     on those statements included an explanatory paragraph that described the
     change in the Company's method of accounting for mortgage servicing rights
     discussed in Notes 1 and 3 to the consolidated financial statements.

     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 and
     the report of the other auditors provide a reasonable basis for our
     opinion.

     In our opinion, based on our audits and the report of the other auditors,
     the 1998 and 1997 consolidated financial statements referred to above
     present fairly, in all material respects, the financial position of Source
     One Mortgage Services Corporation and subsidiaries as of December 31, 1998
     and 1997, and the results of their operations and their cash flows for each
     of the years then ended in conformity with generally accepted accounting
     principles.


     KPMG LLP

     Detroit, Michigan
     February 12, 1999,
     except for Note 23 
     as to which the date is 
     March 29, 1999



Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  15



<PAGE>   16


CONSOLIDATED STATEMENTS OF CONDITION

<TABLE>
<CAPTION>
========================================================================================================================
December 31, (in thousands, except for share amounts)                                     1998                   1997
------------------------------------------------------------------------------------------------------------------------
ASSETS
------------------------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>                    <C>       
Cash                                                                                $   16,410             $    3,134
Investments                                                                             78,477                 86,239
Investment in unconsolidated affiliate (net)                                           234,071                192,137
Mortgage loans receivable                                                              676,317                519,247
Pool loan purchases                                                                    164,952                149,791
Loans held for investment                                                                1,707                  5,191
Capitalized servicing (net)                                                            169,688                181,025
Mortgage claims receivable and real estate acquired
   (net of allowance for loan losses of $11,500 in 1998 and $12,800 in 1997)            33,121                 41,199
Premises and equipment                                                                  23,303                 22,171
Other assets                                                                           119,931                104,556
------------------------------------------------------------------------------------------------------------------------
Total assets                                                                        $1,517,977             $1,304,690
========================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------------------------------------------------------------------------------------------
Liabilities:
Senior debt                                                                         $  814,593             $  686,906
Subordinated debt                                                                       55,771                 55,153
Accounts payable and other liabilities                                                 235,100                107,582
------------------------------------------------------------------------------------------------------------------------
Total liabilities                                                                    1,105,464                849,641
------------------------------------------------------------------------------------------------------------------------
Stockholders' Equity:
Preferred stock, $.01 par value, 12,000,000 shares authorized, 1,760,939 shares
   of 8.42% cumulative Series A (aggregate liquidation preference of $25 per
   share) issued and outstanding as of December 31, 1998 and 1997                           18                     18
Common stock, $.01 par value, 8,000,000 shares authorized,
   3,211,881 shares issued and outstanding as of
   December 31, 1998 and 1997                                                               32                     32
Paid-in capital                                                                        358,447                462,480
Accumulated other comprehensive income                                                  60,396                 41,102
Retained deficit                                                                        (6,380)               (48,583)
------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity                                                             412,513                455,049
------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity                                          $1,517,977             $1,304,690
========================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements.



16  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   17


                                               CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
============================================================================================================================
Year Ended December 31, (in thousands, except for per share amounts)               1998            1997              1996
----------------------------------------------------------------------------------------------------------------------------
REVENUE                                                                      
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>             <C>               <C>      
Mortgage servicing revenue                                                    $  78,064       $  94,952         $ 139,578
Amortization of capitalized servicing                                           (55,179)        (68,031)          (79,193)
Net gain on financial instruments                                                20,431          11,271             9,904
----------------------------------------------------------------------------------------------------------------------------
   Net servicing revenue                                                         43,316          38,192            70,289
----------------------------------------------------------------------------------------------------------------------------
Interest income                                                                  85,393          45,754            40,826
Interest expense                                                                (70,201)        (35,362)          (36,018)
----------------------------------------------------------------------------------------------------------------------------
   Net interest revenue                                                          15,192          10,392             4,808
----------------------------------------------------------------------------------------------------------------------------
Net realized investment gain (loss) on sale and                              
   exchange of securities with affiliates                                          --               326              (855)
Net realized investment gain (loss)                                               2,212          (1,048)              623
Equity in earnings of unconsolidated affiliate                                   13,774           9,507              --
Net gain on sale of mortgages                                                    86,780          21,497            38,346
Net gain (loss) on sale of servicing                                         
   and assumption of subservicing                                                15,240          (8,032)           10,080
Other                                                                            31,854          19,159            18,132
----------------------------------------------------------------------------------------------------------------------------
Total revenue                                                                   208,368          89,993           141,423
============================================================================================================================
EXPENSES                                                                     
----------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits                                                   78,692          54,794            56,294
Office occupancy and equipment                                                   13,181          13,289            13,619
Provision for loan losses                                                         3,820           4,729             3,003
Write-off of goodwill and other intangible assets                                  --              --              29,128
Restructuring charges                                                              --             1,727              --
Other operating expenses                                                         42,522          26,601            34,252
----------------------------------------------------------------------------------------------------------------------------
Total expenses                                                                  138,215         101,140           136,296
----------------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes and extraordinary loss                         70,153         (11,147)            5,127
Income tax expense (benefit)                                                     24,243          (3,617)            9,453
----------------------------------------------------------------------------------------------------------------------------
Income (loss) before extraordinary loss                                          45,910          (7,530)           (4,326)
Extraordinary loss on repurchase of debt                                     
   (net of $3,217 income tax benefit)                                              --            (5,975)             --
----------------------------------------------------------------------------------------------------------------------------
Net income (loss)                                                                45,910         (13,505)           (4,326)
Less dividends on preferred stock                                                 3,707           3,707             3,707
----------------------------------------------------------------------------------------------------------------------------
Net income (loss) applicable to common stock                                  $  42,203       $ (17,212)        $  (8,033)
============================================================================================================================
Basic net income (loss) per common share:                                    
   Before extraordinary loss                                                  $   13.14       $   (3.78)        $   (3.57)
   Extraordinary loss                                                              --             (2.01)             --
----------------------------------------------------------------------------------------------------------------------------
Basic net income (loss) per common share                                      $   13.14       $   (5.79)        $   (3.57)
============================================================================================================================
</TABLE>
                                                                      
See accompanying notes to consolidated financial statements.



Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  17



<PAGE>   18


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

<TABLE>
<CAPTION>
============================================================================================================================
Year ended December 31, (in thousands, except for per share amounts)           1998               1997               1996
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>               <C>                <C>      
Net income (loss)                                                          $ 45,910          $(13,505)          $ (4,326)
Other comprehensive income, net of tax
   Unrealized gains (losses) on investments:
   Unrealized holding gain (loss) arising during year
      (net of income tax expense (benefit) of $10,389, $22,245
      and $(5) for 1998, 1997 and 1996, respectively)                        19,294            41,314                (10)
   Less:  reclassification adjustment for (gains) losses
      included in net income (net of income tax (expense) benefit
      of $(114) and $299 for 1997 and 1996, respectively)                      --                (212)               556
----------------------------------------------------------------------------------------------------------------------------
Other comprehensive income                                                   19,294            41,102                546
----------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss)                                                  65,204            27,597             (3,780)
Less dividends on preferred stock                                             3,707             3,707              3,707
----------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) applicable to common stock                     $ 61,497          $ 23,890           $ (7,487)
----------------------------------------------------------------------------------------------------------------------------
Basic comprehensive income (loss) per common share                         $  19.15          $   8.03           $  (3.33)
============================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements. 




18  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report



<PAGE>   19


                                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
====================================================================================================================================
Year ended December 31, 1998, 1997 and 1996
(in thousands, except for per share amounts)
------------------------------------------------------------------------------------------------------------------------------------
                                                                                     Accumulated                          Total
                                                                                           Other        Retained         Stock-
                                        Preferred      Common        Paid-In       Comprehensive        Earnings       holders'
                                            Stock       Stock        Capital              Income        (Deficit)        Equity    
------------------------------------------------------------------------------------------------------------------------------------
<S>                                    <C>            <C>          <C>                  <C>             <C>           <C>      
Balances at January 1, 1996            $     18       $    22      $ 346,088            $  (546)        $(23,338)     $ 322,244
Net income                                   --            --             --                 --           (4,326)        (4,326)
Change in unrealized                                                                                 
   investment gain (net)                     --            --             --                546               --            546
Preferred dividends declared                                                                         
   of $2.105 per share                       --            --             --                 --           (3,707)        (3,707)
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996                18            22        346,088                 --          (31,371)       314,757
Net loss                                     --            --             --                 --          (13,505)       (13,505)
Change in unrealized                                                                                 
   investment gain (net)                     --            --             --             41,102                --        41,102
Repurchase of 21,239 shares of                                                                       
   common stock, $.01 par value,                                                                     
   from parent                               --            --         (2,638)                --                --        (2,638)
Issuance of 105,000 shares                                                                           
   of common stock, $.01                                                                             
   par value, to parent                      --             1         12,674                 --                --        12,675
Issuance of 230,293 shares                                                                           
   of common stock,                                                                                  
   $.01 par value, to parent                 --             2         27,797                 --                --        27,799
Issuance of 650,827 shares of                                                                        
   common stock, $.01 par value,                                                                     
   to parent                                 --             7         78,559                 --                --        78,566
Preferred dividends declared                                                                         
   of $2.105 per share                       --            --             --                 --            (3,707)       (3,707)
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997                18            32        462,480             41,102           (48,583)      455,049
Net income                                   --            --             --                 --            45,910        45,910
Change in unrealized                                                                                 
   investment gain (net)                     --            --             --             19,294                --        19,294
Common stock dividends paid                  --            --       (104,033)                --                --      (104,033)
Preferred dividends declared                                                                         
   of $2.105 per share                       --            --             --                 --            (3,707)       (3,707)
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1998          $     18       $    32      $ 358,447            $60,396          $ (6,380)     $412,513
====================================================================================================================================
</TABLE>


See accompanying notes to consolidated financial statements.



Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  19



<PAGE>   20


CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
=============================================================================================================================
Year ended December 31, (in thousands)                                             1998               1997              1996
-----------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>               <C>               <C>          
Net income (loss)                                                          $     45,910      $    (13,505)     $     (4,326)
Noncash items included in the determination of net income (loss):
   Amortization of capitalized servicing                                         55,179            68,031            79,193
   Write-off of goodwill and other intangible assets                                 --                --            29,128
   Net unrealized gain on financial instruments                                 (12,140)          (11,072)           (1,670)
   Provision for loan losses                                                      3,820             4,729             3,003
   Depreciation and amortization                                                  3,931             6,586             8,825
   (Gain) loss on sale of financial instruments                                  (3,551)              (46)               --
   Write down of loans held for investment identified as held for sale               --             3,000                --
   Amortization of goodwill                                                          --                --             2,090
   Net realized (gain) loss on investments                                       (1,943)              722               232
   (Gain) loss on sale of servicing and assumption of subservicing              (15,240)            8,032           (10,080)
   Gain on sale of permanent investments                                           (769)               --                --
   Amortization of deferred gain on sale of servicing                                --            (6,885)           (6,139)
   Undistributed earnings from unconsolidated affiliate                         (12,251)           (8,668)               --
Mortgage loan production                                                    (10,866,289)       (4,403,281)       (3,831,639)
Mortgage loan sales and amortization                                         10,709,219         4,198,971         3,897,730
Additions to financial instruments                                               (6,090)           (2,292)           (2,885)
Net proceeds from sale of financial instruments                                  24,987               760                --
Net increase (decrease) in accounts payable and other liabilities                95,752            15,950           (15,002)
Net decrease in other assets                                                     13,355            31,154             5,433
Net change in current and deferred income taxes receivable
   and payable                                                                   23,164           (12,160)          (10,158)
Extraordinary loss on repurchase of debt                                             --             5,975                --
-----------------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by operating activities                                 57,044          (113,999)          143,735
-----------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
-----------------------------------------------------------------------------------------------------------------------------
Collections on and sales of pool loan purchases,
   mortgage claims receivable and real estate acquired                          278,390           274,158           175,289
Additions to pool loan purchases, mortgage
   claims receivable and real estate acquired                                  (296,884)         (285,100)         (205,745)
Additions to capitalized mortgage servicing rights                             (249,128)         (139,500)          (88,578)
Net proceeds from sales of servicing                                            182,809           242,628            11,706
Net proceeds from sale of permanent investments                                  13,537                --                --
Additions to long-term investments                                               (5,044)          (52,426)           (3,453)
Collections on note receivable                                                    7,000                --                --
Principal payments received on long-term investments                              3,799               385               408
Net decrease (increase) in short-term investments                                 8,261            24,141           (14,354)
Proceeds from sale of common equity securities to affiliates                         --                --               514
Net (acquisition) disposition of premises and equipment                          (4,188)              914            (1,410)
Net (increase) decrease in loans held for investment                             (1,713)            9,793             2,517
-----------------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by investing activities                                (63,161)           74,993          (123,106)
-----------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
-----------------------------------------------------------------------------------------------------------------------------
Proceeds from issuance of commercial paper                                           --         5,785,634         5,140,110
Repayments on commercial paper                                                       --        (6,147,814)       (5,034,543)
Net increase (decrease) in credit agreement borrowings                          127,133           524,301           (20,497)
Retirement of debt                                                                   --          (129,872)         (104,350)
Net proceeds from issuance of common stock                                           --            12,675                --
Dividends paid                                                                 (107,740)           (3,707)           (3,707)
Other                                                                                --                --              (865)
-----------------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities                                 19,393            41,217           (23,852)
-----------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash                                                  13,276             2,211            (3,223)
Cash at beginning of year                                                         3,134               923             4,146
-----------------------------------------------------------------------------------------------------------------------------
Cash at end of year                                                        $     16,410      $      3,134      $        923
=============================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements. 



20  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   21


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES

ORGANIZATION
--------------------------------------------------------------------------------

     Source One Mortgage Services Corporation (together with its subsidiaries,
     the "Company") was incorporated in 1972 and is the successor to Citizens
     Mortgage Corporation, which was organized in 1946. The Company is a
     wholly-owned subsidiary of White Mountains Holdings, Inc. ("White
     Mountains") (formerly Fund American Enterprises, Inc.) and its parent Fund
     American Enterprises Holdings, Inc. ("Fund American"), a Delaware
     corporation organized in 1980, which was formerly known as The Fund
     American Companies, Inc. and Fireman's Fund Corporation.  

     The Company is one of the largest mortgage banking companies in the United 
     States that is not affiliated with a commercial bank. As of December 31, 
     1998, the Company had a mortgage loan servicing portfolio totaling $25.1 
     billion, including $15.9 billion of loans subserviced for others, which is 
     serviced on behalf of approximately 213 institutional investors and 
     numerous other security holders. As of December 31, 1998, the Company had 
     163 retail branch offices in 31 states and Puerto Rico and originated $10.9
     billion in mortgage loans for the year then ended.

     As a mortgage banker, the Company primarily engages in the business of
     producing and selling conforming and subprime residential mortgage loans,
     servicing conforming residential mortgage loans and subservicing
     residential mortgage loans for third parties. Its sources of revenue are
     net servicing revenue, net interest revenue, net gain on sale of mortgages,
     net gain on sale of servicing, earnings from unconsolidated affiliate and
     other revenue. Through subsidiaries, the Company also provides
     credit-related insurance products (such as life, disability, health,
     accidental death and property and casualty insurance).

BASIS OF PRESENTATION
--------------------------------------------------------------------------------

     The accompanying consolidated financial statements of the Company include
     the accounts of Central Pacific Mortgage Company, a wholly-owned subsidiary
     of the Company, (together with its subsidiaries, "Central Pacific") and all
     other subsidiaries, and have been prepared in accordance with generally
     accepted accounting principles ("GAAP"). 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 the Company. 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 at 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 prior year financial statements have been reclassified to
     conform with the current year presentation.

     Fund American acquired the stock of the Company in 1986. The purchase price
     paid for the Company in 1986 was in excess of historical book value of the
     Company's net assets. The excess purchase price allocated to identifiable
     assets was amortized primarily over 5 to 20 years depending on asset type
     and prior to December 1996, the portion allocated to goodwill was amortized
     over 20 years. During 1996, the Company had been re-evaluating the
     recoverability of goodwill and certain other intangible assets. The Company
     considered the impact of the following factors on its forecast of future
     operations (i) increased competition and industry consolidation which had
     adversely impacted the value of the Company's mortgage loan production and
     servicing operation; (ii) the attainment of a definitive agreement in the
     fourth quarter of 1996 to sell approximately $17.0 billion of the Company's
     mortgage servicing portfolio at essentially book value and (iii) a
     reduction in interest rates in the fourth quarter of 1996. Based on such
     valuation, the Company had determined that its projected results would not
     support the future amortization of the Company's remaining goodwill and
     certain other intangible assets of $29.1 million at December 31, 1996 and,
     therefore, wrote-off such assets.

ACCOUNTING STANDARDS RECENTLY ADOPTED AND ISSUED
--------------------------------------------------------------------------------

     In December 1996, the Financial Accounting Standards Board ("the FASB")
     issued Statement of Financial Accounting Standards ("SFAS") No. 127,
     "Deferral of the Effective Date of Certain Provisions of SFAS No. 125".
     SFAS No. 127 deferred the adoption of certain transfer and collateral
     provisions of SFAS No. 125 to periods beginning after December 31, 1997.
     The adoption of SFAS No. 127 did not have a material effect on the
     Company's current financial position or results of operations.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  21

<PAGE>   22


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    The Company adopted the provisions of SFAS No. 131, "Disclosure about
    Segments of an Enterprise and Related Information" as of December 31, 1998.
    SFAS No. 131 superseded SFAS No. 14, "Financial Reporting for Segments of a
    Business Enterprise". SFAS No. 131 establishes standards for the way that
    public business enterprises report information about operating segments in
    the annual financial statements and requires that those enterprises report
    selected information about operating segments in interim financial reports.
    SFAS No. 131 also establishes standards for related disclosure about
    products and services, geographic areas and major customers. The Company was
    not previously subject to SFAS No. 14, and therefore, segment information
    had not previously been disclosed. Segment information is presented for 1998
    only (See Note 19 to the consolidated financial statements).

    The Company adopted the provisions of SFAS No. 132, "Employers' Disclosure
    about Pensions and Other Post Retirement Benefits" as of December 31, 1998.
    SFAS No. 132 standardizes disclosure requirements for pensions and other
    postretirement benefits. The statement resulted in no change to the
    recognition or measurement of the plans. Restatement of disclosure for
    earlier periods provided for comparative purposes is required, therefore,
    amounts for 1997 and 1996 have been restated and are directly comparable to
    1998 amounts.  
     
    The adoption of SFAS No. 131 and SFAS No. 132 resulted in a change to 
    financial statement disclosure only and had no effect on the Company's 
    financial position or results of operations.

    In March 1998, the American Institute of Certified Public Accountants ("the
    AICPA") issued Statement of Position ("SOP") 98-1, "Accounting For the Cost
    of Computer Software Developed or Obtained For Internal Use". The Company
    plans to adopt the SOP effective January 1, 1999. The SOP will require the
    capitalization of certain costs incurred after the date of adoption in
    connection with developing or obtaining software for internal use. The
    Company currently expenses a majority of such costs as incurred. The
    adoption of SOP 98-1 is not expected to have a material impact on the
    Company's financial position or results of operations.

    In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
    Instruments and Hedging Activities" which establishes accounting and
    reporting standards for derivative instruments and hedging activities. SFAS
    No. 133 requires companies to record all derivatives on the balance sheet as
    either assets or liabilities and measure those instruments at fair value.
    The manner in which companies are to record gains and losses resulting from
    changes in the values of those derivatives depends on the use of the
    derivative and whether it qualifies for hedge accounting. SFAS No. 133 is
    effective beginning in 2000 with earlier adoption permitted. The Company
    expects to adopt SFAS No. 133 in 2000. The Company has not yet evaluated the
    impact of adopting SFAS No. 133.

    In October 1998, the FASB issued SFAS No. 134, "Accounting for
    Mortgage-Backed Securities Retained After the Securitization of Mortgage
    Loans Held for Sale by a Mortgage Banking Enterprise". SFAS No. 134 requires
    that after the securitization of a mortgage loan held for sale, an entity
    engaged in mortgage banking activities classify the resulting
    mortgage-backed securities or other retained interest based on its ability
    and intent to sell or hold those investments. SFAS No. 134 is effective for
    fiscal quarters beginning after December 15, 1998. The adoption of SFAS No.
    134 is not expected to have a material impact on the Company's financial
    position or results of operations.

INVESTMENTS
--------------------------------------------------------------------------------

    Investments primarily consist of the following: short-term investments
    stated at cost; investment partnership interests reported using the cost
    method of accounting since the Company's interests are minor (less than 5%);
    and a fixed maturity investment considered available for sale and stated at
    fair value with unrealized gains and losses, if any, reported net of tax, as
    a component of accumulated other comprehensive income in stockholders'
    equity. The discount on the investment is being amortized into income over
    the anticipated life of the investment.

DERIVATIVE FINANCIAL INSTRUMENTS
--------------------------------------------------------------------------------
    The Company uses interest rate floor contracts, interest rate swap
    agreements and principal-only swap agreements in order to manage the
    exposure to interest rate risk inherent in its capitalized servicing asset
    (collectively "financial instruments"). In accordance with SFAS No. 115,
    such financial instruments are considered to be held for trading purposes.
    The financial instruments are carried at fair value and are included in
    investments in the consolidated statements of condition. Unrealized gains
    and losses arising from changes in the value of these instruments are
    recorded in net gain on financial instruments in the consolidated statements
    of income. Gains and losses occurring from the termination, maturity, sale
    or extinguishment of the financial instruments are recorded immediately in
    net gain on financial instruments in the consolidated statements of income.


22  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   23


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

INVESTMENT IN UNCONSOLIDATED AFFILIATE
--------------------------------------------------------------------------------
    
     Investment in unconsolidated affiliate consists of the Company's investment
     in common stock, redeemable preferred stock and options to acquire common
     stock of Financial Security Assurance Ltd. ("FSA"). The Company accounts
     for its investment in FSA common stock using the equity method. The Company
     accounts for its investment in FSA preferred stock and options under the
     provisions of SFAS No. 115 whereby, the investments are classified as
     available for sale and reported at fair value as of the balance sheet date,
     with related unrealized investment gains and losses excluded from earnings
     and reported, net of tax, as a component of accumulated other comprehensive
     income in stockholders' equity.

MORTGAGE LOANS RECEIVABLE
--------------------------------------------------------------------------------

    Mortgage loans receivable are stated at the lower of aggregate cost or fair
    value, including the fair value of commitments to originate and commitments
    to sell mortgage loans. Conventional mortgage loans are placed on a
    nonaccrual basis when delinquent ninety days or more as to interest or
    principal. Interest on delinquent Federal Housing Administration ("FHA")
    insured loans is accrued at the insured rate beginning on the sixty-first
    day of delinquency. Interest on delinquent Veterans Administration ("VA")
    guaranteed loans is accrued at the loan rate during the period of
    delinquency.

RECOGNITION OF REVENUES RELATED TO MORTGAGE LOANS RECEIVABLE
--------------------------------------------------------------------------------

    Discounts from the origination of mortgage loans receivable are deferred and
    recognized as adjustments to gain or loss on sale. Gains and losses from the
    sale of mortgage loans are recognized when proceeds are received. Loan
    origination fees, net of certain direct costs, have been deferred and are
    recognized as income when the related mortgage loans are sold.

POOL LOAN PURCHASES
--------------------------------------------------------------------------------

    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 Government
    National Mortgage Association ("GNMA"), Federal National Mortgage
    Association ("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC")
    mortgage-backed security pools that the Company services. Following the
    purchase of these loans, interest is accrued at a rate based on expected
    recoveries.

LOANS HELD FOR INVESTMENT
--------------------------------------------------------------------------------

     Loans held as permanent investments are stated at the lower of cost or
     market value determined at the time the permanent investment decisions were
     made.

CAPITALIZED SERVICING
--------------------------------------------------------------------------------

    Capitalized servicing includes certain costs incurred in the origination and
    acquisition of mortgage servicing rights ("originated and purchased
    servicing") 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 net cash flows. Impairment of 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
    the Company's principal recourse portfolio includes a reserve for estimated
    losses on the corresponding loans.

    Through 1996, capitalized servicing also included, as a separate component,
    the present value of future servicing revenue in excess of normal servicing
    revenue on loans sold with servicing retained ("excess servicing") which was
    deferred and amortized using a method that relates the anticipated servicing
    revenue to total projected servicing revenue to be received over the
    expected life of the loan. Impairment tests for excess servicing were
    performed on a disaggregated basis. The original discount rate was used to
    discount excess servicing future cash flows (refer to Note 3 to the
    consolidated financial statements for further discussion).

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  23


<PAGE>   24


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

RECOGNITION OF REVENUES RELATED TO SERVICING MORTGAGE LOANS
--------------------------------------------------------------------------------

    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.

COMMON EQUITY SECURITIES
--------------------------------------------------------------------------------

    Common equity securities are classified as available for sale and carried at
    fair value. Unrealized gains and losses, net of tax, are recorded as a
    separate component of stockholders' equity with no corresponding credit or
    charge to net income. Realized gains and losses from sales of common equity
    securities are based on the specific identification method.

MORTGAGE CLAIMS RECEIVABLE AND REAL ESTATE ACQUIRED
--------------------------------------------------------------------------------

    Mortgage claims receivable represent claims filed primarily with FHA and VA
    and are carried at cost less an estimated allowance for amounts which are
    not fully recoverable from 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
    determined on an individual property basis. Costs relating to holding the
    properties are charged to expense as incurred.

    The allowance for loan losses is based upon an analysis of the mortgage loan
    servicing portfolio and reflects an amount which, in management's judgment,
    is adequate to provide for estimated losses.

PREMISES AND EQUIPMENT
--------------------------------------------------------------------------------

    Premises and equipment, including leasehold improvements and systems and
    programming software, are stated at cost less accumulated depreciation and
    amortization. Depreciation and amortization are computed on a straight-line
    basis over the estimated useful lives of the related assets or over the
    lease terms, whichever period is shorter.

BASIC NET INCOME PER SHARE
--------------------------------------------------------------------------------
    Basic net income per share amounts were computed based on the weighted
    average total number of common shares outstanding. There were 3,211,881,
    2,973,999, and 2,247,000 weighted average common shares outstanding for the
    years ended December 31, 1998, 1997 and 1996, respectively.

DIVIDENDS PER SHARE
--------------------------------------------------------------------------------

     Cash dividends per share were computed based on the total number of common
     shares outstanding as of the dividend record dates.

NOTE 2. INVESTMENT IN UNCONSOLIDATED AFFILIATE

    In March 1997, the Company issued 230,293 shares of its common stock to
    White Mountains in exchange for 1.0 million shares of the common stock of
    FSA valued at $27.8 million. The value of the Company's common stock
    represented the book value of the stock as of December 31, 1996. The value
    of the FSA common stock represented White Mountains' equity carrying value
    of such assets at that time. Additionally, the Company agreed to issue
    shares of its common stock to White Mountains in exchange for the remainder
    of its FSA holdings, the value of which was determined at that time.
    Effective the second quarter of 1997, upon receipt of insurance regulatory
    and lender approvals, the Company received White Mountains' remaining FSA
    holdings. The Company issued an additional 650,827 shares of its common
    stock to White Mountains in exchange for 2.5 million shares of FSA common
    stock, 2.0 million shares of FSA convertible redeemable preferred stock and
    options to acquire 2.6 million shares of FSA common stock valued at $78.5
    million, net of associated tax liabilities and other adjustments.

    At December 31, 1998 and 1997, the Company owned 3.5 million shares of FSA
    common stock. This represented approximately 11.6% and 12.1% of the total
    shares of FSA common stock outstanding at those times. In addition, Fund
    American had voting rights to an additional 3.9 million shares of FSA common
    stock at December 31, 1998 and 1997, raising the consolidated entity's
    voting control of FSA to approximately 23.1% and 24.0%, respectively. At
    December 31, 1998 and 1997, the Company also owned FSA options and preferred
    stock which, in total, give the

24  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   25


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    Company the right to acquire up to 4.6 million additional shares of FSA
    common stock for aggregate consideration of $125.7 million.

    The Company accounts for its investment in FSA common stock using the equity
    method. FSA is a leading Aaa/AAA writer of financial guaranty insurance
    whose common stock is publicly traded on the New York Stock Exchange
    ("NYSE"). The market value of the FSA common stock as of December 31, 1998
    and 1997, as quoted on the NYSE, exceeded the Company's carrying value of
    the FSA common stock on the equity method. The Company accounts for its
    investments in FSA options and preferred stock 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, net of tax,
    excluded from earnings and reported as a component of accumulated other
    comprehensive income in stockholders' equity.

    The following table summarizes financial information for FSA, which was
    derived from the audited financial statements of FSA as of and for the
    periods indicated:


<TABLE>
<CAPTION>
=================================================================================================================
(in millions)                                                                         1998               1997
-----------------------------------------------------------------------------------------------------------------
FSA balance sheet data
-----------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>                <C>     
Total investments                                                                 $  1,875           $  1,432
Total assets                                                                         2,406              1,901
Deferred premium revenue                                                               722                595
Loss and loss adjustment expense reserves                                               64                 75
Preferred shareholder's equity                                                           1                  1
Common shareholders' equity                                                          1,073                882
-----------------------------------------------------------------------------------------------------------------
FSA income statement data
-----------------------------------------------------------------------------------------------------------------
Gross premiums written                                                            $    319           $    236
Net premiums written                                                                   220                173
Net premiums earned                                                                    138                110
Net investment income                                                                   79                 72
Net income                                                                             117                101
=================================================================================================================
  The following table summarizes the amounts recorded by the Company:
=================================================================================================================
(in millions)                                                                         1998               1997
-----------------------------------------------------------------------------------------------------------------
Investment in FSA common stock                                                    $    120           $    104
Investment in FSA options and preferred stock                                          114                 88
-----------------------------------------------------------------------------------------------------------------
Total investment in FSA                                                                234                192
-----------------------------------------------------------------------------------------------------------------
Equity in earnings from FSA common stock (a)                                            14                 10
Equity in net unrealized investment gains (losses)
   from FSA's investment portfolio, before tax (b)                                       3                  2
Unrealized investment gains on FSA options
   and preferred stock, before tax (b)                                                  27                 61
=================================================================================================================
</TABLE>

(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to stockholders' equity as a component of accumulated
    other comprehensive income.

NOTE 3. CAPITALIZED SERVICING

    For the years ended December 31, 1998, 1997 and 1996, the Company estimated
    the fair values of its mortgage servicing rights by calculating the present
    value of the expected net future cash flows associated with such rights. In
    making those estimates, the Company incorporated assumptions that market
    participants would use in their estimates of future servicing income and
    expense.

    The Company evaluated the predominant risk characteristics (prepayment,
    default and operational) on its owned servicing portfolio. The Company
    stratified the portfolio by interest rate, loan type (investor), original
    term to maturity and principal recourse. In 1996, as a result of the pending
    sale of $17.0 billion of the Company's nonrecourse mortgage servicing
    portfolio, the Company valued the $17.0 billion portfolio as one stratum
    using the market price as determined by the third party purchaser. The
    Company measured impairment of its owned servicing portfolio using
    assumptions that market participants would use to value their estimates of
    future net servicing

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  25


<PAGE>   26


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    revenue. In estimating fair value, the Company used market consensus
    prepayment rates and discounted the net future cash flows using discount
    rates that approximated the current market rates of 10.5% for conventional
    loans, 12.0% for insured loans and 21.0% for recourse loans for those years.
    The fair value of each stratum was computed and compared to its recorded
    book value to determine if an impairment valuation allowance, or recovery of
    a previously established allowance, was required.

    As a result of the February 1997 sale of $17.0 billion of nonrecourse
    mortgage servicing rights, the Company's principal recourse portfolio became
    a more significant component of its total remaining owned servicing
    portfolio. In determining the fair value of its principal recourse portfolio
    as of December 31, 1998 and 1997, respectively, the Company included a $5.2
    million and $8.2 million reserve for estimated recourse losses on the
    corresponding loans in its calculation for measuring impairment of its
    capitalized servicing asset.

    The discount rate and prepayment assumptions are significant factors used in
    estimating the fair value of the Company's mortgage servicing rights and
    could be significantly impacted by changes in interest rates. Accordingly,
    it is likely that management's estimate of the fair value of the mortgage
    servicing rights could change in the near term due to changes in interest
    rates.

    In 1997, the Company adopted certain provisions of SFAS No. 125 which
    eliminated the distinction between "normal" servicing rights and excess
    servicing receivables. Therefore, in adopting SFAS No. 125, the Company
    combined its "normal" mortgage servicing rights and its excess servicing
    receivables. The Company estimated the fair value of the combined asset
    based on the methodology described above, which did not materially affect
    the Company's 1997 results.

    Prior to the adoption of SFAS No. 125, the Company 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. In making
    these estimates, the Company used "interest only strip" interest rates as
    quoted by market participants to determine the appropriate discount rates
    and prepayment speed assumption rates that are based on interest rates, loan
    types and original term to maturity. The discount rate used to capitalize
    excess servicing ranged from 12.0% to 12.6% for 1996. For the year ended
    December 31, 1996, the weighted average discount rate inherent in the
    carrying amount of the capitalized excess servicing asset was 10.4%.

    The following table summarizes the fair value of mortgage servicing rights
    and certain characteristics of the Company's servicing portfolio related to
    those mortgage servicing rights as of December 31, 1998:

<TABLE>
<CAPTION>
=========================================================================================================================
                              Fair Value                             Weighted
                                Mortgage            Principal         Average              Weighted           Weighted
                               Servicing              Balance        Interest               Average            Average
                                  Rights             Serviced            Rate              Maturity     Service Fee(a)
Loan Type                 (in thousands)        (in millions)    (in percent)           (in months)       (in percent)
-------------------------------------------------------------------------------------------------------------------------
<S>                          <C>                    <C>                 <C>                     <C>               <C> 
Fixed Rate:
   Insured                   $   117,446            $  4,901             7.47%                  334                .50%
   Conventional                   32,956               1,573             7.78                   271                .39
   Recourse                       25,845               1,787             8.43                   202                .47
Adjustable Rate                    1,723                 106             7.89                   256                .41
-------------------------------------------------------------------------------------------------------------------------
Total                        $   177,970            $  8,367             7.74%                  293                .47%
=========================================================================================================================
</TABLE>

(a) Includes servicing fees assigned to mortgage loans receivable for valuation
    purposes of .25% for conventional fixed rate loans, .44% for insured fixed
    rate loans and .375% for conventional adjustable rate loans.

    The above table excludes $830 million of principal balance of mortgage loans
    serviced, of which $635 million relates to originations not capitalized
    prior to the adoption of SFAS No. 122 and $195 million relates to
    originations funded not yet capitalized.

26  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   27


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes changes in the Company's capitalized servicing
asset:

<TABLE>
<CAPTION>
===================================================================================================================================
                                                                                                    Deferred               Total
                                             Mortgage           Valuation                       Gain on Sale         Capitalized
(in thousands)                              Servicing           Allowance   Subservicing        of Servicing           Servicing
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                         <C>                 <C>            <C>                 <C>                 <C>          
Balances at January 1, 1996                 $ 438,063           $ (27,968)     $      --           $ (13,024)          $ 397,071    
Additions                                     125,514                  --             --                  --             125,514
Scheduled amortization                        (69,932)                 --             --                  --             (69,932)
Impairment/unscheduled                                                                                               
        amortization                           (1,076)             (8,185)            --                  --              (9,261)
Amortization of deferred gain                      --                  --             --               6,139               6,139
Recourse loan losses                               --               7,257             --                  --               7,257
Sales                                         (45,849)                 --             --                  --             (45,849)
-----------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996                 446,720             (28,896)            --              (6,885)            410,939
Additions                                      90,412              (1,259)            --                  --              89,153
Scheduled amortization                        (37,537)                 --         (8,880)                 --             (46,417)
Impairment/unscheduled                                                                                               
        amortization                               --             (21,151)          (463)                 --             (21,614)
Amortization of deferred gain                      --                  --             --               6,885               6,885
Recourse loan losses                               --               3,881             --                  --               3,881
Sales                                        (273,667)              2,285          9,580                  --            (261,802)
-----------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997                 225,928             (45,140)           237                  --             181,025
Additions                                     240,780                  --             --                  --             240,780
Scheduled amortization                        (38,624)                 --         (1,796)                 --             (40,420)
Impairment/unscheduled                                                                                               
        amortization                               --             (14,759)            --                  --             (14,759)
Recourse loan losses                               --               2,741             --                  --               2,741
Sales                                        (221,213)             21,534             --                  --            (199,679)
-----------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1998               $ 206,871           $ (35,624)     $  (1,559)          $      --           $ 169,688
===================================================================================================================================
</TABLE>

    In connection with the February 1997 servicing sale and related subservicing
    assumption, the Company recorded a subservicing asset of approximately $13.3
    million. The value of the asset represented the net present value of
    projected net cash flows over the subservicing period including a profit
    margin. In December 1997, the subservicing agreement was amended to extend
    the Company's subservicing responsibilities for one additional year at less
    favorable terms than the original agreement provided. Accordingly, the net
    carrying value of the subservicing asset was reduced by approximately $3.7
    million which represented the net present value of projected net cash flows
    over the extended subservicing period including a profit margin. In November
    1998, the subservicing agreement was amended again to extend the Company's
    subservicing responsibilities for two additional years at slightly more
    favorable terms than the first amendment provided. Based upon an updated
    analysis of the net present value of projected net cash flows, the net
    carrying value of the subservicing asset was not adjusted. The remaining
    negative asset is being amortized on a straight-line basis over the
    corresponding subservicing period and tested for impairment.

    In 1994, the Company sold the rights to service $3.9 billion of mortgage
    loans to a third party and continued to service these loans pursuant to a
    subservicing agreement. The Company recorded a $19.9 million deferred gain
    on the sale which was being recognized over the five-year life of the
    subservicing agreement as mortgage servicing revenue. In the fourth quarter
    of 1996, the third party sold the rights to service approximately $1.0
    billion of these mortgage loans, representing approximately 25% of the total
    loans subserviced by the Company for this third party. Accordingly, the
    Company recognized an additional $2.4 million of the deferred gain in 1996,
    representing approximately 25% of the deferred balance at the time of the
    sale. In the fourth quarter of 1997, the third party sold the rights to
    service the remaining portfolio of loans. As a result, the Company
    recognized the remaining $4.4 million of the deferred gain.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  27


<PAGE>   28


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 4. COMMON EQUITY SECURITIES AND INVESTMENTS

    In June 1997, the Company acquired an investment in U S WEST, Inc. ("U S
    West") redeemable preferred stock from Fund American for cash proceeds of
    $49.3 million. The investment, which is classified as available for sale, is
    a fixed maturity investment which is redeemable in September 2004 and may be
    redeemed at the option of U S West beginning in September 1999. The discount
    on this investment is being amortized over the anticipated life of the
    investment. The carrying value of this investment, which approximates fair
    value, totaled $49.8 million and $49.4 million as of December 31, 1998 and
    1997, respectively. The Company recognized income from this investment of
    approximately $3.8 million and $2.2 million in 1998 and 1997, respectively,
    which is included in interest income in the consolidated statements of
    income.

    In January 1996, the Company sold its then remaining $1.4 million of common
    equity securities to White Mountains for cash proceeds of $.5 million. The
    Company realized a pretax loss of $.9 million on the sale. In December 1996,
    the Company received shares of certain common equity securities with a
    market value of $2.3 million as a return of a partnership investment. The
    resulting gain of $1.4 million is included in the determination of income in
    1996. In January 1997, the Company transferred these shares to White
    Mountains in exchange for 21,239 shares of the Company's common stock held
    by White Mountains, which were retired by the Company. The Company realized
    a pretax gain of $.3 million on the transfer. All of the equity securities
    involved in the above transactions were actively traded, readily marketable,
    listed on a national exchange and, for purposes of such transactions, valued
    at their reported closing prices on the day preceding the date of each
    transaction. As of December 31, 1997, the Company had no remaining common
    equity securities.

    The change in net unrealized investment loss on the Company's common equity
    securities was charged to stockholders' equity as follows:

<TABLE>
<CAPTION>
=====================================================================================================================
Year ended December 31, (in thousands)                                 1998                   1997         1996
---------------------------------------------------------------------------------------------------------------------
<S>                                                           <C>                  <C>              <C>         
Net unrealized investment loss at beginning of year           $          --        $         --     $      (546)
Decrease in gross unrealized gains                                       --                  --              --
Decrease in gross unrealized losses                                      --                  --             840
Decrease in deferred income tax expense                                  --                  --            (294)
---------------------------------------------------------------------------------------------------------------------
Net unrealized investment loss at end of year                 $          --        $         --     $        --
=====================================================================================================================
</TABLE>

NOTE 5. MORTGAGE LOANS RECEIVABLE

    The following table summarizes mortgage loans receivable:

<TABLE>
<CAPTION>
=================================================================================================================
December 31, (in thousands)                                                               1998             1997
-----------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>              <C>        
Adjustable rate mortgage loans, weighted average interest rates of 6.39% and
   6.36% as of December 31, 1998 and 1997, respectively                            $    15,110      $    51,589
Fixed rate 5 year through 25 year mortgage loans, weighted average
   interest rates of 7.10% and 7.68% as of December 31, 1998 and 1997,
   respectively (a)                                                                    239,879           60,382
Fixed rate 30 year mortgage loans, weighted average interest rates of 7.33%
   and 7.76% as of December 31, 1998 and 1997, respectively (b)                        420,395          404,996
-----------------------------------------------------------------------------------------------------------------
                                                                                       675,384          516,967
Net premiums                                                                               933            2,280
-----------------------------------------------------------------------------------------------------------------
Total mortgage loans receivable                                                    $   676,317      $   519,247
=================================================================================================================
</TABLE>

(a)  Includes $4,333 and $1,497 of subprime mortgage loans with a weighted
     average interest rate of 11.64% and 10.93% as of December 31, 1998 and
     1997, respectively.
(b)  Includes $15,508 and $1,549 of subprime mortgage loans with a weighted
     average interest rate of 10.78% and 10.58% as of December 31, 1998 and
     1997, respectively.

28  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   29


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6. POOL LOAN PURCHASES

    The following table summarizes pool loan purchases:


<TABLE>
<CAPTION>
=======================================================================================================================
                                                         Principal Balance
                                                          (in thousands)                          Number of Loans
December 31,                                            1998                 1997            1998                 1997
-----------------------------------------------------------------------------------------------------------------------
<S>                                              <C>                  <C>                   <C>                 <C>
Loan Type:
   FHA                                           $   119,558          $   103,067           1,640                1,781
   VA                                                 45,259               43,349             550                  669
   Conventional                                          135                3,375               4                   45
-----------------------------------------------------------------------------------------------------------------------
Total pool loan purchases                        $   164,952          $   149,791           2,194                2,495
=======================================================================================================================
</TABLE>

NOTE 7. LOANS HELD FOR INVESTMENT

    During 1997, the Company identified for sale a majority of its mortgage
    loans held for investment and marked them down from amortized cost to
    current market value. The Company recognized a $3.0 million pretax charge to
    net gain on sale of mortgages as a result of establishing a valuation
    allowance for these loans. As of December 31, 1997, these loans totaled
    approximately $10.2 million, net of the valuation allowance, of which $4.5
    million were included in loans held for investment and $5.7 million were
    included in mortgage claims receivable and real estate acquired in the
    consolidated statement of condition. During 1998, the majority of these
    loans were sold. The remaining balance of approximately $1.2 million, net of
    a $.2 million valuation allowance, are classified as loans held for
    investment in the December 31, 1998 consolidated statement of condition.

NOTE 8. SENIOR AND SUBORDINATED DEBT

    Senior and Subordinated Debt consists of the following:

<TABLE>
<CAPTION>
=======================================================================================================================
December 31, (in thousands)                                                             1998                     1997
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                          <C>                       <C>           
Credit agreements, weighted average interest rates of 5.79%
   and 6.34% as of December 31, 1998 and 1997, respectively                  $       697,229           $      569,470
8.875% medium-term notes due October 15, 2001                                         18,723                   18,723
9.0% debentures due June 1, 2012                                                     100,000                  100,000
9.375% subordinated debentures, due December 31, 2025                                 55,976                   55,976
Less unamortized discount, premium and issuance costs (net)                           (1,564)                  (2,110)
-----------------------------------------------------------------------------------------------------------------------
Total senior and subordinated debt                                           $       870,364           $      742,059
=======================================================================================================================
</TABLE>

CREDIT AGREEMENTS
--------------------------------------------------------------------------------

    The Company amended and restated its $701.0 million secured revolving credit
    agreement in July 1998, to increase its borrowing capacity and flexibility.
    The provisions of the amended agreement increased its borrowing capacity
    from $701.0 million to $800.0 million, which allows the Company to meet
    higher borrowing requirements resulting from increased production volumes.
    The provisions also allow the Company to more fully utilize the facility by
    easing its restrictions with respect to the Company's use of its high LTV
    mortgage loans and non-conforming second mortgage loans as collateral and
    increasing the collateral value of the Company's mortgage-backed-security
    ("MBS") pools. Borrowings under the facility are secured primarily by the
    Company's mortgage loans receivable and pool loan purchases. The revolving
    credit facility expires on July 9, 1999. As of December 31, 1998, there was
    $650.5 million outstanding under this facility. As of December 31, 1997,
    there was $559.0 million outstanding under the previous facility.

    Under the credit agreement described above, the Company receives interest
    expense credits as a result of holding escrow and custodial funds in trust
    accounts at lender or non-lender banks.

    The Company entered into a new secured credit agreement in May 1998, to fund
    the origination or acquisition of subprime and high LTV loans. Under this
    agreement, the Company may borrow up to $175.0 million through April 29,
    1999. Borrowings under this facility are secured by the underlying loans. As
    of December 31, 1998, there was $21.6 million outstanding under this
    facility.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  29


<PAGE>   30


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    The Company entered into an additional secured credit agreement in July
    1998, to be used for working capital and general corporate purposes,
    including the funding of mortgage loans. Under this agreement, the Company
    may borrow up to $35.0 million through July 9, 1999. Borrowings under this
    facility are secured by the Company's investment in FSA common stock. As of
    December 31, 1998, there were no outstanding borrowings under this facility.

    The Company must comply with certain financial covenants provided in its
    secured revolving credit facilities, including restrictions relating to
    tangible net worth and leverage. In addition, there are certain covenants
    which limit the Company's ability to pay dividends or make distributions of
    its capital to holders of its common stock. The limits do not apply to
    preferred stock dividend and subordinated debt interest requirements each
    year. The Company is currently in compliance with all such covenants.

    Central Pacific replaced its existing $15.0 million unsecured revolving
    credit agreement with a new mortgage warehousing agreement in April 1998, to
    fund the origination or acquisition of mortgage loans. Under this agreement,
    Central Pacific could borrow up to $25.0 million through April 15, 1999.
    Borrowings under this new facility are secured by the underlying loans. In
    July 1998, Central Pacific amended this new agreement to increase its
    borrowing capacity to $40.0 million. In February 1999, the agreement was
    extended to June 1, 1999. As of December 31, 1998, there was $25.1 million
    outstanding under this agreement. As of December 31, 1997, there was $10.5
    million outstanding under the previous agreement.

    Central Pacific must comply with certain financial covenants provided in its
    secured credit agreement, including restrictions relating to tangible net
    worth and leverage. Central Pacific is currently in compliance with all such
    covenants.

MEDIUM-TERM NOTES AND DEBENTURES
--------------------------------------------------------------------------------

    In June 1992, the Company issued $100.0 million of 9% debentures due June
    2012 under terms of a $250.0 million shelf registration statement filed with
    the Securities and Exchange Commission ("SEC") in April 1992. The debentures
    may not be redeemed by the Company prior to maturity. The proceeds were used
    for general corporate purposes. In January 1999, the Company repurchased and
    retired $8.0 million of these debentures (refer to Note 23 to the
    consolidated financial statements).

    In October 1991, the Company issued $160.0 million of 8.875% medium-term
    notes due October 2001. In May 1997, the Company repurchased and retired
    $119.6 million of these medium-term notes. As a result, the Company
    recognized an extraordinary loss of approximately $6.0 million, net of
    approximately $3.2 million of associated income tax benefit. In 1995, the
    Company repurchased and retired $21.6 million of these medium-term notes.

SUBORDINATED DEBENTURES
--------------------------------------------------------------------------------

    Effective December 8, 1995, the Company exchanged and retired 2,239,061
    shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million
    in principal amount of 9.375% subordinated interest deferrable debentures
    ("subordinated debentures"), due December 31, 2025. Interest on the
    subordinated debentures is paid quarterly in arrears at the annual rate of
    9.375% on the last business day of each March, June, September and December.

    The subordinated debentures are redeemable at the option of the Company, in
    whole or in part, at any time on or after May 1, 1999. On or after such
    date, the subordinated debentures may be redeemed at the option of the
    Company at a price equal to 100% of the principal amount redeemed ($25 for
    each $25 principal amount of subordinated debenture), plus accrued and
    unpaid interest to the date fixed for redemption.

    Aggregate maturities of medium-term notes, debentures and subordinated
    debentures, excluding discount, premium and issuance costs, for the five
    calendar years after December 31, 1998 are as follows:

<TABLE>
<CAPTION>
=================================================================================================================================
(in thousands)                    1999             2000          2001           2002       2003     Thereafter           Total
---------------------------------------------------------------------------------------------------------------------------------
<S>                        <C>               <C>             <C>           <C>           <C>         <C>           <C>        
                           $        --       $       --      $ 18,723      $      --     $   --      $ 155,976     $   174,699
=================================================================================================================================
</TABLE>
30  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   31


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 9. STOCKHOLDERS' EQUITY

    During 1998, the Company declared and paid cash dividends on its common
    stock totaling $104.0 million which represented a return of capital. The
    Company did not declare or pay cash dividends on its common stock during
    1997.

    The Company's secured revolving credit facility contains restrictions that
    limit its ability to pay dividends or make distributions on its capital.
    Generally, dividends may be paid as long as the Company maintains the
    tangible net worth requirements outlined in the financial covenants of the
    credit agreement. Effective July 10, 1998, the provisions of the Company's
    credit facility were amended to allow the payment of approximately $64.1
    million in dividends on common stock. As of December 31, 1998, the Company
    has dividend capacity of approximately $40.2 million remaining (refer to
    Note 23 to the consolidated financial statements).

    In March 1997, the Company issued 105,000 shares of its common stock to Fund
    American for cash proceeds of $12.7 million. In addition, the Company issued
    230,293 shares of its common stock to White Mountains in exchange for 1.0
    million shares of the common stock of FSA valued at $27.8 million. The
    Company issued an additional 650,827 shares of its common stock to White
    Mountains effective in the second quarter of 1997 in exchange for 2.5
    million shares of FSA common stock, 2.0 million shares of FSA convertible
    redeemable preferred stock and options to acquire 2.6 million shares of FSA
    common stock valued at $78.5 million, net of associated tax liabilities and
    other adjustments. Stockholders' equity includes accumulated other
    comprehensive income composed of unrealized gains and losses on the
    investments in FSA convertible redeemable preferred stock and options to
    acquire FSA common stock, net of tax.

    In January 1997, the Company transferred its remaining common equity
    securities with a market value of $2.6 million to White Mountains in
    exchange for 21,239 shares of the Company's common stock held by White
    Mountains, which were retired by the Company.

    At December 31, 1998, the Company had 1,760,939 shares of 8.42% cumulative
    preferred stock, Series A ("preferred stock") issued and outstanding. The
    Company is authorized to issue 12,000,000 shares of preferred stock.

    The preferred stock is not redeemable prior to May 1, 1999. On or after such
    date, the preferred stock may be redeemed at the option of the Company at a
    price of $25 per share, plus accrued and unpaid dividends to the redemption
    date. The preferred stock ranks senior to the common stock as to dividends
    and upon the distribution of assets in the event of any liquidation,
    dissolution, or winding up of the Company. Issued and outstanding shares of
    the preferred stock are subordinate as to dividends and upon liquidation, to
    the outstanding debt of the Company.

    Quarterly cash dividends are paid on preferred stock at an annual rate of
    8.42% or $2.105 per share, if declared by the Board of Directors, in arrears
    on the first day of each February, May, August and November. Dividends on
    the preferred stock accrue on a daily basis whether or not there are funds
    legally available for the payment of such dividends and whether or not such
    dividends are declared.

NOTE 10. FINANCIAL INSTRUMENTS

FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
--------------------------------------------------------------------------------

    The Company utilizes derivative financial instruments in the management of
    interest rate risk. The Company's use of derivative financial instruments is
    primarily limited to commitments to extend credit, mandatory forward
    commitments, interest rate floor contracts ("floors"), interest rate swap
    agreements ("I/R swaps") and principal-only swap agreements ("P/O swaps").
    Although SFAS No. 115 requires that these financial instruments be
    classified as held for trading purposes the Company does not consider these
    investments to be speculative holdings.

    The Company 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 reduce its own 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 risk in excess of the amount
    recognized in the consolidated statements of condition. The contract or
    notional amounts of those instruments reflect the extent of risk the Company
    has in the instruments.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  31


<PAGE>   32


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    The Company's exposure to credit loss in the event of nonperformance by the
    counterparty to the financial instrument for commitments to extend credit
    ("mortgage loan pipeline") is represented by the contractual notional amount
    of those instruments. The Company's locked mortgage loan pipeline that is
    expected to close totaled $608.3 million and $284.5 million as of December
    31, 1998 and 1997, respectively. Fixed rate commitments result in the
    Company having market 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 the Company's credit evaluation of the
    mortgagor and consists of the mortgagor's residential property.

    The Company obtains mandatory forward commitments of up to 120 days to sell
    mortgage-backed securities to hedge the market risk associated with a
    substantial portion of the mortgage loan pipeline that is expected to close
    and all mortgage loans receivable. As of December 31, 1998 and 1997, the
    Company had approximately $1,805.3 million and $776.8 million of mandatory
    forward commitments outstanding, respectively. If secondary market interest
    rates decline after the Company obtains a mandatory forward commitment for a
    loan, the loan may not close and the Company may incur a loss from the cost
    of covering its obligations under such commitment. If secondary market rates
    increase before the Company obtains a mandatory forward commitment for a
    loan and the loan closes, the Company may realize a loss when the loan is
    subsequently sold.

    The Company's risk management function closely monitors the mortgage loan
    pipeline to determine appropriate forward commitment coverage on a daily
    basis in order to manage the risk inherent in these off-balance-sheet
    financial instruments. In addition, the risk management area seeks to reduce
    counterparty risk by committing to sell mortgage loans only to its eighteen
    approved dealers, with no dealer having in excess of 20% of current
    commitments.

    The Company sells loans either through mortgage-backed securities issued
    pursuant to programs of GNMA, FNMA, FHLMC or through whole loan sales to
    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 without recourse to the Company
    for loss of principal in the event of a subsequent default by the mortgage
    borrower due to underlying FHA or VA insurance. Prior to December 1992,
    substantially all conventional securities were sold with recourse to the
    Company to the extent of insufficient proceeds from private mortgage
    insurance, foreclosure and other recoveries. Since December 1992,
    conventional loans have been sold without recourse to the Company.

    Servicing agreements relating to mortgage-backed securities issued pursuant
    to the programs of GNMA, FNMA and FHLMC require the Company to advance funds
    to make the required payments to investors in the event of a delinquency by
    the borrower. The Company expects that it would recover most funds advanced
    upon default by the borrower or at foreclosure. However, in connection with
    VA partially guaranteed loans and certain conventional loans (which may be,
    at most, partially insured by private mortgage insurers), funds advanced may
    not cover losses due to potential declines in collateral value. The Company
    is subject to limited amounts of principal risk with respect to these loans
    since the insurer has the option to reimburse the servicer for the lower of
    fair market value of the property or the mortgage loan outstanding, in
    addition to the VA guarantee on the loan. In addition, most of the Company'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, the Company is obligated to pay the
    investor interest at the note rate from the date of the loan payoff through
    the end of that calendar month without reimbursement.

    As of December 31, 1998, 1997 and 1996, the Company serviced approximately
    $4.0 billion, $5.4 billion and $13.5 billion of GNMA loans in its owned
    servicing portfolio, respectively, and $1.7 billion, $2.5 billion and $2.9
    billion of conventional loans with recourse, respectively.

    In order to cover loan losses that may result from these servicing
    arrangements and other losses, the Company has provided an allowance for
    loan losses of $11.5 million and $12.8 million as of December 31, 1998 and
    1997, respectively. In addition, the valuation allowance for the Company's
    capitalized servicing asset related to its principal recourse portfolio
    includes a $5.2 million and $8.2 million reserve for estimated losses on the
    corresponding loans as of December 31, 1998 and 1997, respectively.
    Management believes these amounts are adequate to cover unreimbursed
    foreclosure advances and principal losses, including losses on loans with
    recourse.

32  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   33


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


    In order to offset changes in the value of its capitalized servicing asset
    and to mitigate the effect on earnings of higher amortization and impairment
    of the asset which results from increased prepayment activity, the Company
    invests in various financial instruments. As interest rates decline,
    prepayment activity generally increases, thereby reducing the value of the
    capitalized servicing asset, while the value of the financial instruments
    increases. Conversely, as interest rates increase, the value of the
    capitalized servicing asset increases, while the value of such financial
    instruments decreases. The financial instruments utilized by the Company
    include interest rate floors, I/R swaps and P/O swaps.

    The floors are derivative contracts which derive their value from
    differences between the floor rate specified in the contract and market
    interest rates. The cash flow from the floors is equal to the difference
    between the floor rate and the prevailing interest rate applied to the
    notional amount. Payments are made to the Company only when the prevailing
    interest rates are below the floor rate. Some of the floor contracts cap the
    payments by specifying a second rate that is less than the floor rate. If
    the prevailing interest rates fall below this rate, payments will not
    increase. To the extent that prevailing interest rates decrease, the value
    of the floors increases, even if interest rates do not fall below the floor
    rate. To the extent that prevailing interest rates increase, the value of
    the floors decreases. However, the Company is not exposed to losses in
    excess of its initial investment in the floors. During 1998, the Company
    entered into floor contracts with a notional value of $1.2 billion for an
    initial investment of $6.1 million. In addition, during 1998 the Company
    sold floors with a carrying value of $8.3 million and a notional value of
    $814.6 million for proceeds of $11.3 million and realized a net gain of $3.0
    million. As of December 31, 1998, the Company's open floors had a total
    notional value of $1.1 billion, an original cost of $5.3 million and a
    carrying value of $9.9 million. The floors have remaining terms of
    approximately 5 to 10 years with floor rates ranging from 3.54% to 5.05%.
    During 1997, the Company entered into floor contracts with a notional value
    of $264.6 million for an initial investment of $2.3 million. In addition,
    during 1997 the Company sold floors with a carrying value of $.7 million and
    a notional value of $550 million for proceeds of $.8 million and realized a
    net gain of $.1 million. As of December 31, 1997, the Company's open floors
    had a total notional value of $.7 billion, an original cost of $4.7 million
    and a carrying value of $8.2 million.

    The I/R swaps are derivative contracts which entitle the Company to receive
    interest at a fixed rate and obligate it to pay interest at a variable rate
    based on a contracted notional amount. The Company's exposure to losses on
    the agreements is related to the differences, over the life of the contract,
    between the contracted fixed interest rates and the variable interest rates.
    During 1998, the Company entered into I/R swap agreements with a total
    notional value of $290.0 million. As of December 31, 1998, these I/R swaps
    had a carrying value of $4.8 million. The I/R swaps have remaining terms of
    5 to 10 years.

    The P/O swaps are derivative contracts, the value of which is determined by
    changes in the value of the underlying P/O strip security. The payments
    received by the Company under the P/O swaps relate to the cash flows of the
    referenced P/O security. The payments made by the Company are based upon a
    notional amount tied to the market price and the remaining balance of the
    underlying P/O security, multiplied by a floating rate indexed to the London
    Interbank Offered Rates for U.S. dollar deposits ("LIBOR"). The Company's
    exposure to loss in the P/O swaps is related to changes in the market value
    of the underlying P/O security over the life of the contract. During 1998,
    the Company entered into P/O swap transactions with a notional value of
    $50.0 million. In addition, during 1998 the Company sold P/O swaps with a
    carrying value of $13.1 million and an original notional value of $98.1
    million for proceeds of $13.7 million and realized a net gain of $.6
    million. As of December 31, 1998, the Company's open P/O swap agreements,
    with an original notional value of $50.0 million had a carrying value of
    $2.7 million. The P/O swaps have remaining terms of approximately 5 years.
    During 1997, the Company entered into P/O swap transactions with a notional
    value of $48.1 million. As of December 31, 1997, the Company's open P/O swap
    agreements, with an original notional value of $98.1 million had a carrying
    value of $12.5 million.

    The floors, I/R swaps and P/O swaps are carried at market value and are
    included in investments in the consolidated statements of condition.
    Realized and unrealized gains and losses are recorded in net gain on
    financial instruments in the consolidated statements of income.


Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  33


<PAGE>   34


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE OF FINANCIAL INSTRUMENTS
--------------------------------------------------------------------------------

    The Company determines the estimated fair value of its financial instruments
    using appropriate market information and valuation methodologies.
    Considerable judgment is required to interpret the market information to
    develop the estimates of fair value. As a result, the estimates provided
    herein are not necessarily indicative of the amounts that could be realized
    in a current market exchange.

    The following methods and assumptions were used by the Company to estimate
    the fair value of each class of financial instruments for which it is
    practicable to estimate that value:

    Cash and Investments

    For cash, short-term investments and fixed maturity investments the
    carrying value equals or approximates fair value.

    For interest rate floors, I/R swaps and P/O swaps, fair value is estimated
    based on quoted market prices for those or similar investments and is equal
    to the carrying value.

    For investment partnership interests fair value is determined as the equity
    method value calculated from the audited partnership financial statements.

    Mortgage Loans Receivable

    For mortgage loans receivable, fair value is estimated using quoted market
    prices for securities backed by similar loans.

    Pool Loan Purchases

    For pool loan purchases, fair value is estimated based on discounted cash
    flow analyses, using the Company'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.

    Loans Held For Investment

    In 1997, the Company identified for sale the majority of its loans held for
    investment and marked them down from amortized cost to current market value,
    and therefore, the carrying amount for these loans equals fair value.

    Receivables From Sales of Servicing

    For receivables from sales of servicing, carrying value equals or
    approximates fair value.

    Loans in Foreclosure and Mortgage Claims Receivable

    For these financial instruments, fair value is estimated by discounting
    anticipated future cash flows using the Company's short-term incremental
    borrowing rate.

    Debt

    For credit agreements (short-term debt), the carrying amount approximates
    fair value. For debentures and medium-term notes (long-term debt), fair
    value is estimated by discounting future cash flows using the Company's
    incremental borrowing rates for similar types of borrowing arrangements. For
    subordinated debentures (long-term debt), fair value is based on quoted
    market prices.

    Off-Balance-Sheet Financial Instruments

    Fair value for commitments to sell mortgage loans is based on the current
    settlement values of 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.

34  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report

<PAGE>   35
                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     The estimated fair values of the Company's financial instruments are as
     follows:

<TABLE>
<CAPTION>
=============================================================================================================
December 31,                                             1998                              1997
-------------------------------------------------------------------------------------------------------------
                                               Carrying              Fair        Carrying                Fair
(in thousands)                                   Amount             Value          Amount               Value
<S>                                         <C>              <C>              <C>                 <C>        
-------------------------------------------------------------------------------------------------------------
Financial Assets:
   Cash                                     $    16,410      $     16,410     $     3,134         $     3,134
   Investments
     Interest rate floor contracts                9,860             9,860           8,153               8,153
     Interest rate swap                           4,849             4,849              --                  --
     Principal-only swaps                         2,745             2,745          12,508              12,508
     Other                                       61,023            67,542          65,578              75,092
   Mortgage loans receivable                    676,317           679,998         519,247             529,260
   Pool loan purchases                          164,952           165,146         149,791             150,175
   Loans held for investment                      1,707             1,707           5,191               5,191
   Receivables from sales of servicing           73,825            73,825          27,324              27,324
   Loans in foreclosure and mortgage
     claims receivable (net) (a)                 27,058            26,530          35,579              34,905
-------------------------------------------------------------------------------------------------------------
Financial Liabilities:
   Short-term debt                          $   696,959      $    696,959     $   569,399         $   569,399
   Long-term debt                               173,405           171,853         172,660             186,978
Off-Balance-Sheet Financial Instruments:
   Mandatory forward commitments                    n/a           559,527             n/a               1,642
   Commitments to extend credit
     expected to close (pipeline)                   n/a            11,139             n/a               6,498
=============================================================================================================
</TABLE>
(a)  Excludes $5.9 million and $5.6 million of real estate owned in 1998 and 
     1997, respectively.

     The Company's investments in FSA options and preferred stock 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 consolidated
     statements of condition at fair value (refer to Note 2 to the consolidated
     financial statements).

NOTE 11. MORTGAGE SERVICING

    The Company's portfolio of mortgages serviced, including loans subserviced
    and excluding loans sold but not transferred, totaled $25.1 billion, $26.5
    billion and $29.2 billion as of December 31, 1998, 1997 and 1996,
    respectively. The Company's portfolio of mortgages serviced as of December
    31, 1998 is summarized below:

<TABLE>
<CAPTION>

==========================================================================================================================
                                                                                Weighted Average
                                                  ------------------------------------------------------------------------
                                      Principal                                                     Net          Remaining
                                        Balance            Loan           Interest            Servicing        Contractual
                                       Serviced         Balance               Rate             Fee Rate               Life
Loan Type                         (in millions)   (in thousands)       (in percent)        (in percent)        (in months)
--------------------------------------------------------------------------------------------------------------------------
<S>                                    <C>              <C>                   <C>                  <C>                 <C>
Residential
   Conventional                        $ 3,929          $    64               8.14%                .396%               237
   FHA                                   2,486               75               7.74                 .398                334
   VA                                    2,736               81               7.26                 .400                331
Commercial                                  46              927               7.16                 .189                173
--------------------------------------------------------------------------------------------------------------------------
                                       $ 9,197          $    72               7.76%                .397%               291
Subservicing                            15,915                                                                       
--------------------------------------------------------------------------------------------------------------------------
Total mortgage servicing portfolio     $25,112          $    65               7.99%                   (a)              270
==========================================================================================================================       
</TABLE>

(a)      This amount would be calculated as a combination of two different
         measurements: the net servicing fee earned on the Company's owned
         servicing portfolio, which is calculated as a percentage of the
         outstanding principal balance serviced; and the subservicing fee earned
         on the Company's subservicing portfolio, which is calculated based upon
         the terms of the various subservicing agreements.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  35


<PAGE>   36


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     The servicing fee rates in the table above are shown after deducting any
     guarantee fees. Guarantee fees, when applicable, range from six basis
     points for governmental loans up to approximately thirty basis points for
     certain conventional loans. Certain loans sold to private investors have no
     guarantee fees.

     The following table summarizes the Company's owned mortgage servicing
     portfolio by interest rate range:

<TABLE>
<CAPTION>
==================================================================================================================================
December 31,                                         1998                                             1997
----------------------------------------------------------------------------------------------------------------------------------
                                                                      Weighted                                         Weighted
                                     Number        Principal           Average         Number        Principal          Average
                                         of          Balance     Interest Rate             of          Balance    Interest Rate
Interest Rate Range                   Loans    (in millions)       in percent)          Loans    (in millions)     (in percent)
-------------------------------------------------------------------------------------------------------------------=--------------
<S>                                 <C>              <C>                  <C>         <C>              <C>                <C>  
5.99% and lower                         438          $    35              5.17%           843          $    66             5.41%
6.00%-6.49%                           1,193              127              6.22          1,823              159             6.13
6.50%-6.99%                          10,870            1,111              6.64          4,166              319             6.66
7.00%-7.49%                          28,036            2,337              7.08         12,968              729             7.17
7.50%-7.99%                          30,928            2,550              7.58         29,240            2,455             7.63
8.00%-8.49%                          15,778            1,155              8.12         27,989            2,280             8.13
8.50%-8.99%                          17,999              809              8.62         32,178            1,867             8.59
9.00%-9.49%                           5,934              275              9.12         13,452              722             9.07
9.50%-9.99%                           7,580              339              9.64         29,142            1,420             9.55
10.00% and above                      9,574              459             10.73         32,488            1,610            10.49
----------------------------------------------------------------------------------------------------------------------------------
Total                               128,330          $ 9,197              7.76%       184,289          $11,627             8.52%
==================================================================================================================================
</TABLE>

    The following table summarizes the Company's owned mortgage servicing
portfolio by location of property:

<TABLE>
<CAPTION>

====================================================================================================================================
December 31,                                         1998                                                1997
------------------------------------------------------------------------------------------------------------------------------------
                                                                   Percentage                                           Percentage
                                                                 of Principle                                         of Principle
                                    Number         Principal       Balance of           Number         Principal        Balance of
                                        of           Balance        Servicing               of           Balance         Servicing
State                                Loans     (in millions)        Portfolio            Loans     (in millions)         Portfolio
------------------------------------------------------------------------------------------------------------------------------------
<S>                                 <C>           <C>                   <C>             <C>       <C>                        <C>  
California                          17,617        $    1,795             19.5%          20,459    $        1,889              16.3%
New York                            17,572               935             10.2           22,118             1,162              10.0
Texas                               11,448               676              7.4           15,655               736               6.3
Washington                           5,033               486              5.3            7,889               690               5.9
Florida                              7,849               471              5.1           12,894               663               5.7
Michigan                             7,810               393              4.3           10,773               520               4.5
Maryland                             4,159               377              4.1            5,020               362               3.1
New Jersey                           5,145               364              4.0            7,088               503               4.3
Ohio                                 4,461               298              3.2            6,658               357               3.1
Illinois                             3,441               260              2.8            6,335               420               3.6
Other*                              43,795             3,142             34.1           69,400             4,325              37.2
------------------------------------------------------------------------------------------------------------------------------------
Total                              128,330        $    9,197            100.0%         184,289    $       11,627             100.0%
====================================================================================================================================
</TABLE>

*   No other state constitutes more than 2.8% of the Company's owned servicing 
    portfolio as of December 31, 1998.

    The above tables exclude loans subserviced for others having a principal
    balance of $15,915 million and $14,919 million as of December 31, 1998 and
    1997, respectively.

    During 1998, the Company sold the rights to service approximately $10.6
    billion of its nonrecourse servicing portfolio to third parties for net
    proceeds of $227.9 million. The Company recognized a $15.2 million pretax
    gain on these sales and adjustments to previous sales. During 1997, the
    Company sold the rights to service $17.0 billion of its nonrecourse
    servicing portfolio to a third party for net proceeds of $266.9 million. The
    Company recognized a $8.0 million pretax loss on the sale. As of December
    31, 1998 and 1997, the Company had outstanding receivables from servicing
    sales totaling approximately $73.8 million and $27.3 million, respectively,
    which are included in other assets in the consolidated statements of
    condition.

36  Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report

<PAGE>   37


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    Escrow funds of approximately $207.9 million, $196.8 million and $207.8
    million as of December 31, 1998, 1997 and 1996, respectively, relating to
    mortgages serviced and subserviced, are held in non-interest bearing
    accounts at non-affiliated banks and are not included in the consolidated
    financial statements.

    The Company has in force an errors and omissions policy in the amount of $20
    million. Primary fidelity coverage up to a limit of $30 million is provided
    under a Fund American master policy, for which the Company pays a portion of
    the premium.

NOTE 12. RESTRUCTURING CHARGES

    In April 1997, the Company's management approved and implemented a
    restructuring plan designed to reduce its operating costs in order to
    improve its financial performance. As part of this plan, the Company reduced
    its work force, primarily in overhead areas, by approximately 100 employees
    during the second quarter of 1997 to bring its overhead costs in line with
    its production and servicing operations. As a result, the Company recognized
    restructuring charges totaling $1.7 million during the second quarter of
    1997. The amount included approximately $1.6 million of employee separation
    costs, including severance payments, health care coverage and postemployment
    education benefits and $.1 million of miscellaneous expenses. As of December
    31, 1998, no liability remains in connection with this plan. As of December
    31, 1997, $.1 million remained accrued in the Company's consolidated
    statements of condition.

    In 1994, the Company implemented a restructuring plan to bring its mortgage
    loan production network in line with anticipated levels of mortgage loan
    production as a result of a contracting mortgage loan origination market. As
    of December 31, 1998, no liability remains in connection with this plan. As
    of December 31, 1997, $.2 million remained accrued in the Company's
    consolidated statements of condition relating to future lease expenses for
    closed facilities.

NOTE 13. LEASE COMMITMENTS

    The Company has entered into a number of noncancelable operating lease
    agreements with respect to premises and equipment. The minimum annual rental
    commitments under these leases as of December 31, 1998 are as follows:

<TABLE>
<CAPTION>

====================================================================================================
(in thousands)           1999         2000        2001            2002           2003          Total
<S>                <C>          <C>            <C>            <C>         <C>             <C>       
----------------------------------------------------------------------------------------------------                   
                   $    2,693   $    2,593     $ 2,136        $  1,504    $     1,284     $   10,210
====================================================================================================
</TABLE>

    Total rental expense for the years ended December 31, 1998, 1997 and 1996
    was $5.2 million, $3.9 million, and $4.5 million, respectively. Some leases
    contain escalation clauses that correspond with increased real estate taxes,
    other operating expenses and/or renewal options that call for increased
    rents when the leases are renewed.

NOTE 14. OTHER OPERATING EXPENSES

    The following table summarizes other operating expenses:

<TABLE>
<CAPTION>
=========================================================================================================================
Year ended December 31, (in thousands)                               1998                  1997                      1996
-------------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>                          <C>                      <C>         
Professional services                                  $            5,456           $     3,587              $      3,376
Advertising                                                         5,276                 1,537                     1,088
Telephone                                                           5,083                 3,948                     4,316
Travel and entertainment                                            3,397                 1,989                     1,885
Postage                                                             3,141                 1,812                     2,119
Office supplies and printing                                        2,917                 1,903                     2,063
Software systems                                                    2,580                 1,501                     1,669
Loan Processing Expense                                             2,547                 1,136                     1,873
Amortization of goodwill                                               --                    --                     2,090
Other                                                              12,125                 9,188                    13,773
-------------------------------------------------------------------------------------------------------------------------
Total other operating expenses                         $           42,522           $    26,601              $     34,252
=========================================================================================================================
</TABLE>

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  37


<PAGE>   38


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 15. INCOME TAXES

    The Company files a consolidated federal income tax return with Fund
    American. Federal income tax expense is provided substantially on a separate
    return basis. As of December 31, 1998, the Company had recorded $53.8
    million of deferred tax liability relating to accumulated unrealized gains
    and equity in earnings of an investment in an unconsolidated affiliate. As
    of December 31, 1997, this amount was $39.1 million, of which $13.9 million
    was recorded as part of the initial exchange. The Company files state income
    tax returns on a stand-alone basis.

    The following table summarizes federal income taxes due from or (to) Fund
    American:

<TABLE>
<CAPTION>

==============================================================================================
December 31, (in thousands)                                   1998                       1997
----------------------------------------------------------------------------------------------
<S>                                                           <C>                       <C> 
Net current taxes                                       $   (9,164)                $    9,058
Net deferred taxes                                         (32,549)                   (17,219)
==============================================================================================
</TABLE>

    Total income tax expense (benefit) is as follows:


<TABLE>
<CAPTION>
==========================================================================================================================
Year ended December 31, (in thousands)                        1998                       1997                         1996
<S>                                                    <C>                         <C>                        <C>         
--------------------------------------------------------------------------------------------------------------------------
Current income taxes:
   Federal                                             $    18,222                 $   (4,396)                $     17,280
   State and local                                           1,079                      1,352                          144
Deferred expense (benefit)                                   4,942                       (573)                      (7,971)
--------------------------------------------------------------------------------------------------------------------------
Total income tax expense (benefit)                     $    24,243                 $   (3,617)                $      9,453
==========================================================================================================================
</TABLE>

    The current federal income tax benefit for the year ended December 31, 1997,
    as shown above, excludes a benefit of $3.2 million which relates to the
    extraordinary loss on the repurchase and retirement of debt which has been
    reported as an amount, net of tax, in the consolidated statement of income.

    Deferred tax expense (benefit) for the years ended December 31, 1998, 1997
    and 1996 represents the net change in the deferred tax asset or liability
    during the year. Deferred income taxes arise from temporary differences
    between the tax bases of assets and liabilities and their reported amounts
    in the consolidated financial statements. The net deferred tax expense
    (benefit) for the years ended December 31, 1998, 1997 and 1996, shown above,
    excludes deferred tax expense of $10.4 million, $22.1 million and $.3
    million, respectively. The 1998 and 1997 expenses are associated with
    unrealized gains on the Company's investment in an unconsolidated affiliate
    which were recorded directly to stockholders' equity, net of tax. The 1996
    expense is associated with unrealized gains and losses on common equity
    securities, which was recorded directly to stockholders' equity, net of tax.

    The following table summarizes the types of temporary differences giving
    rise to the net deferred tax assets and net deferred tax liabilities:

<TABLE>
<CAPTION>
=====================================================================================================================
December 31, (in thousands)                                      1998                                 1997
---------------------------------------------------------------------------------------------------------------------
                                                       Deferred           Deferred         Deferred          Deferred
                                                            Tax                Tax              Tax               Tax
                                                         Assets        Liabilities           Assets       Liabilities
---------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>                 <C>              <C>               <C>       
Purchase accounting adjustments                     $        --         $    4,822       $       --        $    5,520
Unrealized gain on investment in
   unconsolidated affiliate (net)                            --             46,391               --            36,002
Equity in earnings of unconsolidated
   affiliate                                                 --              7,383               --             3,095
Unrealized gain on financial instruments                     --              4,254               --             4,597
Capitalized servicing                                    21,097                 --           26,163                --
Allowance for loan losses                                 4,252                 --            4,803                --
Depreciation                                                 --              2,259               --             2,159
Deferred bi-weekly income                                 1,360                 --              969                --
Accrued postretirement benefits                           1,300                 --            1,279                --
Other, net                                               12,038              7,487            7,921             6,981
---------------------------------------------------------------------------------------------------------------------
Total                                               $    40,047         $   72,596       $   41,135        $   58,354
=====================================================================================================================
</TABLE>

38 Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   39


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    In assessing the realizability of deferred tax assets, management considers
    whether it is more likely than not that some portion or all of the deferred
    tax assets will not be realized. The ultimate realization of deferred tax
    assets is dependent upon the generation of future taxable income during the
    periods in which those temporary differences become deductible. Based upon
    the level of historical taxable income and projections for future taxable
    income over the periods in which the deferred tax assets are deductible,
    management believes it is more likely than not the Company will realize the
    benefits of these deductible differences. Accordingly, no valuation
    allowances have been provided as of December 31, 1998 and 1997.

    A reconciliation of taxes, calculated using the federal statutory rate of
    35%, to income tax expense (benefit) follows:

<TABLE>
<CAPTION>
=====================================================================================================================      
Year ended December 31, (in thousands)                                        1998             1997              1996
---------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>              <C>               <C>       
Tax expense (benefit) at federal statutory rate                         $   24,553       $   (3,902)       $    1,795
Write-off of goodwill and other intangible assets                               --               --             6,960
Purchase accounting adjustments                                                 --               --               732
Dividends received deduction                                                (1,230)            (706)               --
State taxes                                                                    701              879                94
Other, net                                                                     219              112              (128)
---------------------------------------------------------------------------------------------------------------------
Total income tax expense (benefit)                                      $   24,243       $   (3,617)        $   9,453
=====================================================================================================================
</TABLE>

NOTE 16. PENSION PLAN

    The Company has a defined benefit pension plan covering most of its
    employees. Benefits under the plan are based on years of service and the
    employees' highest average compensation over five consecutive years in their
    last ten years of employment. The Company's policy is to fund the pension
    plan in amounts which comply with the minimum funding requirements specified
    by the Employee Retirement Income Security Act. Plan assets primarily
    consist of common stock and corporate bond mutual funds.

    In the fourth quarter of 1997, the Company's Board of Directors approved
    certain amendments to the Company's pension plan. The approved amendments
    included the expansion of eligibility requirements for early retirement from
    age 55 with ten years of service to the earlier of age 55 with ten years of
    service or age 50 with fifteen years of service for retirements beginning on
    or after January 1, 1997. In addition, the accrual rate for years of benefit
    service was reduced from 1.6% to 1.2% for years of service credited on and
    after January 1, 1998. The Company expects the net effect of these
    amendments will be to reduce the future cost and funding requirements of the
    plan.

    The following table sets forth the change in the plan's projected benefit
    obligation and plan assets and the plan's funded status:

<TABLE>
<CAPTION>
=====================================================================================================================
Year ended December 31, (in thousands)                                                         1998              1997
---------------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>               <C>       
Benefit obligation at beginning of year                                                  $   26,975        $   23,724
Service cost                                                                                    895             1,448
Interest cost                                                                                 1,857             1,718
Amendments                                                                                       --               645
Actuarial loss                                                                                1,206                60
Benefits paid                                                                                  (644)             (620)
---------------------------------------------------------------------------------------------------------------------
Benefit obligation at end of year                                                            30,289            26,975
---------------------------------------------------------------------------------------------------------------------
Fair value of plan assets at beginning of year                                               24,669            20,942
Actual return on plan assets                                                                  4,530             3,752
Employer  contribution                                                                           --               595
Benefits paid                                                                                  (644)             (620)
---------------------------------------------------------------------------------------------------------------------
Fair value of plan assets at end of year                                                     28,555            24,669
---------------------------------------------------------------------------------------------------------------------
Funded status                                                                                 1,734             2,306
Unrecognized net gain                                                                         2,413               931
Unrecognized prior service cost                                                                  14                87
---------------------------------------------------------------------------------------------------------------------
Accrued pension cost included in accounts payable and other liabilities                  $    4,161        $    3,324
=====================================================================================================================
</TABLE>


Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  39


<PAGE>   40



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    A summary of the components of net periodic pension cost is as follows:

<TABLE>
<CAPTION>
=======================================================================================================================
Year ended December 31, (in thousands)                                  1998                     1997              1996
-----------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>                         <C>              <C>      
Service cost for benefits earned during the year                 $       895                 $  1,448         $   1,578
Interest cost on projected benefit obligation                          1,857                    1,718             1,633
Amortization of unrecognized transition obligation                        --                       11                45
Expected return on plan assets                                        (1,842)                  (1,678)           (1,382)
Amortization of unrecognized prior service cost                          (73)                    (139)             (130)
Amortization of unrecognized net loss                                     --                       27               361
-----------------------------------------------------------------------------------------------------------------------
Net periodic pension cost                                        $       837                 $  1,387         $   2,105
=======================================================================================================================
</TABLE>

    Weighted-average assumptions used in the determination of the projected
benefit obligation were:

<TABLE>
<CAPTION>
=======================================================================================================================
December 31,                                                                1998             1997                  1996
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>               <C>                  <C>  
Discount rate                                                              6.75%             7.0%                 7.25%
Rate of increase in compensation levels                                     4.5%             4.5%                  5.0%
Expected long-term rate of return on assets                                 8.5%             8.5%                  8.0%
=======================================================================================================================
</TABLE>

Note 17. POSTRETIREMENT BENEFITS

    The Company has an unfunded postretirement benefit plan which provides for
    postretirement health care and life insurance benefits. Postretirement life
    insurance benefits are provided to substantially all employees.
    Postretirement health care benefits are provided to substantially all
    employees hired prior to January 1, 1991. The Company provides for term life
    insurance coverage based on the employees' annual earnings and length of
    service. Postretirement health care benefits are contributory, whereby the
    Company provides for 87.5% of medical costs to retirees who retired prior to
    January 1, 1993. Effective January 1, 1993, the plan was amended to provide
    for a portion of monthly retiree medical costs, based on years of service,
    to retirees who retire on or after January 1, 1993.

<TABLE>
<CAPTION>
=====================================================================================================================
Year ended December 31, (in thousands)                              1998                   1997                  1996
---------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>                    <C>                   <C>      
Benefit obligation at beginning of year                          $ 3,795                $ 3,410               $ 3,379
Service cost                                                          78                     94                   110
Interest cost                                                        268                    256                   239
Amendments                                                            --                    157                    --
Actuarial loss/(gain)                                                180                     52                  (127)
Benefits paid                                                       (228)                  (174)                 (191)
---------------------------------------------------------------------------------------------------------------------
Benefit obligation at end of year                                  4,093                  3,795                 3,410
Plan assets at fair value                                             --                     --                    --
---------------------------------------------------------------------------------------------------------------------
Benefit obligation in excess of plan assets                        4,093                  3,795                 3,410
Unrecognized prior service cost                                     (139)                  (157)                   --
Unrecognized net (loss)/gain                                        (166)                    15                    67
---------------------------------------------------------------------------------------------------------------------
Accrued postretirement cost included in accounts payable and
   other liabilities                                             $ 3,788                $ 3,653               $ 3,477
=====================================================================================================================
</TABLE>

    A summary of the components of net periodic postretirement benefit cost is
as follows:

<TABLE>
<CAPTION>
=====================================================================================================================
Year ended December 31, (in thousands)                              1998                   1997                  1996
---------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>                    <C>                   <C>      
Service cost                                                     $    78                $    94               $   110
Interest cost                                                        268                    256                   239
Amortization of unrecognized prior service cost                       17                     --                    --
Net periodic postretirement cost                                 $   363                $   350               $   349
=====================================================================================================================
</TABLE>

    A discount rate of 6.75% and 7.0% was used to determine the accumulated
    postretirement benefit obligation as of December 31, 1998 and 1997,
    respectively. An 8.2% annual rate of increase in the per capital costs of
    covered health care benefits was assumed for 1999, gradually decreasing to
    5.0% by the year 2007 and remaining at that level thereafter.

40 Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report


<PAGE>   41


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    A one-percent change in assumed health care cost trend rates would have the
    following effects:

<TABLE>
<CAPTION>
================================================================================================================
Year ended December 31, 1998                                                   1% increase           1% decrease
----------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>                  <C>    
Effect on total service and interest cost                                         4.21%                (3.73%)
Effect on postretirement benefit obligation                                       4.88%                (4.32%)
================================================================================================================
</TABLE>

NOTE 18. STOCK PLANS

    Effective October 1, 1996, the Company amended its Employee Stock Ownership
    Plan ("ESOP") to include employees of White Mountains as eligible employees
    and to add an employee savings plan feature under Section 401(k) of the
    Internal Revenue Code of 1986. Eligible employees may contribute to the plan
    up to 14% of their salary not to exceed the maximum allowable under Internal
    Revenue Service guidelines. Contributions are invested at the direction of
    the employee in one or more funds or can be directed to purchase common
    stock of Fund American at fair market value.

    In the fourth quarter of 1997, the Company's Board of Directors approved
    certain amendments to the Company's ESOP to be effective as of January 1,
    1998. The most significant of the amendments provided for the Company's ESOP
    contribution to be changed to a 401(k) matching contribution. The matching
    contribution is equal to a certain percentage of employee contributions, up
    to a maximum of 5%, which is dependent on the Company's annual return on
    equity. In addition, the amendment provided for the transfer of all of the
    participant accounts in the ESOP portion of the plan to the 401(k) portion
    of the plan. This will allow the participants to direct the investment of
    the Company's contributions among the various investment options.

    The Company has long-term incentive plans which provide for the granting of
    stock-based and cash incentive awards to key management employees of the
    Company. Awards under the plans are payable upon the achievement of
    specified financial goals covering overlapping three-year periods beginning
    January 1, 1994, 1995, 1996, 1997, 1998 and 1999.

    In 1998, the Company established an Incentive Compensation Plan ("ICP") for
    certain key executives and directors of the Company. Under this plan,
    participants were provided the opportunity to invest in simulated equity
    shares of the Company. The value of the shares represents the calculated
    fair value of the Company as defined by the plan which was equal to $42.783
    per share at the time of issuance in May 1998. The Company issued
    approximately 50,253 shares in exchange for cash proceeds of $2.2 million.
    Concurrent with the purchase of each equity share, the participants were
    granted five simulated equity options. The value of the options is equal to
    the appreciation in the value of the equity shares over the strike price.
    The initial strike price is equal to $42.783 per share and increases each
    January 1 by 4% beginning in 1999. The Company issued approximately 251,267
    options which vest over a three-year period beginning May 1, 1998. In
    September 1998, the Company established a second Incentive Compensation Plan
    ("ICP II") for certain other key employees of the Company. Under this plan,
    the Company issued approximately 31,900 options with an initial strike price
    of $49.198 which vest over a three-year period beginning September 1, 1998.
    The strike price increases each September 1, by 4% beginning in 1999. During
    1998, the Company recognized compensation expense relating to these plans
    totaling approximately $3.5 million. As of December 31, 1998, the Company's
    accrued liability relating to these plans, including the initial investment
    in simulated equity shares, was approximately $5.6 million.

NOTE 19. REPORTABLE SEGMENTS

    The Company has determined that its reportable segments include Production
    and Servicing. The Production segment originates and sells into the
    secondary market a variety of residential loan products, including
    conventional, government, subprime, manufactured housing, 203 (k) and high
    LTV loans. The Servicing segment services conforming residential mortgage
    loans and subservices residential mortgage loans for third parties.

    The accounting policies of the segments are the same as those described in
    the summary of significant accounting policies. The Company accounts for any
    intersegment activity as if it were with third parties, that is at estimated
    market prices.

    The Company determined its reportable segments based upon the organization
    of information provided to its board of directors. Each segment is a
    strategic business unit that offers either a product or a service. The
    segments are managed separately because each requires different technology
    and strategies.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  41


<PAGE>   42


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    Segment information is provided for the year ended December 31, 1998 only.
    During 1997, the Company experienced a fundamental reorganization and
    redesigned its internal financial reporting methodologies for information
    that is provided to its board of directors. Consequently, comparative
    information is not available.

<TABLE>
<CAPTION>
=====================================================================================================================
Year ended December 31, 1998  (in thousands)
---------------------------------------------------------------------------------------------------------------------
                                             Production          Servicing                Other (a)             Total
                                          ---------------------------------------------------------------------------
<S>                                       <C>                 <C>                 <C>                     <C>        
Revenues from external customers          $     124,758       $     79,557        $       7,893 (b)       $   212,208
Intersegment revenues                            (2,614)             2,614                   --                    --
Interest revenue                                 65,418             13,341                2,537                81,296
Interest expense                                (54,138)            (8,578)              (9,085)              (71,801)
Depreciation expense                             (1,268)              (443)              (1,376)               (3,087)
Other significant non-cash items:
   OMSR income                                   72,597                 --                   --                72,597
   Amortization of capitalized servicing             --            (55,179)                  --               (55,179)
Segment profit                                   42,588             22,054              (15,902)               48,740
Segment Assets (c)                              676,317            334,640              211,593             1,222,550
=====================================================================================================================
</TABLE>

(a) Primarily represents unallocated overhead.
(b) Primarily represents unallocated net gain on sale of pool loan purchases and
    loans held for investment and gain on sale of servicing.
(c) Management does not typically review segment assets information. The only
    segment assets reviewed or monitored by management are mortgage loans
    receivable, pool loan purchases and capitalized servicing. `Other' segment
    assets include all other mortgage-banking related assets.

    The following reconciles the above table to the amounts shown on the
    consolidated financial statements as of and for the year ended December 31,
    1998:

<TABLE>
<CAPTION>
=====================================================================================================================
(in thousands)
---------------------------------------------------------------------------------------------------------------------
<S>                                                                                                 <C>
Revenue:                                                                          
External revenues for reportable segments                                                           $   212,208
Interest revenue for reportable segments                                                                 81,296
Interest expense for reportable segments                                                                (71,801)
Adjustments to revenue                                                            
   Amortization of capitalized servicing                                                                (55,179)
   Net gain on financial instruments                                                                     20,431
Non mortgage-banking-related revenues                                                                    21,413   (a)
---------------------------------------------------------------------------------------------------------------------
Total revenue                                                                                       $   208,368   (b)
---------------------------------------------------------------------------------------------------------------------
Interest revenue:
Interest revenue for reportable segments                                                            $    81,296
Interest revenue from non mortgage-banking-related investments                                            4,097   (a)
---------------------------------------------------------------------------------------------------------------------
Total interest revenue                                                                              $    85,393
---------------------------------------------------------------------------------------------------------------------
Interest expense:
Interest expense for reportable segments                                                            $   (71,801)
Interest expense and capital charges allocated to segments (c)                                            1,600
---------------------------------------------------------------------------------------------------------------------
Total interest expense                                                                              $   (70,201)
---------------------------------------------------------------------------------------------------------------------
Income before income taxes:
Income before income taxes for reportable segments                                                  $    48,740
Non mortgage-banking-related income before income taxes                                                  21,413   (a)
---------------------------------------------------------------------------------------------------------------------
Total income before income taxes                                                                    $    70,153
---------------------------------------------------------------------------------------------------------------------
Total assets:
Total assets for reportable segments                                                                $ 1,222,550
Non mortgage-banking-related assets                                                                     295,427   (a)
---------------------------------------------------------------------------------------------------------------------
Total assets                                                                                        $ 1,517,977
=====================================================================================================================
</TABLE>

(a) Relates to the Company's investment in unconsolidated affiliate and other
    investments.
(b) Approximately 48% of the Company's total consolidated revenue is generated
    from sales of loans to GNMA, FNMA and FHLMC and the related servicing of
    those loans.
(c) Represents allocated interest expense and capital charges related to the
    Company's investment in unconsolidated affiliate and other investments.

42 Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report

<PAGE>   43


                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 20. CONTINGENCIES

     Various claims have been made against the Company in the ordinary course of
     business. Management believes that any liabilities which could result would
     not materially affect the Company's financial position or results of
     operations.

NOTE 21. RELATED-PARTY TRANSACTIONS

     As discussed in Notes 4 and 9, the Company had various related-party
     transactions with Fund American and White Mountains. The Company also has a
     tax allocation agreement with Fund American.

     The Company believes that all of 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.

NOTE 22. SUPPLEMENTAL CASH FLOW INFORMATION

     For purposes of reporting cash flows, cash includes cash on hand and
     amounts on deposit at banks, excluding custodial bank accounts.

     The following table provides additional cash and noncash information not
     presented elsewhere in the consolidated financial statements:


<TABLE>
<CAPTION>
=================================================================================================================
Year ended December 31, (in thousands)                            1998                   1997               1996
-----------------------------------------------------------------------------------------------------------------
<S>                                                       <C>                    <C>                   <C>      
Interest paid                                             $     80,502           $     44,809          $  57,172
-----------------------------------------------------------------------------------------------------------------
Income taxes paid                                         $        650           $      8,268          $  18,650
-----------------------------------------------------------------------------------------------------------------
Noncash investing and financing activities:

Exchange of common equity securities for
   shares of common stock from parent (Note 4)            $         --           $      2,638          $      --
Receivable from sale of servicing rights                        73,825                 27,324                 --
Capital contribution from parent in exchange for
   investment in unconsolidated affiliate (Note 2)                  --                106,365                 --
Acquisition of common equity securities as a return
   of partnership investment, net (Note 4)                          --                     --              2,312
=================================================================================================================
</TABLE>

NOTE 23. SUBSEQUENT EVENTS

     In January 1999, the Company repurchased and retired $8.0 million of its 9%
     debentures due 2012. As a result, the Company recognized a $.3 million
     pretax loss on the repurchase and retirement of debt.

     During the first quarter of 1999, the Company declared and paid dividends
     on its common stock totaling $11.9 million.

     In late March 1999, the Company and Citicorp Mortgage, Inc. ("Citicorp")
     reached a definitive agreement under which Citicorp will acquire
     substantially all of the mortgage-banking-related assets and assume certain
     liabilities of the Company. In addition, Citicorp will employ substantially
     all of the Company's employees. The transaction is contingent upon the
     receipt of various regulatory and agency approvals.

Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report  43


<PAGE>   44


SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)


     Selected quarterly financial data for 1998 and 1997 is shown in the
     following table. The quarterly financial data includes, in the opinion of
     management, all necessary recurring adjustments for a fair presentation of
     the results of operations for the interim periods.


<TABLE>
<CAPTION>
====================================================================================================================================
Quarters Ended                                                    March            June            September           December
(in thousands, except for per share amounts)                         31              30                   30                 31
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                        <C>             <C>                 <C>                   <C>         
1998
Total revenue                                              $     47,997    $     49,783        $      50,876       $     59,712
Net income                                                       13,120          10,492                9,978             12,320 (b)
Comprehensive income (loss)                                      31,146          22,475              (17,699)            29,282
------------------------------------------------------------------------------------------------------------------------------------
Basic net income per common share (a)                      $       3.80    $       2.98        $        2.82       $       3.55
Basic comprehensive income (loss) per common share (a)             9.41            6.71                (5.80)              8.83
------------------------------------------------------------------------------------------------------------------------------------
1997
Total revenue                                              $     24,752    $     17,179 (c)    $      23,385       $     24,677
Income (loss) before extraordinary loss                             187          (6,291)(c)            1,088             (2,514)(d)
Extraordinary loss                                                   --          (5,975)                  --                 --
Net income (loss)                                                   187         (12,266)(c)            1,088             (2,514)(d)
Comprehensive (loss) income                                        (120)          1,154 (c)           23,504              3,059 (d)
------------------------------------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share
   before extraordinary loss (a)                            $      (.33)    $     (2.25)        $        .05       $      (1.07)
Extraordinary loss per common share                                  --           (1.86)                  --                 --
Basic net (loss) income per common share (a)                       (.33)          (4.11)                 .05              (1.07)
Basic comprehensive (loss) income per common share (a)             (.47)            .07                 7.03                .66
====================================================================================================================================
</TABLE>

(a) After deducting dividends on preferred stock.
(b) Includes approximately $2.6 million of pretax income primarily related to
    adjustments to servicing sales prior to the fourth quarter of 1998.
(c) Includes a $3.0 million pretax write-down of loans held for investment, $1.7
    million of pretax restructuring charges and a $1.1 million pretax loss on
    the February 1997 servicing sale and related assumption of subservicing.
(d) Includes a $3.7 pretax million loss related to the February 1997 servicing
    sale and related assumption of subservicing and $1.4 million pretax of
    various one-time charges.


44 Source One Mortgage Services Corporation and Subsidiaries 1998 Annual Report

<PAGE>   45




                               BOARD OF DIRECTORS

                               Michael C. Allemang
              Executive Vice President and Chief Financial Officer
                    Source One Mortgage Services Corporation

                                Raymond Barrette
              Executive Vice President and Chief Financial Officer
                    Fund American Enterprises Holdings, Inc.

                                Terry L. Baxter*
                                    President
                         White Mountains Holdings, Inc.

                               Robert R. Densmore
                            Executive Vice President
                    Source One Mortgage Services Corporation

                                 Mark A. Janssen
                     Executive Vice President and Secretary
                    Source One Mortgage Services Corporation

                                Francis X. Mohan*
                      President and Chief Executive Officer
                    Source One Mortgage Services Corporation

                                James H. Ozanne*
                                    Chairman
                    Source One Mortgage Services Corporation

                                 Roger K. Taylor
                      President and Chief Operating Officer
                   Financial Security Assurance Holdings Ltd.

                 *Member of the Executive Committee of the Board


                                 SENIOR OFFICERS

                                Francis X. Mohan
                      President and Chief Executive Officer

                               Michael C. Allemang
              Executive Vice President and Chief Financial Officer

                               Robert R. Densmore
                            Executive Vice President
                                    Servicing

                                 Mark A. Janssen
             Executive Vice President - Production & Capital Markets
                                  and Secretary

                                 Susan L. Bowen
                              Senior Vice President
                               Production Division

                                 Melinda F. Cain
                              Senior Vice President
                                 Capital Markets

                                 John J. Cleary
                              Senior Vice President
                               Loan Administration

                              Kathleen M. DeFrances
                              Senior Vice President
                              Residential Division

                               Gregory J. Ghilardi
                              Senior Vice President
                                 Human Resources

                               Patrick D. Gillies
                              Senior Vice President
                           Delinquency Administration

                               Thomas J. Marshall
                              Senior Vice President
                                 Risk Management

                               Michael E. Muldoon
                              Senior Vice President
                               Subprime Servicing

                               Pablo Sanchez, Jr.
                              Senior Vice President
                                Subprime Division

                                Charles D. Taylor
                              Senior Vice President
                              Information Services


                        Central Pacific Mortgage Company

                                 John A. Courson
                      President and Chief Executive Officer


                                [SOURCE ONE LOGO]
                              27555 Farmington Road
                      Farmington Hills, Michigan 48334-3357
                                 (248) 488-7000
                                  www.somsc.com