<PAGE>   1
                                                                    EXHIBIT 13a

TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS


  Back in 1946, Source One Mortgage Services Corporation laid the foundation for
  the Company that has evolved today. Just as a house that was built in 1946
  would undergo renovations, so too has Source One.

  We started with four employees in a one-room office and, over the years, have
  upgraded to a 1,500 employee Company. What has always remained the same,
  however, is the foundation on which the Company was built. Our goal of
  providing a home for every loan has been apparent all along.

  Worthy goals are not achieved overnight and we're still working on the goal
  of providing a home for every loan. To that end, we've made some changes and
  some additions in 1997.

  It's true that our last year was a period of significant change for the
  Company.

  It was the first year of our operation under a strategic plan adopted to
  position us to return low ROE capital to our parent company while
  simultaneously shaping a more profitable business with the capital remaining
  in the Company.

  The sale of a $17 billion portfolio to Chase Mortgage for $267 million in
  February set the stage for the year. This transaction both liquified a
  low-return servicing asset and reduced our exposure to swings in interest
  rates. In conjunction with the sale, we negotiated the subservicing rights to
  this portfolio and began seeking other subservicing partners.

  Change isn't easy, making this a difficult year for the management and
  employees of Source One. We reduced our work force, added new products
  quickly, changed our focus from conventional to government originations, made
  changes in top management and our Board of Directors, all while we were
  completely restructuring our sales organization.

  We spent significant time and money renovating the Company in 1997 and have a
  major challenge before us in 1998 to execute the plan for which the
  groundwork was laid last year.

  We still have a lot of work to do, but in our judgement, we have the people
  and the plan to make Source One profitable again. Early 1998 results are
  solidly in the black.

OPERATING RESULTS

  After a very slow start, our mortgage loan production grew 15% in 1997 to
  $4.4 billion. Unfortunately, we concluded the year with a net loss of $13.5
  million compared with a net loss of $4.3 million the year before.

  We realized several strategic gains during the year including the reduction
  of our term debt with the proceeds received from the $17 billion servicing
  rights sale in February. We repurchased $119.6 million of 8.875% medium term
  notes due October 15, 2001. This repurchase resulted in a $6.0 million after
  tax loss. However, it reduces our future borrowing costs and frees up $138
  million of assets that were being used to secure the noteholders.

STRATEGIC DIRECTION

  The key to our success in 1998 is the addition of new products to supplement
  our conventional, FHA and VA loans. We now have in place a revamped,
  revitalized and streamlined sales organization with special, stand alone
  business units targeting sub-prime, 125% loan to value (125% LTV), 203(k) and
  manufactured housing products. The most important step in adding new,
  higher-margin products was the establishment of an exclusive sub-prime/125%
  LTV operation in Lagrangeville, New York.

  We have also consolidated similar or overlapping backroom functions that
  handle the loans both before and after they have been closed. The
  consolidation has reduced the number of times a loan is handled and moved
  within the Company.

  We continue to aggressively pursue subservicing business. To date, we have
  only been able to secure modest contracts for current and flow business. The
  marketplace appears to accept that the Company is no longer a candidate for
  sale to another firm and that attitude change should have a positive impact
  on our subservicing efforts.

  Preliminary 1998 profitability projections are very positive. All of our
  production and support people exhibit a renewed enthusiasm about the business
  and we see a strong commitment to meet or exceed our 1998 Business Plan.




                                       1
<PAGE>   2
TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS

SENIOR MANAGEMENT AND BOARD

  There were several significant management and Board of Directors changes
  during 1997.

  James H. Ozanne was named Chairman in March. He joined us from his role as
  President at Fund American Enterprises, Inc., and board member of Source One.

  James A. Conrad, former President and CEO, elected to take early retirement
  as did Lawrence J. Brady, Senior Vice President, Residential Division.

  Mark A. Janssen, Executive Vice President, previously responsible for Capital
  Markets, saw his duties expanded to include the Production Division. He was
  also named Secretary of the Company and a member of the Board of Directors.

  Allan L. Waters, Gordon S. Macklin and Robert P. Keller all elected to resign
  from the Board of Directors in order to pursue other activities.

  Raymond Barrette, Executive Vice President and Chief Financial Officer of
  Fund American Enterprises Holdings, Inc., joined the Board. We look forward
  to a long and mutually beneficial association.

  Susan L. Bowen, Senior Vice President, was named to oversee the sales and
  operations functions of the Production Division.

  Kathleen DeFrances was promoted to Senior Vice President in charge of the
  Residential Division.

  Pablo Sanchez joined the Company as a Senior Vice President responsible for
  our newly formed Sub-prime Unit. He joins the firm from his association with
  Beneficial.

  And, Frank Mohan was named President and CEO in September. With 35 years of
  experience as a senior consumer finance executive, Mohan arrived with a
  mandate to add more profitable products to our business mix and to return the
  overall Company to profitability. (The challenge continues, and we're making
  excellent headway.)

IN CONCLUSION

  Our renovation efforts are just coming to fruition; metaphorically speaking,
  the paint has yet to dry.

  We realize 1998 will be a challenge. But, we are staffed and collectively
  committed to successfully accomplish the difficult goals we've set for
  ourselves.

  We have in place efficient production and servicing units which can originate
  and service not only conventional loans, but manufactured housing, sub-prime,
  government, 203(k) and 125% LTV products.

  Our Sub-prime Unit has strategically and impactfully enlisted the support of
  our Production Division and they will consciously focus their respective
  efforts toward writing higher margin sub-prime loans.

  We extend a genuine and sincere thanks to all of our dedicated employees who
  have stood by the Company during its difficult transition. Their diligence
  toward providing the highest quality service to both our mortgage and
  subservicing customers has given us the solid base from which we can continue
  to grow.

  Our collective thanks to our Board of Directors for its support and
  direction.

  And last, but certainly not least, a respectful thanks to our customers who
  have made all the years possible.

  Sincerely,



  Francis X. Mohan                                        James H. Ozanne
  ------------------------                                ----------------------
  Francis X. Mohan                                        James H. Ozanne
  President and CEO                                       Chairman


  March 27, 1998



                                       2
<PAGE>   3


SELECTED CONSOLIDATED FINANCIAL DATA
& CORPORATE INFORMATION*



<TABLE>
<CAPTION>
INCOME STATEMENT DATA (in thousands, except per share amounts)
-------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,                                             1997         1996         1995         1994          1993
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                           <C>            <C>           <C>          <C>          <C>
Total revenue                                                  $   93,874    $  148,680    $ 148,595    $ 142,493    $  173,564
Total expenses                                                    105,021       143,553      105,313      137,215       111,387
-------------------------------------------------------------------------------------------------------------------------------
(Loss) income before income taxes, extraordinary
  loss and cumulative effect of accounting change                 (11,147)        5,127       43,282        5,278        62,177
Income tax (benefit) expense                                       (3,617)        9,453       16,132        4,474        22,056
-------------------------------------------------------------------------------------------------------------------------------
(Loss) income before extraordinary loss and
  cumulative effect of accounting change                           (7,530)       (4,326)      27,150          804        40,121
Extraordinary loss on retirement of debt                           (5,975)            -         (902)           -             -
Cumulative effect of accounting change (a)                              -             -            -      (44,296)            -
-------------------------------------------------------------------------------------------------------------------------------
Net (loss) income                                              $  (13,505)   $   (4,326)   $  26,248    $ (43,492)   $   40,121
-------------------------------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share (b):
  Before extraordinary loss and cumulative
    effect of accounting change                                $    (3.78)   $    (3.57)   $    7.55    $   (1.65)   $     9.48
  Basic net (loss) income per common share                          (5.79)        (3.57)        7.20       (14.21)         9.48
-------------------------------------------------------------------------------------------------------------------------------
Cash dividends per common share (c)                            $        -    $        -    $       -    $       -    $     6.39
Cash dividends declared on common shares                                -             -            -            -        26,616
Payment for common shares repurchased                               2,638             -      120,000      122,000             -
Insurance of common shares                                        119,040             -            -            -             -
-------------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME STATEMENT DATA (d)
-------------------------------------------------------------------------------------------------------------------------------
Net (loss) income                                              $ ( 13,505)   $   (4,326)   $  26,248    $ (43,492)   $   40,121
Other comprehensive income (loss)                                  41,102           546        3,519       (3,779)       23,731
-------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss)                                    $   27,597    $   (3,780)   $  29,767    $ (47,271)   $   63,852
-------------------------------------------------------------------------------------------------------------------------------
Basic comprehensive income (loss) per
  common share (b)                                             $     8.03    $    (3.33)   $    8.57    $  (15.28)   $    15.09
-------------------------------------------------------------------------------------------------------------------------------
OPERATING DATA
-------------------------------------------------------------------------------------------------------------------------------
Total mortgage loan production (in millions)                   $    4,403    $    3,831    $   2,852    $   4,586    $   11,452
Servicing portfolio at end of year (e):
  Balance (in millions)                                        $   26,546    $   29,201    $  31,831    $  39,568    $   38,403
  Number of loans serviced (f)                                    438,261       478,779      494,051      543,428       518,972
  Weighted average interest rate (f)                                 8.45%         8.48%        8.33%        8.14%         8.53%
  Weighted average net servicing fee (f) (g)                         .420%         .422%        .419%        .410%         .432%
  Percent delinquent (f)                                             6.35%         6.24%        5.28%        4.07%         4.44%
  Percent in process of foreclosure                                  1.18%          .93%         .80%         .77%          .92%
Servicing rights acquisitions (in millions)                    $       36    $    2,789    $   4,674    $   3,707    $    6,368
Sale of servicing rights (in millions)                         $   17,018    $    3,302    $  10,973    $   3,868    $        -
Number of employees at end of year                                  1,572         1,682        1,680        2,055         3,060
-------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA (in thousands)
December 31,
-------------------------------------------------------------------------------------------------------------------------------
Mortgage loans receivable                                      $  519,247    $  314,937 $    381,028 $    210,472    $1,298,506
Capitalized servicing (net) (h)                                   181,025       410,939      397,071      530,450       666,666
Total assets                                                    1,304,690     1,131,054    1,135,029    1,210,012     2,647,153
Senior debt                                                       686,906       643,262      661,846      647,251     1,959,643
Subordinated debt                                                  55,153        54,535       54,786            -             -
Total liabilities                                                 849,641       816,297      812,785      733,925     2,095,153
Total stockholders' equity                                        455,049       314,757      322,244      476,087       552,000
-------------------------------------------------------------------------------------------------------------------------------
</TABLE>


*See accompanying notes to selected consolidated financial data.




                                       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 (loss) income 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 includes net income (loss) and the net change in
     after tax unrealized investment gain (refer to Note 1 to the consolidated
     financial statements for further discussion).

(e)  Includes loans subserviced for others having a principal balance of $14.9
     billion, $2.8 billion, $4.0 billion and $4.3 billion as of December 31,
     1997, 1996, 1995 and 1994, respectively, except as noted.

(f)  Excludes interim servicing of loans having a principal balance of $1,651
     million and $4,190 million as of December 31, 1994 and 1993, respectively.

(g)  Excludes loans subserviced for others as noted in (d) above.

(h)  Reflects a $68.1 million cumulative pretax effect 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 1998.
  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 has decided to broaden
  its product line by offering higher margin products. The Company has recently
  begun to produce 203(k) (FHA home improvement) loans, manufactured housing
  loans, subprime loans and 125% loan-to-value ("125% LTV") second mortgage
  loans. The 203(k) loans and the manufactured housing loans are being sold
  into agency pools with servicing retained. The subprime and 125% LTV loans
  are being originated for a fee and sold to third parties on a servicing
  released basis. The Company is currently expanding its capability to service
  and subservice subprime loans and to subservice 125% LTV loans. Although
  these higher margin products are a new focus for the Company, they accounted
  for less than 2% of total production in 1997 and are currently expected to
  account for less than 10% of total production in 1998. 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, 1998, 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").

  No cash dividends on common stock were declared for the years ended December
  31, 1997, 1996 or 1995. The Company's secured credit agreement contains
  covenants which limit its ability to pay dividends or make distributions on
  its capital in excess of preferred stock dividend and subordinated debt
  interest requirements each year. In addition, the Company must comply with
  certain financial covenants provided in its secured credit agreement,
  including restrictions relating to tangible net worth and leverage. The
  Company is currently in compliance with all such covenants.



                                      4
<PAGE>   5

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

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 net loss includes a $9.2 million pretax
  extraordinary loss on the early retirement of the Company's medium-term debt,
  a $8.0 million pretax loss on the sale of servicing to a third party and the
  related assumption of subservicing, a $3.0 million pretax charge relating to
  loans held for investment identified as held for sale, $3.1 million of pretax
  restructuring and compensation charges and a $17.7 million pretax increase in
  the valuation allowances for impairment of the Company's capitalized
  servicing asset. These amounts are partially offset by a $11.3 million net
  gain on financial instruments and $9.5 million pretax equity in earnings of
  an unconsolidated affiliate. The 1996 net income includes a $29.1 million
  pretax charge for the write-off of the Company's goodwill and other
  intangible assets, and a $.9 million pretax charge for impairment of its
  capitalized servicing asset. These amounts are partially offset by a $10.1
  million pretax gain on the sale of servicing to a third party and a $9.9
  million pretax net gain on financial instruments.

  The Company reported comprehensive income of $27.6 million for the year ended
  December 31, 1997 compared to a comprehensive loss of $3.8 million for the
  year ended December 31, 1996. Comprehensive income includes net income (loss)
  and the net change in after tax unrealized investment gain (refer to Note 1
  to the consolidated financial statements for further discussion). The
  Company's 1997 unrealized investment gains are associated primarily with its
  investment in Financial Security Assurance Holdings Ltd. ("FSA"), an
  unconsolidated affiliate, which it acquired during 1997 (refer to Note 2 to
  the consolidated financial statements for further discussion). The Company's
  1996 unrealized investment gains are associated with its investment in common
  equity securities.

  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. As part
  of the Company's corporate strategy to minimize exposure to interest rate
  risk inherent in its servicing asset, the Company took steps to reduce the
  size of its owned servicing portfolio and expand its subservicing business
  in the first quarter of 1997. In February 1997, the Company sold $17.0
  billion of its nonrecourse mortgage servicing portfolio to a third party for
  adjusted proceeds of $266.9 million and recognized a pretax loss of $8.0
  million on the sale and the related assumption of subservicing. 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>


  The Company is continuing its efforts to expand its subservicing business.
  Concurrent with the above strategy, the Company also continued to act on its
  strategy to optimize returns on its owned servicing portfolio by buying and
  selling mortgage servicing rights based on the underlying risk and return
  characteristics. The Company purchased the rights to service $.04 billion and
  $2.8 billion of mortgage loans from third parties during 1997 and 1996,
  respectively. During 1996, the Company sold the rights to service $3.3
  billion of mortgage loans for net proceeds of $55.9 million and a pretax gain
  of $10.1 million. Additional sales transactions may occur in the future when
  management deems it to be economically advantageous.

  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.

  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,



                                      5
<PAGE>   6

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

  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 February 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 decreased $7.8 million during the year ended December
  31, 1997 from the comparable 1996 period. Amortization includes a $17.7
  million and $.9 million increase in the valuation allowances for impairment
  of the Company's capitalized servicing asset in 1997 and 1996, respectively.
  Excluding the effects of these charges, amortization expense decreased to
  $46.5 million in 1997 from $71.0 million in 1996. This decrease in
  amortization expense is primarily the result of a smaller servicing asset due
  to the February 1997 servicing sale. The impairment charge in 1997 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 from year end 1996.

  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 invests in various financial instruments 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 that can occur with decreases in
  market interest rates. 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 ("floors") and principal-only ("P/O") swap transactions.

  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. 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.

  The P/O swaps are derivative contracts, the value of which is determined by
  changes in the value of the referenced 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
  referenced P/O security multiplied by a floating rate indexed to the London
  Interbank Offered Rates for U.S. dollar deposits ("LIBOR").

  The Company recognized a net gain on its financial instruments of $11.3
  million and $9.9 million for the years ended

                                      6
<PAGE>   7

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

  December 31, 1997 and 1996, respectively. The 1997 net gain includes
  $2.0  million in realized losses from the sale of financial instruments
  slightly offset by net cash flows received and $13.3 million in unrealized
  gains due to a net increase in the fair value of the various financial
  instruments. The 1996 net gain includes $8.1 million in realized gains from
  the sale of financial instruments and net cash flows received and $1.8
  million in unrealized gains due to a net increase in the fair value of the
  various financial instruments. As of December 31, 1997 and 1996, the carrying
  value of the financial instruments was $20.7 million and $8.0 million,
  respectively, and is included in investments in the consolidated statements
  of condition (refer to Note 11 to the consolidated financial statements for
  further discussion).

  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 February 1997
  servicing sale, an increase in interest income from pool loan purchases due
  to a higher average asset balance and income earned on an investment acquired
  in the second quarter of 1997. This increase was slightly offset by a
  decrease in conventional mortgage loan production and the corresponding
  decrease in the average conventional mortgage loans receivable inventory.
  Interest expense decreased slightly to $35.4 million in 1997 from $36.0
  million in 1996. This decrease is primarily due to the retirement of
  medium-term notes and long-term debentures during 1996, the early retirement
  of medium-term notes in 1997 and a reduction in debt from the cash proceeds
  received from the 1997 servicing sale. This decrease was almost entirely
  offset by a decrease in interest expense credits received on escrow and
  custodial funds held in trust accounts resulting from the decrease in the
  Company's owned servicing portfolio and an increase in short-term borrowings
  necessary to fund increased production.

  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. These amounts include the write-down of certain
  investments to realizable value offset by certain realized gains related to a
  partnership investment.

  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 of the Company's investment in FSA by its
  direct parent. The Company recognized $9.5 million of equity in earnings of
  FSA for the year ended December 31, 1997 (refer to Notes 2 and 10 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. At this time, the Company is uncertain if future
  originations will continue to be comprised of a proportionately higher volume
  of correspondent production. 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 (refer to Note 7 to the
  consolidated financial statements for further discussion).

  The Company recorded a $4.3 million pretax loss from the sale of $17.0
  billion of nonrecourse mortgage servicing rights 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 amendment of the subservicing arrangement which extended the
  Company's subservicing responsibilities for one additional year at less
  favorable terms than the original agreement provided. The Company will
  continue to service these loans pursuant to a subservicing agreement at
  least until March 1999, June 1999 and August 1999 for Federal Home Loan
  Mortgage Corporation ("FHLMC") loans,


                                      7
<PAGE>   8

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

  Government National Mortgage Association ("GNMA") loans and Federal
  National Mortgage Association ("FNMA") loans, respectively. The subservicing
  period can be extended for one additional year beyond these dates at the
  option of the purchaser. During 1996, the Company sold the rights to service
  $3.3 billion of its mortgage servicing portfolio and realized a pretax gain
  of $10.1 million.

  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 the year ended December 31, 1997 as compared
  to the same 1996 period, 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 higher loan officer commissions associated with
  the increase in total mortgage loan production in 1997 and an increase in
  the long term incentive plan accrual.

  The provision for loan losses was $8.6 million and $10.3 million for the
  years ended December 31, 1997 and 1996, respectively. The decrease in the
  1997 provision is primarily due to lower loss volumes resulting from the
  decrease in the Company's owned servicing portfolio, a decrease in the
  average loss per loan and lower loss volumes on certain California
  residential mortgage loans in 1997. In addition, 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.

  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.

  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 includes 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, 1997, $.1

                                      8
<PAGE>   9

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

  million of these charges remained accrued in the Company's consolidated
  statement of condition.

  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, 1997
  includes an additional provision for the effect of the February 1997
  servicing sale. The 1996 provision 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.

  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 necessary to achieve a year 2000 date
  conversion with no effect on 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. Currently, the project is
  substantially complete and unit tested, with an estimated completion date in
  early 1998. At that time, testing of the full system will begin and is
  estimated to be complete well before the end of 1998. The cost of achieving
  year 2000 compliance is estimated to be less than $2.0 million above the cost
  of normal software upgrades and replacements. As of December 31, 1997
  approximately $1.0 million had been spent on the project.

  The Company has initiated formal communications with all of its significant
  business partners to determine the extent to which the Company's interface
  systems are vulnerable to those third parties' failure to remedy their own
  year 2000 issues. There is no guarantee that the systems of other companies
  on which the Company's systems rely will be converted on a timely basis and
  will not have an adverse effect on the Company's systems.

YEAR ENDED DECEMBER 31, 1996 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1995

  SUMMARY - The Company reported a net loss of $4.3 million for the year ended
  December 31, 1996 as compared to net income of $26.2 million for the year
  ended December 31, 1995. The 1996 net loss reflects a $29.1 million pretax
  charge for the write-off of the Company's goodwill and other intangible
  assets and a $.9 million pretax charge for impairment of its capitalized
  servicing asset. These amounts were partially offset by a $10.1 million
  pretax gain on the sale of servicing to a third party and a $9.9 million
  pretax net gain on financial instruments. The 1995 net income includes a
  $28.0 million pretax charge for impairment of the capitalized servicing
  asset, $40.0 million of pretax gains on the sale of servicing to third
  parties and a $.8 million pretax net gain on financial instruments.

  The Company reported a comprehensive loss (which includes net income (loss)
  and the net change in after tax unrealized investment gain) of $3.8 million
  for the year ended December 31, 1996 as compared to comprehensive income of
  $29.8 million for the year ended December 31, 1995. The Company's 1996 and
  1995 unrealized investment gains are associated with its investment in common
  equity securities.

  The Company's total mortgage servicing portfolio decreased to $29.2 billion
  as of December 31, 1996 from $31.8 billion as of December 31, 1995. The
  Company continued to act on its corporate strategy to optimize returns on its
  owned servicing portfolio by buying and selling mortgage servicing rights
  based on the underlying risk and return characteristics. The Company
  purchased the rights to service $2.8 billion and $4.7 billion of mortgage
  loans from third parties during 1996 and 1995, respectively. During 1996, the
  Company sold the rights to service $3.3 billion of mortgage loans for net
  proceeds of $55.9 million and a pretax gain of $10.1 million. During 1995,
  the Company sold a total of $11.0 billion in servicing rights to third
  parties for net proceeds of $199.1 million and a pretax gain of $40.0
  million.

  Total mortgage production for the years ended December 31, 1996 and 1995 was
  $3.8 billion and $2.9 billion, respectively. Production related to
  refinancing activity made up 33% of total mortgage loan production for 1996 as

                                      9
<PAGE>   10

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

  compared to 23% for 1995. The increase in mortgage loan production in 1996
  reflects overall lower market interest rates during 1996 and a corresponding
  increase in refinancing activity from 1995 levels.

  Mortgage loan payoffs for the years ended December 31, 1996 and 1995 were
  $3.0 billion and $2.3 billion, respectively. The average prepayment rate of
  the Company's total servicing portfolio was 10.5% for the year ended December
  31, 1996 as compared to 8.3% for 1995. The Company's prepayment experience is
  significantly influenced by fluctuations in mortgage interest rates, although
  the effect is not immediate. A steady decline in market interest rates for
  mortgage loans during 1995 in addition to average lower interest rates in
  1996 contributed to the increase in mortgage loan prepayments during 1996.

  REVENUE - Mortgage servicing revenue decreased to $139.6 million in 1996 from
  $141.9 million in 1995. This decrease is primarily due to a lower average
  servicing portfolio balance during 1996 compared to 1995. This decrease was
  partially offset by the recognition of a portion of the Company's deferred
  gain on the 1994 sale of servicing rights. Amortization of capitalized
  servicing decreased $9.4 million during the year ended December 31, 1996 from
  the comparable 1995 period. Amortization includes a $.9 million and $28.0
  million increase in the valuation allowances for impairment of the Company's
  capitalized servicing asset in 1996 and 1995, respectively. Excluding the
  effects of these charges, amortization expense increased to $71.0 million
  from $53.4 million for the years ended December 31, 1996 and 1995,
  respectively. The increase in amortization expense is primarily due to higher
  market consensus prepayment rates as well as a higher average servicing asset
  balance during 1996 as compared to 1995. The impairment charge in 1995 is a
  result of increased market consensus prepayment rates and a corresponding
  decrease in the fair value of the Company's capitalized servicing asset from
  year end 1994.

  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, and as a result, the
  Company recognized an additional $2.4 million of the deferred gain. In 1996
  and 1995, the Company recognized deferred gains totaling $6.1 million and
  $4.2 million, respectively, as part of mortgage servicing revenue in the
  consolidated statements of income.

  For the year ended December 31, 1996, the Company recognized a $9.9 million
  gain on its financial instruments as compared to a gain of $.8 million in
  1995. The 1996 gain includes $8.1 million in realized gains from the sale of
  financial instruments and net cash flows received and $1.8 million in
  unrealized gains due to a net increase in the fair market value of various
  financial instruments. The 1995 gain includes unrealized gains due to a net
  increase in the fair market value of the financial instruments. As of
  December 31, 1996 and 1995, the carrying value of the financial instruments
  was $8.0 million and $3.5 million, respectively, and is included in
  investments in the consolidated statements of condition (refer to Note 11 to
  the consolidated financial statements for further discussion).

  Interest income increased to $40.8 million in 1996 from $37.7 million in
  1995. The increase in interest income is indicative of the increase in
  production levels experienced in 1996 as compared to 1995. Interest expense
  increased to $36.0 million in 1996 from $27.3 million in 1995. This increase
  is due to the increase in short-term borrowings necessary to fund production
  as well as the additional expense related to the $56.0 million in principal
  amount of subordinated debentures issued in December 1995.

  The Company had net realized losses on the sale and exchange of securities
  with affiliates of $.9 million and $2.2 million for the years ended December
  31, 1996 and 1995, respectively. The 1996 loss was a result of the Company
  selling its then remaining common equity securities to White Mountains for
  cash. The 1995 loss resulted from the transfer of $27.0 million of certain
  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. 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, valued at their closing prices on the day
  preceding the date of each transaction.

  The net realized investment gain of $.6 million for the year ended December
  31, 1996 includes a $1.4 million gain on

                                     10
<PAGE>   11

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

  the return of a partnership investment, offset by the writedown of
  certain investments to realizable value. The net realized loss of $.5 million
  for the year ended December 31, 1995 primarily reflects net losses realized
  on the sale of the Company's common equity securities to third parties.

  Net gain on sale of mortgages increased to $38.3 million in 1996 from $24.0
  million in 1995. The increase reflects increased production and related
  mortgage sales volumes in 1996.

  Other revenue was $18.1 million and $15.6 million for the years ended
  December 31, 1996 and 1995, respectively. The increase in other revenue,
  which consists primarily of insurance commissions and brokerage fees, was
  directly related to the increase in production volumes.

  EXPENSES - Salaries and employee benefits expense was $56.3 and $51.3 million
  for the years ended December 31, 1996 and 1995, respectively. Generally
  accepted accounting principles ("GAAP") require 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 fees are accounted for as a reduction
  to salaries and employee benefits expense as illustrated in the following
  table:



<TABLE>
<CAPTION>
--------------------------------------------------------------------------
Year ended December 31, (in thousands)                1996      1995
--------------------------------------------------------------------------
<S>                                                <C>       <C>
Unadjusted salaries and employee benefits expense   $76,114   $68,807
GAAP net origination revenues                       (19,820)  (17,550)
--------------------------------------------------------------------------
GAAP salaries and employee benefits expense         $56,294   $51,257
--------------------------------------------------------------------------
</TABLE>


  An increase in loan origination revenues, reflecting higher retail mortgage
  loan production in 1996, slightly offsets the increase in unadjusted salaries
  and employee benefits expense. Excluding the effects of loan origination
  revenues, salaries and employee benefits expense increased 11% in 1996 as
  compared to 1995. This increase reflects the additional personnel expenses
  and loan officer commissions associated with the Company's increased mortgage
  loan production in 1996.

  The provision for loan losses increased to $10.3 million in 1996 from $7.0
  million in 1995. This increase is attributable to a higher average loss per
  loan, higher loss volumes relating to certain California residential mortgage
  loans and increased losses due to servicing portfolios acquired by the
  Company during the fourth quarters of 1995 and 1996. The delinquency rates of
  these acquired portfolios were higher than the Company's historical average
  delinquency rate. The Company purchased these portfolios for prices which
  were reflective of these higher delinquency rates. In addition, the 1996
  provision includes a $.9 million charge to increase the valuation allowance
  of a certain commercial real estate owned property. The valuation allowance
  for this property totaled $2.6 million at December 31, 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.

  Other operating expenses, which consist primarily of loan processing expenses
  and general office expenses, increased to $34.3 million in 1996 from $32.8
  million in 1995. Loan processing expenses tend to decrease or increase with
  mortgage loan production. Accordingly, the increase in other operating
  expenses in 1996 reflects higher mortgage loan production in 1996 compared to
  1995.

LIQUIDITY AND CAPITAL RESOURCES

  The Company's primary cash flow requirements relate to funding mortgage loan
  production and investments 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
  until the investment downgrade described below, commercial paper borrowings.
  The Company also generates 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.


                                     11
<PAGE>   12

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

  In July 1997, the Company amended and restated its secured revolving credit
  agreement to reflect a reduction in its borrowing requirements resulting from
  the cash proceeds received from the 1997 servicing sale. The provisions of
  the amended agreement decreased the Company's revolving credit facility from
  $750.0 million to $500.0 million, reduced borrowing costs by lowering the
  facility fee and will allow the Company to use proceeds from the servicing
  sale to pay additional dividends on its common stock of up to $75.0 million.
  The provisions also granted the Company the option to increase the size of
  the facility up to $750.0 million, with bank concurrence (refer to Note 23 to
  the consolidated financial statements). In order to fund increased production
  volumes and replace commercial paper financing no longer available as a
  result of the downgrade of the Company's debt rating as described below, the
  Company exercised its right under the agreement to request additional
  commitments in December 1997. With bank concurrence, the Company obtained
  additional commitments of $100.0 million which increased the available
  revolving facility to $600.0 million. 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 24, 1998. As of
  December 31, 1997, the Company had $559.0 million outstanding under this
  facility. As of December 31, 1996, the Company had no borrowings outstanding
  under the previous facility, however, the Company had $347.2 million of
  commercial paper borrowings outstanding.

  The Company must comply with certain financial covenants provided in its
  secured revolving credit facility, including restrictions relating to
  tangible net worth and leverage. In addition, the secured facility contains
  certain covenants which limit the Company's ability to pay dividends or make
  distributions of its capital in excess of preferred stock dividend and
  subordinated debt interest requirements each year. The Company is currently
  in compliance with all such covenants.

  The Company's $60.0 million unsecured revolving credit agreement was not
  extended in July 1997. This agreement was designed to give the Company
  benefit for escrow funds held in custodial banks. The Company continues to
  receive this benefit by replacing borrowings under this facility with
  borrowings under the bid loan provision of the Company's secured credit
  agreement. The Company's total bank facility borrowing capacity was not
  reduced by the termination of the unsecured agreement because borrowings
  under this agreement reduced the Company's ability to borrow up to the
  maximum amount under its secured credit facility. As of December 31, 1996,
  there was $45.0 million outstanding under the Company's unsecured agreement.

  The Company has a $650.0 million domestic commercial paper program. In
  November 1997, the Company's commercial paper rating was downgraded by
  Moody's from Prime-3 to Not Prime. In addition, in April 1997, the Company's
  commercial paper rating was downgraded by Standard & Poors from A-2 to A-3.
  As a result of the rating downgrade in November, the Company is not able to
  issue commercial paper and has replaced its commercial paper borrowings with
  borrowings under its $600.0 million revolving credit facility.

  The Company amended a short-term borrowing agreement in April 1997 which it
  had entered into August 1996. The provisions of the amended agreement
  increased the Company's facility from $25.0 million to $50.0 million. As a
  result of the rating downgrade in November 1997, the Company is not able to
  borrow under this agreement. As of December 31, 1996, there was $15.0 million
  outstanding under the original agreement.

  Central Pacific Mortgage Company ("Central Pacific"), a wholly-owned
  subsidiary of the Company, entered into a new unsecured revolving credit
  agreement in May 1997 under which it can borrow up to $15.0 million through
  June 1, 1998. Central Pacific amended this agreement in December 1997 to
  change certain reporting requirements and financial covenants. Borrowings
  under the agreement are guaranteed by the Company. As of December 31, 1997,
  there was $10.5 million outstanding under this agreement. As of December 31,
  1996, there were no borrowings outstanding under the previous agreement which
  allowed for borrowings up to $10.0 million.

  Central Pacific must comply with certain financial covenants provided in its
  revolving credit agreement, including restrictions relating to tangible net
  worth and leverage. As guarantor, these covenants apply to the Company.
  Central Pacific is currently in compliance with all such covenants.


                                     12
<PAGE>   13

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

  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
  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 first interest payment was made on December 29, 1995 for the period from
  November 1, 1995 (the last regular dividend payment date with respect to the
  preferred stock) through December 8, 1995 at the annual rate of 8.42% and
  from December 9, 1995 through December 31, 1995 at the annual rate of 9.375%.
  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.

  Under a $200.0 million shelf registration statement filed with the SEC in
  November 1988, the Company issued $40.0 million of medium-term notes in 1989,
  with a total weighted average interest rate of 9.65% due 1996, and in October
  1991, the Company issued $160.0 million of 8.875% medium-term notes due
  October 2001. During 1995, the Company repurchased and retired $10.3 million
  of the medium-term notes due in 1996 and $21.6 million of the medium-term
  notes due in 2001. During 1996, the Company repaid the remaining $29.7
  million of the medium-term notes due in 1996 on their maturity dates. In May
  1997, the Company repurchased and retired $119.6 million of the medium-term
  notes due in 2001.

  In 1986, the Company issued $125.0 million of 8.25% debentures due November
  1, 1996. The Company repurchased and retired $50.4 million of these
  debentures during 1995 and repaid the remaining $74.6 million on their
  maturity date in 1996.

  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. The Company did not declare any dividends on
  its common stock during 1997, 1996 or 1995 (refer to Note 23 to the
  consolidated financial statements).

  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. The Company paid
  cash dividends totaling $3.7 million, $3.7 million and $8.4 million on its
  preferred stock for the years ended December 31, 1997, 1996 and 1995,
  respectively.

  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.

  In February 1997, the Company sold $17.0 billion of its nonrecourse mortgage
  servicing portfolio to a third party for adjusted proceeds of $266.9 million.
  The Company has used the proceeds of $242.6 million received from the sale
  through December 31, 1997 to reduce outstanding short-term debt and to retire
  $119.6 million of its 8.875% medium-term notes. The remaining balance of
  $27.3 million, including accrued interest, is reflected as a receivable from
  sale of servicing in the consolidated statement of condition as of December
  31, 1997. The Company is currently evaluating its


                                     13
<PAGE>   14

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

  options as to how it will utilize the remaining proceeds from the sale.
  These options include: (i) purchasing additional mortgage servicing rights
  from third parties; (ii) further reducing its outstanding indebtedness; (iii)
  reducing its outstanding preferred or common shareholders' equity or (iv) any
  combination of the foregoing.

  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. During the first
  quarter of 1997, the Company issued 230,293 shares of its common stock to its
  White Mountains in exchange for 1.0 million shares of FSA common stock valued
  at $27.8 million and issued 105,000 shares of its common stock to Fund
  American for cash proceeds of $12.7 million. During the second quarter of
  1997, the Company recorded the remaining contribution by White Mountains of
  $78.5 million of contracted net assets consisting of 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 in
  exchange for 650,827 shares of the Company's common stock. The capital
  infusions were undertaken to improve the Company's debt ratings and reduce
  the Company's borrowing costs.

  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.

  During 1995, the Company sold the rights to service a total of $11.0 billion
  of mortgage loans to third parties for net proceeds of $199.1 million, which
  were used to repurchase and retire debt, repurchase common stock and for
  general corporate purposes.

  During 1995, the Company transferred a total of $27.0 million of common
  equity securities and $93.0 million in cash and money market investments to
  White Mountains in exchange for 959,049 shares of the Company's common stock
  held by White Mountains, which were retired by the Company.

  The Company is currently considering further steps to restructure its debt
  including (i) the issuance of approximately $50.0 million of additional
  medium-term notes pursuant to an existing shelf registration and (ii)
  entering into interest rate swaps whereby the Company's obligation to pay a
  fixed rate of interest on a portion of its outstanding medium-term notes and
  debentures will be swapped for an obligation to pay a floating rate of
  interest. The Company believes that using floating rate debt to finance a
  larger portion of its mortgage servicing assets is prudent, since the value
  of such assets generally increases as interest rates increase, and declines
  as interest rates decrease.

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 have decreased during
  periods of rising interest rates. Periods of low inflation and falling
  interest rates tend to reduce loan servicing income and the value of 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 11 to the
  consolidated financial statements).


                                     14
<PAGE>   15
REPORT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS
SOURCE ONE MORTGAGE SERVICES CORPORATION

  We have audited the accompanying consolidated statement of condition of
  Source One Mortgage Services Corporation and subsidiaries ("the Company") as
  of December 31, 1997, and the related consolidated statements of income,
  comprehensive income, stockholders' equity, and cash flows for the year 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 audit. We did not audit the financial statements of
  Financial Security Assurance Holdings Ltd. ("FSA") (a 12.1 percent owned
  equity investee company). The Company's investment in FSA at December 31,
  1997, was $104 million, and its equity in earnings of FSA was $9.5 million
  for the year ended December 31, 1997. The financial statements of FSA were
  audited by other auditors, Coopers & Lybrand L.L.P., whose report has been
  furnished to us, and our opinion, insofar as it relates to the amounts
  included for FSA, is based solely on the report of the other auditors. The
  accompanying consolidated financial statements of the Company as of December
  31, 1996, and for each of the years in the two-year period ended December 31,
  1996, were audited by other auditors whose report thereon dated January 30,
  1997, (except for Notes 7 and 22, as to which the date was March 21, 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 audit in accordance with generally accepted auditing
  standards. Those standards require that we plan and perform the audit to
  obtain reasonable assurance about whether the financial statements are free
  of material misstatement. An audit includes examining, on a test basis,
  evidence supporting the amounts and disclosures in the financial statements.
  An audit also includes assessing the accounting principles used and
  significant estimates made by management, as well as evaluating the overall
  financial statement presentation. We believe that our audit and the report of
  the other auditors provide a reasonable basis for our opinion.

  In our opinion, based on our audit and the report of the other auditors, the
  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, 1997, and the results of
  their operations and their cash flows for the year then ended in conformity
  with generally accepted accounting principles.



  KPMG Peat Marwick LLP

  Detroit, Michigan
  January 29, 1998,
  except for Note 23
  as to which the date is
  March 20, 1998



                                     15

<PAGE>   16

CONSOLIDATED STATEMENTS OF CONDITION



<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------
December 31, (in thousands, except for share and per share amounts)                             1997                1996
-------------------------------------------------------------------------------------------------------------------------
ASSETS
-------------------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>                 <C>
Cash                                                                                      $     3,134         $       923
Investments                                                                                    86,239              46,555
Investment in unconsolidated affiliate (net)                                                  192,137                   -
Mortgage loans receivable                                                                     519,247             314,937
Pool loan purchases                                                                           149,791             131,539
Loans held for investment                                                                       5,191              17,984
Capitalized servicing (net)                                                                   181,025             410,939
Receivable from sale of servicing                                                              27,324                   -
Common equity securities (net)                                                                      -               2,312
Mortgage claims receivable and real estate acquired
  (net of allowance for loan losses of $12,800 in 1997 and $15,400 in 1996)                    41,199              57,119
Premises and equipment                                                                         22,171              28,054
Other assets                                                                                   77,232             120,692
-------------------------------------------------------------------------------------------------------------------------
Total assets                                                                              $ 1,304,690         $ 1,131,054
=========================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
-------------------------------------------------------------------------------------------------------------------------
Liabilities:
Senior debt                                                                               $   686,906         $   643,262
Subordinated debt                                                                              55,153              54,535
Accounts payable and other liabilities                                                        107,582             118,500
-------------------------------------------------------------------------------------------------------------------------
Total liabilities                                                                             849,641             816,297
=========================================================================================================================
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 $44,023) issued and
  outstanding as of December 31, 1997 and 1996                                                     18                  18
Common stock, $.01 par value, 8,000,000 shares authorized,
  3,211,881 and 2,247,000 shares issued and outstanding as of
  December 31, 1997 and 1996, respectively                                                         32                  22
Paid-in capital                                                                               462,480             346,088
Accumulated other comprehensive income                                                         41,102                   -
Retained deficit                                                                              (48,583)            (31,371)
-------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity                                                                    455,049             314,757
-------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity                                                $ 1,304,690         $ 1,131,054
=========================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements.


                                      16
<PAGE>   17
CONSOLIDATED STATEMENTS OF INCOME


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands, except for per share amounts)               1997             1996              1995
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                          <C>               <C>              <C>
REVENUE
-----------------------------------------------------------------------------------------------------------------------------
Mortgage servicing revenue                                                   $    94,952       $   139,578      $    141,883
Amortization of capitalized servicing                                            (64,150)          (71,936)          (81,385)
Net gain on financial instruments                                                 11,271             9,904               840
-----------------------------------------------------------------------------------------------------------------------------
  Net servicing revenue                                                           42,073            77,546            61,338
-----------------------------------------------------------------------------------------------------------------------------
Interest income                                                                   45,754            40,826            37,669
Interest expense                                                                 (35,362)          (36,018)          (27,348)
-----------------------------------------------------------------------------------------------------------------------------
  Net interest revenue                                                            10,392             4,808            10,321
-----------------------------------------------------------------------------------------------------------------------------
Net realized investment gain (loss) on sale and
  exchange of securities with affiliates                                             326              (855)           (2,159)
Net realized investment (loss) gain                                               (1,048)              623              (544)
Equity in earnings of unconsolidated affiliate                                     9,507                 -                 -
Net gain on sale of mortgages                                                     21,497            38,346            24,015
Net (loss) gain on sale of servicing
  and assumption of subservicing                                                  (8,032)           10,080            40,041
Other                                                                             19,159            18,132            15,583
-----------------------------------------------------------------------------------------------------------------------------
Total revenue                                                                     93,874           148,680           148,595
=============================================================================================================================
EXPENSES
-----------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits                                                    54,794            56,294            51,257
Office occupancy and equipment                                                    13,289            13,619            14,326
Provision for loan losses                                                          8,610            10,260             6,956
Write-off of goodwill and other intangible assets                                      -            29,128                 -
Restructuring charges                                                              1,727                 -                 -
Other operating expenses                                                          26,601            34,252            32,774
-----------------------------------------------------------------------------------------------------------------------------
Total expenses                                                                   105,021           143,553           105,313
-----------------------------------------------------------------------------------------------------------------------------
(Loss) income before income taxes and
  extraordinary loss                                                             (11,147)            5,127            43,282
Income tax (benefit) expense                                                      (3,617)            9,453            16,132
-----------------------------------------------------------------------------------------------------------------------------
(Loss) income before extraordinary loss                                           (7,530)           (4,326)           27,150
Extraordinary loss on repurchase of debt
  (net of income tax benefit of $3,217
  in 1997 and $486 in 1995)                                                       (5,975)                -              (902)
-----------------------------------------------------------------------------------------------------------------------------
Net (loss) income                                                                (13,505)           (4,326)           26,248
Less dividends on preferred stock                                                  3,707             3,707             7,634
-----------------------------------------------------------------------------------------------------------------------------
Net (loss) income applicable to common stock                                 $   (17,212)      $    (8,033)     $     18,614
=============================================================================================================================
Basic net (loss) income per common share:
  Before extraordinary loss                                                  $     (3.78)      $     (3.57)     $       7.55
  Extraordinary loss                                                               (2.01)                -              (.35)
-----------------------------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share                                     $     (5.79)      $     (3.57)     $       7.20
=============================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements.


                                      17
<PAGE>   18
CONSOLIDATED STATEMENTS
OF COMPREHENSIVE INCOME

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands, except for per share amounts)                    1997             1996           1995
------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>             <C>             <C>
Net (loss) income                                                                  $  (13,505)     $    (4,326)    $   26,248
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 $22,245, $(5) and
     $914 for 1997, 1996 and 1995, respectively)                                       41,314              (10)         1,697
  Less: reclassification adjustment for (gains) losses
     included in net income (net of income tax (expense) benefit
     of $(114), $299 and $981 for 1997, 1996 and 1995, respectively)                     (212)             556          1,822
------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income                                                             41,102              546          3,519
------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss)                                                            27,597           (3,780)        29,767
Less dividends on preferred stock                                                       3,707            3,707          7,634
------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) applicable to
  common stock                                                                     $   23,890      $    (7,487)    $   22,133
==============================================================================================================================
Basic comprehensive income (loss) per common share                                 $     8.03      $     (3.33)    $     8.57
==============================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements.



                                      18
<PAGE>   19
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------------------------------------------------------
Year ended December 31, 1997, 1996 and 1995
(in thousands, except for share and 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, 1995                 $  40        $   32     $  522,032     $ (4,065)       $   (41,952)      $   476,087
Net income                                      -             -              -            -             26,248            26,248
Change in unrealized investment
 gain (net)                                     -             -              -        3,519                  -             3,519
Repurchase of 959,049 shares of
 common stock, $.01 par value,
 from parent                                    -           (10)      (119,990)           -                  -          (120,000)
Exchange of 2,239,061 shares of
 8.42% cumulative Series A
 preferred stock, $.01 par value
 (aggregate liquidation preference
 of $25 per share) for 9.375%
 subordinated debentures                      (22)            -        (55,954)           -                  -           (55,976)
Preferred dividends declared
 of $2.105 per share                            -             -              -            -             (7,634)           (7,634)
================================================================================================================================
Balances at December 31, 1995                  18            22        346,088         (546)           (23,338)          322,244
Net loss                                        -             -              -            -             (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
================================================================================================================================
</TABLE>


See accompanying notes to consolidated financial statements.

                                      19
<PAGE>   20
CONSOLIDATED STATEMENTS OF CASH FLOWS



<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands)                                      1997                1996                 1995
----------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                  <C>                   <C>                  <C>
Net (loss) income                                                     $    (13,505)         $   (4,326)          $    26,248
Noncash items included in the determination of
net (loss) income:
  Amortization of capitalized servicing                                     64,150              71,936                81,385
  Write-off of goodwill and other intangible assets                              -              29,128                     -
  Net unrealized gain on financial instruments                             (13,323)             (1,820)                 (840)
  Provision for loan losses                                                  8,610              10,260                 6,956
  Depreciation and amortization                                              6,586               8,825                 7,347
  Write down of loans held for investment identified
     as held for sale                                                        3,000                   -                     -
  Loss on sale of financial instruments                                      2,205                   -                     -
  Net realized loss on investments                                             722                 232                 2,703
  Amortization of goodwill                                                       -               2,090                 2,090
  Loss (gain) on sale of servicing and assumption of
     subservicing                                                            8,032             (10,080)              (40,041)
  Amortization of deferred gain on sale of servicing                        (6,885)             (6,139)               (4,188)
  Undistributed earnings from unconsolidated affiliate                      (8,668)                  -                     -
Mortgage loan production                                                (4,403,281)         (3,831,639)           (2,852,017)
Mortgage loan sales and amortization                                     4,198,971           3,897,730             2,681,461
Net increase (decrease) in accounts payable and other
     liabilities                                                            15,950             (15,002)               18,749
Net decrease in other assets                                                31,154               5,433                 3,985
Net change in current and deferred income taxes
  receivable and payable                                                   (12,160)            (10,158)               16,849
Extraordinary loss on repurchase of debt                                     5,975                   -                   902
----------------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by operating activities                          (112,467)            146,470               (48,411)
----------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
----------------------------------------------------------------------------------------------------------------------------
Collections on and sales of pool loan purchases,
  mortgage claims receivable and real estate acquired                      274,158             175,289               210,876
Additions to pool loan purchases, mortgage claims
  receivable and real estate acquired                                     (285,100)           (205,745)             (172,650)
Additions to capitalized mortgage servicing rights                        (139,500)            (88,578)             (120,786)
Net proceeds from sales of servicing                                       242,628              11,706               181,109
Additions to long-term investments                                         (53,958)             (6,188)               (3,654)
Principal payments received on long-term investments                           385                 408                 1,088
Net decrease (increase) in short-term investments                           24,141             (14,354)               26,412
Proceeds from sale of common equity securities to affiliates                     -                 514                     -
Proceeds from sales of common equity securities                                  -                   -                21,390
Net disposition (acquisition) of premises and equipment                        914              (1,410)                  185
Net decrease (increase) in loans held for investment                         9,793               2,517                  (726)
----------------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by investing activities                      $     73,461          $ (125,841)          $   143,244
----------------------------------------------------------------------------------------------------------------------------
</TABLE>

See accompanying notes to consolidated financial statements.


                                       20

<PAGE>   21

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------------------------------------
Year ended December 31,  (in thousands)                      1997                1996                 1995
--------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
--------------------------------------------------------------------------------------------------------------
<S>                                                     <C>                 <C>                 <C>
Proceeds from issuance of commercial paper               $ 5,785,634         $ 5,140,110         $   4,050,417
Repayments on commercial paper                            (6,147,814)         (5,034,543)           (3,819,904)
Net increase (decrease) in credit agreement
  borrowings                                                 524,470             (20,497)             (133,978)
Retirement of debt                                          (129,872)           (104,350)              (85,872)
Net proceeds from issuance of common stock                    12,675                   -                     -
Repurchase of common stock from parent                             -                   -               (92,980)
Dividends paid on preferred stock                             (3,707)             (3,707)               (8,420)
Other                                                           (169)               (865)               (1,190)
--------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities              41,217             (23,852)              (91,927)
--------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash                                2,211              (3,223)                2,906
Cash at beginning of year                                        923               4,146                 1,240
--------------------------------------------------------------------------------------------------------------
Cash at end of year                                      $     3,134         $       923         $       4,146
--------------------------------------------------------------------------------------------------------------
</TABLE>


See accompanying notes to consolidated financial statements.


                                       21
<PAGE>   22


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. (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,
  1997, the Company had a mortgage loan servicing portfolio totaling $26.5
  billion, including $14.9 billion of loans subserviced for others, which is
  serviced on behalf of approximately 234 institutional investors and numerous
  other security holders. As of December 31, 1997, the Company had 129 retail
  branch offices in 26 states and originated $4.4 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. 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 generally accepted
  accounting principles 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

  The Company adopted certain provisions of Statement of Financial Accounting
  Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of
  Financial Assets and Extinguishments of Liabilities" which supersedes SFAS
  No. 122, "Accounting for Mortgage Servicing Rights" as of January 1, 1997.
  SFAS No. 125 eliminates the distinction


                                      22
<PAGE>   23
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  between "normal" servicing rights and excess servicing receivables and
  changes the Company's method of measuring the value of its capitalized
  servicing asset. SFAS No. 125 is effective for transfers and servicing of
  financial assets beginning in fiscal year 1997. The effective date for certain
  provisions of SFAS No. 125 has been deferred to fiscal year 1998. SFAS No. 125
  prohibits retroactive application, therefore, the reported results for 1996
  and 1995 are in accordance with prior accounting standards. The adoption of
  SFAS No. 125 as it relates to the valuation of capitalized servicing is
  discussed in Note 3 to the consolidated financial statements.

  The Company adopted the provisions of SFAS No. 128, "Earning per Share" in
  December 1997. SFAS No. 128 simplifies the calculation of earnings per share
  and is intended to make the U.S. standard more comparable to the new
  international standard. The adoption of SFAS No. 128 resulted in no change to
  the method by which the Company calculates its earnings per share but
  replaces the Company's historic presentation of "earnings per share" with a
  presentation of "basic earnings per share". These provisions have been
  applied retroactively, and therefore, the 1996 and 1995 earnings per share
  amounts disclosed are directly comparable to the 1997 amounts.

  The Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive
  Income" as of December 31, 1997. SFAS No. 130 establishes standards for the
  reporting and display of comprehensive income and its components (such as
  changes in net unrealized investment gains and losses) in a financial
  statement that is displayed with the same prominence as other financial
  statements. In accordance with the adoption of SFAS No. 130, the Company now
  reports comprehensive income on a separate statement. Comprehensive income
  includes net income and any changes in equity from non-owner sources that
  bypass the income statement. The purpose of reporting comprehensive income is
  to report a measure of all changes in equity of an enterprise that result
  from recognized transactions and other economic events of the period other
  than transactions with owners in their capacity as owners. Application of
  SFAS No. 130 will not impact amounts previously reported for net income or
  affect the comparability of previously issued financial statements.

  The adoption of SFAS No. 128 and SFAS No. 130 resulted in a change in
  financial statement disclosures only and had no effect on the Company's
  financial position or results of operations.

INVESTMENTS

  Investments primarily consist of the following: short-term investments stated
  at cost; real estate investment conduit ("REMIC") residuals considered held
  to maturity and carried at amortized cost using a method which approximates
  the effective yield method of amortization on a prospective basis; 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 and principal-only swaps in
  order to manage the exposure to interest rate risk inherent in its servicing
  asset (collectively "Financial Instruments"). 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 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.

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

                                      23
<PAGE>   24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  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.
  The amount of discount, if any, is amortized to income over the anticipated
  life of the investment.

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).


                                      24
<PAGE>   25
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
  method 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 2,973,999,
  2,247,000 and 2,584,450 weighted average common shares outstanding for the
  years ended December 31, 1997, 1996 and 1995, 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, 1997, the Company owned 3.5 million shares of FSA common
  stock. This represented approximately 12.1% of the total shares of FSA
  common stock outstanding at that time. In addition, Fund American had voting
  rights

                                      25

<PAGE>   26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


  to an additional 3.9 million shares of FSA common stock at December
  31, 1997, raising the consolidated entity's voting control of FSA to
  approximately 24.0%. At December 31, 1997, the Company also owned FSA
  options and preferred stock which, in total, give the 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. The
  market value of the FSA common stock as of December 31, 1997, as quoted on
  the New York Stock Exchange, 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
  period indicated:



<TABLE>
<CAPTION>
=====================================================================================
(in millions)                                                                  1997
-------------------------------------------------------------------------------------
FSA balance sheet data
-------------------------------------------------------------------------------------
<S>                                                                      <C>
Total investments                                                        $    1,432
Total assets                                                                  1,901
Deferred premium revenue                                                        595
Loss and loss adjustment expense reserves                                        75
Preferred shareholder's equity                                                    1
Common shareholders' equity                                                     882
-------------------------------------------------------------------------------------
FSA income statement data
-------------------------------------------------------------------------------------
Gross premiums written                                                   $      236
Net premiums written                                                            173
Net premiums earned                                                             110
Net investment income                                                            72
Net income                                                                      101
=====================================================================================

</TABLE>

    The following table summarizes the amounts recorded by the Company:

<TABLE>
<CAPTION>
=====================================================================================
(in millions)                                                                  1997
-------------------------------------------------------------------------------------
<S>                                                                      <C>
Investment in FSA common stock                                           $      104
Investment in FSA options and preferred stock                                    88
-------------------------------------------------------------------------------------
Total investment in FSA                                                         192
-------------------------------------------------------------------------------------
Equity in earnings from FSA common stock (a)                                     10
Equity in net unrealized investment gains (losses)
  from FSA's investment portfolio, before tax (b)                                 2
Unrealized investment gains on FSA options and
  preferred stock, before tax (b)                                                61
=====================================================================================
</TABLE>

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


                                      26

<PAGE>   27
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 3. CAPITALIZED SERVICING

  For the years ended December 31, 1997, 1996 and 1995, 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.

  In 1997 and 1996, 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 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.

  In 1995, to measure impairment of its mortgage servicing rights, the Company
  stratified the related mortgage loan servicing portfolio based on its
  predominant risk characteristics which were determined to be prepayment,
  default and operational risks. This resulted in stratification by interest
  rate, loan type (investor) and original term to maturity. In estimating fair
  value, the Company used market consensus prepayment rates and discounted the
  net future cash flows using discount rates that approximated then current
  market rates of 10.5% for conventional loans and 12.0% for insured loans.
  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 valuation allowance, was required.

  As a result of the 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.
  Included in the Company's calculation for measuring impairment of its
  capitalized servicing asset is an $8.2 million and $7.3 million reserve for
  estimated recourse losses on the corresponding loans in determining the fair
  value of its principal recourse portfolio as of December 31, 1997 and 1996,
  respectively.

  The discount rate and prepayment assumptions are significant factors used in
  estimating the fair value of 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 effect
  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 of maturity. The discount rate used to capitalize
  excess servicing ranged from 12.0% to 12.6% for 1996 and was 12.0% for 1995.
  For the years ended December 31, 1996 and 1995, the weighted average
  discount rates inherent in the carrying amount of the capitalized excess
  servicing asset were 10.4% and 10.0%, respectively.


                                      27
<PAGE>   28
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  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, 1997:

<TABLE>
<CAPTION>
=========================================================================================================================
                             Fair Value                                    Weighted
                               Mortgage              Principal              Average            Weighted      Weighted
                              Servicing                Balance             Interest             Average       Average
                                 Rights               Serviced                 Rate            Maturity     Service Fee
Loan Type                  (in thousands)           (in millions)         (in percent)        (in months)   (in percent)
-------------------------------------------------------------------------------------------------------------------------
<S>                          <C>                    <C>                        <C>              <C>            <C>
Fixed Rate:
  Insured                    $  102,200              $   5,314                 8.85%              291           .46%
  Conventional                   44,933                  2,515                 8.13               273           .39
  Recourse                       28,654                  2,413                 8.60               205           .49
Adjustable Rate                  12,391                    418                 7.09               326           .53
-------------------------------------------------------------------------------------------------------------------------
Total                        $  188,178              $  10,660                 8.56%              269           .46%
=========================================================================================================================
</TABLE>


  The above table excludes $773 million of principal balance of mortgage loans
  serviced related to originations not capitalized prior to the adoption of
  SFAS No. 122.

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

<TABLE>
<CAPTION>
                                                                                                    Deferred
                                                                                                     Gain on             Total
                                                 Mortgage       Valuation                            Sale of       Capitalized
(in thousands)                                  Servicing       Allowance       Subservicing       Servicing         Servicing
--------------------------------------------------------------------------------------------------------------------------------
<S>                                            <C>              <C>                  <C>           <C>              <C>
Balances at January 1, 1995                    $  547,662       $        -            $     -       $ (17,212)       $  530,450
Additions                                         102,878                -                  -               -           102,878
Scheduled amortization                            (52,853)               -                  -               -           (52,853)
Impairment/unscheduled amortization                  (564)         (27,968)                 -               -           (28,532)
Amortization of deferred gain                           -                -                  -           4,188             4,188
Sales                                            (159,060)               -                  -               -          (159,060)
--------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995                     438,063          (27,968)                 -         (13,024)          397,071
Additions                                         125,514                -                  -               -           125,514
Scheduled amortization                            (69,932)               -                  -               -           (69,932)
Impairment/unscheduled amortization                (1,076)            (928)                 -               -            (2,004)
Amortization of deferred gain                           -                -                  -           6,139             6,139
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                     -          (17,270)              (463)              -           (17,733)
Amortization of deferred gain                           -                -                  -           6,885             6,885
Sales                                            (273,667)           2,285              9,580               -          (261,802)
--------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997                  $  225,928       $  (45,140)          $    237        $      -        $  181,025
================================================================================================================================
</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 represents 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 reflects a reduction of approximately
  $3.7 million which represents the net present value of projected net cash
  flows over the extended subservicing period including a profit margin. The
  asset is being amortized on a straight line basis over the subservicing period
  and tested for impairment.


                                      28


<PAGE>   29
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  During 1994, the Company sold the rights to service $3.9 billion of mortgage
  loans to a third party for net proceeds of $70.2 million and continued to
  service these loans pursuant to a subservicing agreement. Accordingly, the
  Company recorded a deferred gain on the sale which was being recognized as
  income over the five-year life of the subservicing agreement. In the fourth
  quarter of 1996, the third party sold the rights to service approximately
  $1.0 billion of these 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 as mortgage servicing revenue, representing approximately 25% of the
  deferred balance at the time of the sale. In the fourth quarter of 1997, the
  third party sold the remaining portfolio of loans. As a result, the Company
  recognized the remaining balance of the $4.4 million deferred gain as
  mortgage servicing revenue.

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 $49.4 million as of December 31, 1997. The Company recognized
  income from this investment of approximately $2.0 million in 1997, which is
  included in interest income in the consolidated statement of income.

  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.
  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. 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, valued at their reported closing prices on the day preceding
  the date of each transaction.

  The fair value of the portfolio of common equity securities is as follows:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------
December 31, (in thousands)                                                                        1997      1996
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                                             <C>        <C>
Common equity securities at adjusted cost                                                       $     -    $   2,312
Gross unrealized losses                                                                               -         -
-----------------------------------------------------------------------------------------------------------------------
Common equity securities at fair value                                                          $     -    $   2,312
=======================================================================================================================

</TABLE>

  The carrying value of debt securities, which is included in investments in
the consolidated statements of condition, approximates fair value and is as
follows:

<TABLE>
<CAPTION>
=======================================================================================================================
December 31, (in thousands)                                                                        1997      1996
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                                             <C>        <C>
Debt securities at fair value which approximates amortized cost                                 $     -    $   1,577
=======================================================================================================================

</TABLE>

  The change in net unrealized investment loss on the portfolio of common
  equity securities has been charged to stockholders' equity as follows:

<TABLE>
<CAPTION>
=======================================================================================================================
Year ended December 31,  (in thousands)                                               1997       1996        1995
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>         <C>        <C>
Net unrealized investment loss at beginning of year                               $     -     $  (546)   $  (4,065)
Decrease in gross unrealized gains                                                      -           -       (1,068)
Decrease in gross unrealized losses                                                     -         840        6,481
Decrease in deferred income tax expense                                                 -        (294)      (1,894)
-----------------------------------------------------------------------------------------------------------------------
Net unrealized investment loss at end of year                                     $     -     $     -    $    (546)
=======================================================================================================================
</TABLE>


                                      29

<PAGE>   30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. MORTGAGE LOANS RECEIVABLE

  The following table summarizes mortgage loans receivable:

<TABLE>
<CAPTION>
=======================================================================================================================
December 31, (in thousands)                                                                  1997              1996
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                                       <C>              <C>
Adjustable rate mortgage loans, weighted average interest rates of 6.36%
  and 6.60% as of December 31, 1997 and 1996, respectively                                $  51,589         $  35,077
Fixed rate 5 year through 25 year mortgage loans, weighted average
  interest rates of 7.68% and 7.73% as of December 31, 1997 and 1996,
  respectively                                                                               60,382            51,160
Fixed rate 30 year mortgage loans, weighted average interest rates of
  7.76% and 8.19% as of December 31, 1997 and 1996, respectively                            404,996           228,067
-----------------------------------------------------------------------------------------------------------------------
                                                                                            516,967           314,304
Net premiums                                                                                  2,280               633
-----------------------------------------------------------------------------------------------------------------------
Total mortgage loans receivable                                                           $ 519,247         $ 314,937
=======================================================================================================================
</TABLE>

NOTE 6. POOL LOAN PURCHASES

     The following table summarizes pool loan purchases:
<TABLE>
<CAPTION>
============================================================================================================
                                               Principal Balance
                                                 (in thousands)                         Number of Loans
------------------------------------------------------------------------------------------------------------
December 31,                               1997                 1996              1997               1996
------------------------------------------------------------------------------------------------------------
<S>                                    <C>                 <C>                  <C>               <C>
Loan Type:
  FHA                                  $  103,067          $   89,922             1,781             1,621
  VA                                       43,349              35,341               669               592
  Conventional                              3,375               6,276                45                75
------------------------------------------------------------------------------------------------------------
Total pool loan purchases              $  149,791          $  131,539             2,495             2,288
============================================================================================================
</TABLE>


NOTE 7. LOANS HELD FOR INVESTMENT

  In the second quarter of 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 are included in loans held for investment and $5.7
  million are included in mortgage claims receivable and real estate acquired
  in the consolidated statement of condition.

NOTE 8. OTHER ASSETS

  The following table summarizes other assets:



<TABLE>
<CAPTION>
==============================================================================================
December 31, (in thousands)                                           1997             1996
----------------------------------------------------------------------------------------------
<S>                                                           <C>              <C>
Escrow advances                                               $     11,825     $     18,878
Interest receivable - pool loan purchases                           10,225           11,900
Current income tax receivable (Note 16)                              9,058                -
Notes receivable                                                     8,000            7,000
Amount due from sale of servicing                                      354           46,823
Deferred income tax receivable (Note 16)                                 -           18,210
Other                                                               37,770           17,881
----------------------------------------------------------------------------------------------
Total other assets                                            $     77,232     $    120,692
==============================================================================================
</TABLE>


                                      30

<PAGE>   31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9. SENIOR AND SUBORDINATED DEBT

     Senior and Subordinated Debt consists of the following:

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------
December 31, (in thousands)                                                1997             1996
---------------------------------------------------------------------------------------------------
<S>                                                               <C>              <C>
Commercial paper, weighted average interest rate of 5.69%
 as of December 31, 1996                                              $          -     $    362,180
Credit agreements, weighted average interest rates of 6.34%
 and 6.19% as of December 31, 1997 and 1996, respectively                  569,470           45,000
8.875% medium-term notes due October 15, 2001                               18,723          138,355
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)                 (2,110)          (3,714)
--------------------------------------------------------------------------------------------------
Total senior and subordinated debt                                    $    742,059     $    697,797
===================================================================================================
</TABLE>


COMMERCIAL PAPER

  The Company has a $650.0 million domestic commercial paper program backed by
  its secured credit agreement. In November 1997, the Company's commercial paper
  rating was downgraded by Moody's from Prime-3 to Not Prime. In addition, in
  April 1997, the Company's commercial paper rating was downgraded by Standard &
  Poors from A-2 to A-3.  As a result of the rating downgrade in November,
  the Company is not able to issue commercial paper and has replaced its
  commercial paper borrowings with borrowings under its $600.0 million committed
  bank facility. The weighted average number of days to maturity of commercial
  paper outstanding as of December 31, 1996 was 22.8 days.

CREDIT AGREEMENTS

  The Company amended and restated its secured revolving credit agreement in
  July 1997, to reflect a reduction in its borrowing requirements resulting
  from the cash proceeds received from the 1997 servicing sale. The provisions
  of the amended agreement decreased the Company's revolving credit facility
  from $750.0 million to $500.0 million, reduced borrowing costs by lowering
  the facility fee and will allow the Company to use proceeds received from
  the servicing sale to pay additional dividends on its common stock of up to
  $75.0 million. The provisions also granted the Company the option to
  increase the size of the facility up to $750.0 million, with bank
  concurrence (refer to Note 23 to the consolidated financial statements). In
  order to fund increased production volumes and replace commercial paper
  financing no longer available as a result of the downgrade of the Company's
  debt rating as described above, the Company exercised its right under the
  agreement to request additional commitments in December 1997. With bank
  concurrence, the Company obtained additional commitments of $100.0 million
  which increased the available revolving facility to $600.0 million.
  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 24, 1998. As of December 31, 1997, the Company had
  $559.0 million outstanding under this facility. As of December 31, 1996, the
  Company had no outstanding borrowings under the previous facility.

  The Company's $60.0 million unsecured revolving credit agreement was not
  extended in July 1997. This agreement was designed to give the Company
  benefit for escrow funds held in custodial banks. The Company continues to
  receive this benefit by replacing borrowings under this facility with
  borrowings under the bid loan provision of the Company's secured credit
  agreement. The Company's total bank facility borrowing capacity was not
  reduced by the termination of the unsecured agreement because borrowings
  under this agreement reduced the Company's ability to borrow up to the
  maximum amount under its secured credit facility. As of December 31, 1996,
  there was $45.0 million outstanding under the Company's unsecured agreement.

  The Company must comply with certain financial covenants provided in its
  secured revolving credit facility, including restrictions relating to
  tangible net worth and leverage. In addition, the Company's secured facility
  contains certain



                                      31
<PAGE>   32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  covenants which limit its ability to pay dividends or make
  distributions of its capital in excess of preferred stock dividend and
  subordinated debt interest requirements each year. The Company is currently
  in compliance with all such covenants.

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

  The Company amended a short-term borrowing agreement in April 1997 which it
  had entered into August 1996. The provisions of the amended agreement
  increased the Company's facility from $25.0 million to $50.0 million. As a
  result of the rating downgrade in November 1997, the Company is not able to
  borrow under this agreement. As of December 31, 1996, there was $15.0
  million outstanding under the original agreement.

  Central Pacific entered into a new unsecured revolving credit agreement in
  May 1997 under which it can borrow up to $15.0 million through June 1, 1998.
  Central Pacific amended this agreement in December 1997 to change certain
  reporting requirements and financial covenants. Borrowings under the
  agreement are guaranteed by the Company. As of December 31, 1997, there was
  $10.5 million outstanding under this agreement. As of December 31, 1996,
  there were no borrowings outstanding under the previous agreement which
  allowed for borrowings up to $10.0 million.

  Central Pacific must comply with certain financial covenants provided in its
  revolving credit agreement, including restrictions relating to tangible net
  worth and leverage. As guarantor, these covenants apply to the Company.
  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 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
  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 first interest payment was made on December 29, 1995 for the period from
  November 1, 1995 (the last regular dividend payment date with respect to the
  preferred stock) through December 8, 1995 at the annual rate of 8.42% and
  from December 9, 1995 through December 31, 1995 at the annual rate of
  9.375%.

  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, 1997 are as follows:



<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
(in thousands)       1998         1999         2000       2001         2002    Thereafter         Total
--------------------------------------------------------------------------------------------------------
<S>              <C>          <C>          <C>        <C>          <C>        <C>             <C>
                  $     -      $     -      $     -    $18,723      $     -      $155,976      $174,699
========================================================================================================
</TABLE>




                                      32
<PAGE>   33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10. STOCKHOLDERS' EQUITY

  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, 1997, 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. In
  December 1995, the Company exchanged and retired 2,239,061 shares of its
  preferred stock for $56.0 million principal amount of 9.375% subordinated
  debentures, due December 31, 2025.

  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.

  In connection with sales of rights to service a total of $11.0 billion of
  mortgage loans to third parties during 1995, the Company transferred a total
  of $27.0 million of common equity securities and $93.0 million in cash and
  money market investments to White Mountains in exchange for 959,049 shares
  of the Company's common stock held by White Mountains, which were retired by
  the Company.

NOTE 11. 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") and principal-only
  ("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.


                                      33
<PAGE>   34
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 $284.5 million and $175.7 million as of December
  31, 1997 and 1996, 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, 1997 and 1996, the
  Company had approximately $776.8 million and $454.6 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 seventeen
  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 pass-thru rate from the date of the loan payoff
  through the end of that calendar month without reimbursement.

  As of December 31, 1997, 1996 and 1995, the Company serviced approximately
  $5.4 billion, $13.5 billion and $10.7 billion of GNMA loans in its owned
  servicing portfolio, respectively, and $2.5 billion, $2.9 billion and $3.5
  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 $12.8 million, $15.4 million and $13.5 million as of December
  31, 1997, 1996



                                      34
<PAGE>   35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  and 1995, respectively. In addition, the valuation allowance
  for the Company's capitalized servicing asset related to its principal
  recourse portfolio includes an $8.2 million and $7.3 million reserve for
  estimated losses on the corresponding loans at December 31, 1997 and 1996,
  respectively. Management believes these amounts are adequate to cover
  unreimbursed foreclosure advances and principal losses, including losses on
  loans with recourse.

  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 floor contracts ("floors") and principal-only ("P/O")
  swaps.

  The floors derive their value from the 10 year constant maturity treasury
  yield index. The floor strike rates range from 4.00% to 6.14%. To the extent
  that market interest rates increase, the value of the floor declines.
  However, the Company is not exposed to losses in excess of its initial
  investment in the floors. The total notional principal amount of the floors
  was $.7 billion and $1.0 billion as of December 31, 1997 and December 31,
  1996, respectively. As of December 31, 1997 and 1996, the carrying value of
  the Company's open floors was $8.2 million and $4.8 million, respectively.
  The floors have remaining terms ranging from 3 to 5 years.

  The value of the P/O swaps 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 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. The remaining
  original notional value of the P/O swaps was $98.1 million and $50.0 million
  as of December 31, 1997 and 1996, respectively. The carrying value of the
  P/O swaps was $12.5 million and $3.2 million as of December 31, 1997 and
  1996, respectively. The P/O swaps have remaining terms ranging from 3 to 4
  years.

  The floors 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.

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 floor contracts 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 investments in REMIC residuals, for which there are no quoted market
  prices, fair value is estimated based on discounted cash flow analyses,
  using interest only strip interest rates, prepayment speed assumptions and
  LIBOR rates, taking into consideration the characteristics of the related
  collateral.

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



                                      35
<PAGE>   36
NOTES TO CONSOLIDATED 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. Prior
  to 1997, fair value was estimated using quoted market prices for securities
  backed by similar loans.

 CAPITALIZED EXCESS SERVICING

  For capitalized excess servicing, fair value is estimated by computing the
  anticipated revenue to be received over the life of the related loans based
  on market consensus prepayment rates, discounted using quoted interest only
  strip interest rates.

 RECEIVABLE FROM SALE OF SERVICING

  For receivable from sale of servicing, carrying value equals or approximates
  fair value.

 COMMON EQUITY SECURITIES

  For common equity securities, fair value is based on quoted market prices
  and is equal to the carrying 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 commercial paper and 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.

                                      36

<PAGE>   37
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS

 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.

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



<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------
December 31,                                             1997                          1996
---------------------------------------------------------------------------------------------------
                                            Carrying             Fair       Carrying           Fair
(in thousands)                                Amount            Value         Amount          Value
---------------------------------------------------------------------------------------------------
<S>                                       <C>             <C>               <C>           <C>
Financial Assets:
  Cash                                    $    3,134       $    3,134        $   923      $     923
  Investments
     Interest rate floor contracts             8,153            8,153          4,825          4,825
     Principal-only swaps                     12,508           12,508          3,185          3,185
     Other                                    65,578           75,092         38,545         38,354
  Mortgage loans receivable                  519,247          529,260        314,937        315,895
  Pool loan purchases                        149,791          150,175        131,539        135,841
  Loans held for investment                    5,191            5,191         23,351         23,289
  Capitalized excess servicing                   n/a(a)           n/a(a)      38,672         39,617
  Receivable from sale of servicing           27,324           27,324              -              -
  Common equity securities                         -                -          2,312          2,312
  Loans in foreclosure and mortgage
     claims receivable (net) (b)              35,579           34,905         38,387         37,714
---------------------------------------------------------------------------------------------------
Financial Liabilities:
  Short-term debt                         $  569,399       $  569,399       $406,205      $ 406,205
  Long-term debt                             172,660          186,978        291,592        322,715
Off-Balance-Sheet Financial Instruments:
  Mandatory forward commitments                  n/a            1,642            n/a           (160)
  Commitments to extend credit
     expected to close (pipeline)                n/a            6,498            n/a          1,879
---------------------------------------------------------------------------------------------------
</TABLE>


(a)  Information is not applicable as a result of the Company's adoption of
     SFAS No. 125. Refer to notes 1 and 3 to the consolidated financial
     statements.
(b)  Excludes $5.6 million and $13.1 million of real estate owned in 1997 and
     1996, 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 statement of condition at fair value (refer to Note 2 to the
     consolidated financial statements).



                                      37
<PAGE>   38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 12. MORTGAGE SERVICING

  The Company's portfolio of mortgages serviced, including loans subserviced,
  interim servicing contracts and those under contract to acquire and
  excluding loans sold but not transferred, totaled $26.5 billion, $29.2
  billion and $31.8 billion as of December 31, 1997, 1996 and 1995,
  respectively. The Company's portfolio of mortgages serviced as of December
  31, 1997 is summarized below:



<TABLE>
<CAPTION>
                                                                                      Weighted Average
                                                           ----------------------------------------------------------
                                                                                                 Net        Remaining
                              Principal                    Loan               Interest     Servicing      Contractual
                       Balance 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               $    5,521           $    68                      8.37%          .424%              240
  FHA                             3,916                57                      8.80           .427               297
  VA                              2,124                62                      8.42           .403               298
Commercial                           66               889                      7.45           .176               163
--------------------------------------------------------------------------------------------------------------------
                             $   11,627           $    63                      8.52%          .420%              269
Subservicing                     14,919
--------------------------------------------------------------------------------------------------------------------
Total mortgage
  servicing portfolio        $   26,546           $    61                      8.45%           (a)               249
====================================================================================================================
</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 and the subservicing fee earned on its subservicing
     portfolio, which is not calculated as a percentage of the outstanding
     principal balance serviced, and therefore, would not be meaningful.

     The servicing fee rates in the table above are shown after deducting any
     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,                                1997                                                   1996
-----------------------------------------------------------------------------------------------------------------------------------
                                                           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         843           $     66              5.41%                1,239             $      87          5.50%
6.00%-6.49%           1,823                159              6.13                 5,449                   288          6.22
6.50%-6.99%           4,166                319              6.66                15,369                 1,111          6.68
7.00%-7.49%          12,968                729              7.17                42,363                 2,395          7.11
7.50%-7.99%          29,240              2,455              7.63                58,622                 4,104          7.60
8.00%-8.49%          27,989              2,280              8.13                60,852                 4,337          8.10
8.50%-8.99%          32,178              1,867              8.59                77,061                 4,047          8.58
9.00%-9.49%          13,452                722              9.07                37,714                 2,052          9.06
9.50%-9.99%          29,142              1,420              9.55                69,548                 3,618          9.57
10.00% and above     32,488              1,610             10.49                83,585                 4,371         10.49
-----------------------------------------------------------------------------------------------------------------------------------
Total               184,289           $ 11,627              8.52%              451,802             $  26,410          8.59%
====================================================================================================================================
</TABLE>


                                      38

<PAGE>   39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------------------------
December 31,                              1997                                                      1996
------------------------------------------------------------------------------------------------------------------------------------
                                                           Percentage                                                    Percentage
                                                         of Principal                                                  of Principal
                      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            20,459             $  1,889                16.3%           60,547    $          4,955                  18.7%
New York              22,118                1,162                10.0            42,195               2,441                   9.2
Texas                 15,655                  736                 6.3            29,851               1,513                   5.7
Washington             7,889                  690                 5.9            23,048               1,692                   6.4
Florida               12,894                  663                 5.7            28,361               1,408                   5.3
Michigan              10,773                  520                 4.5            25,553               1,019                   3.9
New Jersey             7,088                  503                 4.3            13,689                 895                   3.4
Illinois               6,335                  420                 3.6            16,704               1,036                   3.9
Maryland               5,020                  362                 3.1             8,966                 534                   2.0
Ohio                   6,658                  357                 3.1            15,772                 656                   2.5
Other*                69,400                4,325                37.2           187,116              10,261                  39.0
------------------------------------------------------------------------------------------------------------------------------------
Total                184,289             $ 11,627               100.0%          451,802    $         26,410                 100.0%
====================================================================================================================================
</TABLE>


*No other state constitutes more than 3.1% of the Company's owned servicing
    portfolio as of December 31, 1997.

  The above tables exclude loans subserviced for others having a principal
  balance of $14,919 million and $2,791 million as of December 31, 1997 and
  1996, respectively.

  Escrow funds of approximately $196.8 million, $207.8 million and $236.0
  million as of December 31, 1997, 1996 and 1995, respectively, relating to
  mortgages serviced and subserviced, 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 $35 million is provided
  under a Fund American master policy, for which the Company pays a portion of
  the premium.

NOTE 13. 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 includes 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, 1997, $.1 million of these charges 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, 1997 and 1996, $.2 million and $.5 million, respectively,
  remained accrued in the Company's consolidated statements of condition
  relating to future lease expenses for closed facilities.

                                      39

<PAGE>   40
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 14. 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, 1997 are as follows:



<TABLE>
<CAPTION>
--------------------------------------------------------------------
(in thousands)               1998    1999  2000  2001  2002   Total
--------------------------------------------------------------------
<S>                        <C>     <C>     <C>   <C>   <C>   <C>
                            $2,263  $1,057  $696  $359  $234  $4,609
====================================================================
</TABLE>


  Leases for branches which were closed as a result of the Company's
  restructuring plan implemented in 1994 are included in the table above. As
  of December 31, 1997, $.2 million of future lease payments remained accrued
  in the Company's consolidated statement of condition, and therefore, do not
  represent future operating expenses.

  Total rental expense for the years ended December 31, 1997, 1996 and 1995
  was $3.9 million, $4.5 million and $4.6 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 15. OTHER OPERATING EXPENSES

  The following table summarizes other operating expenses:



<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------
Year ended December 31, (in thousands)            1997           1996          1995
--------------------------------------------------------------------------------------
<S>                                        <C>             <C>             <C>
Telephone                                   $    3,948      $    4,316      $    4,015
Professional services                            3,587           3,376           1,649
Travel and entertainment                         1,989           1,885           1,808
Office supplies and printing                     1,903           2,063           1,768
Postage                                          1,812           2,119           1,985
Software systems                                 1,501           1,669           1,427
Bank charges                                       861           1,618           1,948
Amortization of goodwill                             -           2,090           2,090
Other                                           11,000          15,116          16,084
--------------------------------------------------------------------------------------
Total other operating expenses              $   26,601      $   34,252      $   32,774
======================================================================================
</TABLE>


NOTE 16. 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, 1997, the Company had recorded $39.1
  million of deferred tax liability relating to accumulated unrealized gains
  and equity in earnings of an investment in an unconsolidated affiliate, of
  which $13.9 million was recorded as part of the initial exchange. As of
  December 31, 1995, the Company had recorded $.3 million of deferred tax
  assets relating to accumulated unrealized losses on the portfolio of common
  equity securities. 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)                                          1997        1996
---------------------------------------------------------------------------------------
<S>                                                              <C>         <C>
Net current taxes                                                 $  9,058    $  (5,746)
---------------------------------------------------------------------------------------
Net deferred taxes                                                 (17,219)      18,210
=======================================================================================
</TABLE>

                                      40
<PAGE>   41
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS

  Total income tax (benefit) expense is as follows:


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------
Year ended December 31, (in thousands)                    1997       1996       1995
--------------------------------------------------------------------------------------
<S>                                                   <C>         <C>         <C>
Current income taxes:
  Federal                                              $ (4,396)   $ 17,280   $ 11,847
  State and local                                         1,352         144        248
Deferred (benefit) expense                                 (573)     (7,971)     4,037
--------------------------------------------------------------------------------------
Total income tax (benefit) expense                     $ (3,617)   $  9,453   $ 16,132
======================================================================================
</TABLE>


  The current federal income tax (benefit) expense for the years ended
  December 31, 1997 and 1995, as shown above, excludes a benefit of $3.2
  million and $.5 million, respectively, which relates to the extraordinary
  loss on the repurchase and retirement of debt which has been reported as a
  net amount in the consolidated statements of income.

  Deferred tax (benefit) expense for the years ended December 31, 1997, 1996
  and 1995 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 deferred tax (benefit) expense
  for the years ended December 31, 1997, 1996 and 1995, shown above excludes
  deferred tax expense of $22.1 million, $.3 million and $1.9 million,
  respectively. The 1997 expense is associated with unrealized gains on the
  Company's investment in an unconsolidated affiliate which were recorded
  directly to stockholders' equity. The 1996 and 1995 expenses are associated
  with unrealized gains and losses on the common equity securities portfolio
  which were recorded directly to stockholders' equity.

  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)                                           1997                                   1996
-------------------------------------------------------------------------------------------------------------------------------
                                                         Deferred             Deferred          Deferred             Deferred
                                                              Tax                  Tax               Tax                  Tax
                                                           Assets          Liabilities            Assets          Liabilities
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                      <C>             <C>                  <C>               <C>
Purchase accounting adjustments                          $      -         $    5,520           $      -          $     6,219
Unrealized gain on investment in
 unconsolidated affiliate (net)                                 -             36,002                  -                    -
Equity in earnings of unconsolidated affiliate                  -              3,095                  -                    -
Unrealized gain on financial instruments                        -              4,597                  -                  931
Capitalized servicing                                      26,163                  -             18,384                    -
Allowance for loan losses                                   4,803                  -              4,838                    -
Depreciation                                                    -              2,159                  -                2,583
Deferred bi-weekly income                                     969                  -              1,351                    -
Accrued postretirement benefits                             1,279                  -              1,181                    -
Other, net                                                  7,921              6,981              6,739                4,550
----------------------------------------------------------------------------------------------------------------------------
Total                                                    $ 41,135         $   58,354           $ 32,493         $     14,283
============================================================================================================================
</TABLE>


  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, 1997 and 1996.


                                      41
<PAGE>   42
  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


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



<TABLE>
<CAPTION>
  ------------------------------------------------------------------------------
  Year ended December 31, (in thousands)                 1997    1996     1995
  ------------------------------------------------------------------------------
  <S>                                                <C>        <C>      <C>
  Tax (benefit) expense at federal statutory rate    $ (3,902)  $ 1,795  $15,149
  Write-off of goodwill and other intangible assets         -     6,960        -
  Purchase accounting adjustments                           -       732      732
  Dividends received deduction                           (706)        -      (35)
  State taxes                                             879        94      161
  Other, net                                              112      (128)     125
  ------------------------------------------------------------------------------
  Total income tax (benefit) expense                 $ (3,617)  $ 9,453  $16,132
  ==============================================================================
</TABLE>


NOTE 17. 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. Cash contributions made to
  the plan for the years ended December 31, 1997, 1996 and 1995 totaled $.6
  million, $1.3 million and $1.7 million, respectively. 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 plan's funded status and the related
  amounts recognized in the Company's consolidated statements of condition:



<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
December 31, (in thousands)                                                                      1997       1996
--------------------------------------------------------------------------------------------------------------------
<S>                                                                                          <C>          <C>
Actuarial present value of benefit obligation:
  Accumulated benefit obligation, including vested benefits
     of $19,269 and $16,627 in 1997 and 1996, respectively                                   $   20,960   $   18,586
  Effect of future projected salary increases                                                     6,015        5,138
--------------------------------------------------------------------------------------------------------------------
Projected benefit obligation                                                                     26,975       23,724
Plan assets at fair value                                                                       (24,669)     (20,942)
--------------------------------------------------------------------------------------------------------------------
Projected benefit obligation in excess of plan assets                                             2,306        2,782
Unrecognized net gain (loss)                                                                        931       (1,111)
Unrecognized prior service cost                                                                      87          871
Unrecognized net obligation at transition                                                             -          (11)
--------------------------------------------------------------------------------------------------------------------
Accrued pension cost included in accounts payable
  and other liabilities                                                                      $    3,324   $    2,531
====================================================================================================================
</TABLE>

                                      42
<PAGE>   43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>

-----------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands)                                                   1997      1996      1995
-----------------------------------------------------------------------------------------------------------------
<S>                                                                                   <C>       <C>       <C>
Service cost for benefits earned during the year                                      $ 1,448   $ 1,578   $ 1,354
Interest cost on projected benefit obligation                                           1,718     1,633     1,388
Actual return on plan assets                                                           (3,752)   (1,998)   (3,801)
Net amortization and deferral                                                           1,973       892     2,613
-----------------------------------------------------------------------------------------------------------------
Net periodic pension cost                                                             $ 1,387   $ 2,105   $ 1,554
=================================================================================================================
</TABLE>

<TABLE>
<CAPTION>

     Assumptions used in the determination of the projected benefit obligation were:
-----------------------------------------------------------------------------------------------------------------
December 31,                                                                             1997      1996      1995
-----------------------------------------------------------------------------------------------------------------
<S>                                                                                       <C>      <C>        <C>
Discount rate                                                                             7.0%     7.25%      7.0%
Rate of increase in compensation levels                                                   4.5%      5.0%      6.0%
Expected long-term rate of return on assets                                               8.0%      8.0%      8.0%
=================================================================================================================
</TABLE>

NOTE 18. 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.

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

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands)                                1997             1996        1995
--------------------------------------------------------------------------------------------------------
<S>                                                                 <C>               <C>         <C>
Service cost                                                        $   94            $  110      $   86
Interest cost                                                          256               239         250
--------------------------------------------------------------------------------------------------------
Net periodic postretirement benefit cost                            $  350            $  349      $  336
========================================================================================================
</TABLE>

The following table sets forth the plan's funded status and the related amounts
recognized in the Company's consolidated statements of condition:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------
December 31, (in thousands)                                                           1997          1996
----------------------------------------------------------------------------------------------------------
<S>                                                                              <C>           <C>
Accumulated postretirement benefit obligation:
Retired participants                                                             $   2,255     $    1,868
Fully eligible active participants                                                     739            533
Other active participants                                                              801          1,009
----------------------------------------------------------------------------------------------------------
Total accumulated postretirement benefit obligation                                  3,795          3,410
Plan assets at fair value                                                                -              -
----------------------------------------------------------------------------------------------------------
Accrued postretirement benefit obligation in excess of plan assets                   3,795          3,410
Unrecognized prior service cost                                                       (157)             -
Unrecognized net gain                                                                   15             67
----------------------------------------------------------------------------------------------------------
Accrued postretirement benefit cost included in accounts payable
  and other liabilities                                                          $   3,653     $    3,477
=========================================================================================================
</TABLE>



                                      43
<PAGE>   44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

  An 8.6% annual rate of increase in the per capita costs of covered health
  care benefits was assumed for 1998, gradually decreasing to 5.0% by the year
  2007 and remaining at that level thereafter. Increasing the assumed health
  care cost trend rate by one percentage point in each year would increase the
  accumulated postretirement benefit obligation as of December 31, 1997 by
  5.0% and increase the aggregate of the service cost and interest cost
  components of net periodic postretirement benefit cost for 1997 by 4.1%. A
  discount rate of 7.0% and 7.25% was used to determine the accumulated
  postretirement benefit obligation as of December 31, 1997 and 1996,
  respectively.

NOTE 19. STOCK PLANS

  In 1986, the Company established an Employee Stock Ownership Plan ("ESOP")
  to enable employees to have an equity interest in the Company. The Company
  redeemed all the shares of Class B common stock held by the ESOP in November
  1993 for $4.6 million in cash. Management subsequently used that cash to
  invest in Fund American common stock. The assets currently held by the ESOP
  consist substantially of Fund American common stock. Effective in the fourth
  quarter of 1993, the ESOP was amended to allow employees who terminate their
  employment with the Company, and who are vested in the ESOP, to receive
  their distribution in cash or shares of Fund American common stock.
  Contributions to the ESOP are determined at the discretion of the Board of
  Directors.

  Effective October 1, 1996, the Company amended its 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.

  In connection with the exchange of Class B common stock, the Company
  established a Stock Appreciation Rights ("SAR") plan under which certain
  officers of the Company received stock appreciation rights in exchange for
  their shares of Class B common stock. The SARs may be exercised any time at
  the option of the holders thereof. The value of each SAR is equal to the
  difference between $86.625 and the closing price of Fund American's common
  stock on the date preceding the exercise of the SAR multiplied by a factor
  of 1.223.

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

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.



                                      44
<PAGE>   45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 21. RELATED-PARTY TRANSACTIONS

  As discussed in Notes 4 and 10, 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)                     1997          1996          1995
----------------------------------------------------------------------------------------------
 <S>                                                     <C>           <C>           <C>
 Interest paid                                           $  43,563     $  57,172     $  48,975
----------------------------------------------------------------------------------------------
 Income taxes paid                                       $   8,268     $  18,650     $     345
----------------------------------------------------------------------------------------------
 Noncash investing and financing activities:
 Exchange of common equity securities for
   shares of common stock from parent (Note 4)           $   2,638     $       -     $  27,020
 Receivable from sale of servicing rights                   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             -
 Exchange of 2,239,061 shares of 8.42% cumulative
   Series A preferred stock for 9.375% subordinated
   debentures (Note 10)                                          -             -        55,976
==============================================================================================
</TABLE>


NOTE 23. SUBSEQUENT EVENTS

  In March 1998, the Company paid dividends on its common stock totaling $25.0
  million.

  In March 1998, the Company increased and amended its $600.0 million secured
  revolving credit agreement. The Company exercised its right under the
  agreement to request additional commitments, with bank concurrence,
  increasing its available revolving facility to $701.0 million to meet
  increased borrowing requirements resulting from increased production
  volumes. The provisions of the amendment allow the Company to more fully
  utilize the facility by easing its restrictions with respect to the
  Company's use of its subprime production as collateral and its repurchase of
  delinquent loans out of mortgage pools.




                                      45

<PAGE>   46


SELECTED QUARTERLY FINANCIAL DATA
(UNAUDITED)


  Selected quarterly financial data for 1997 and 1996 is shown in the
  following table.  The quarterly financial data includes, in the opinion of
  management, all necessary recurring adjustments for a fair presentation of
  the results of operations for the interim periods.

<TABLE>

------------------------------------------------------------------------------------------------------
Quarters Ended                                            March       June     September     December
(in thousands, except for per share amounts)               31          30          30           31
------------------------------------------------------------------------------------------------------
<S>                                                    <C>         <C>           <C>        <C>
1997
Total revenue                                           $25,561     $ 17,949 (b)  $24,732      $25,632
Income (loss) before extraordinary loss                     187       (6,291)(b)    1,088       (2,514) (c)
Extraordinary loss                                            -       (5,975)           -            -
Net income (loss)                                           187      (12,266)(b)    1,088       (2,514) (c)
Comprehensive (loss) income                                (120)       1,154 (b)   23,504        3,059  (c)
------------------------------------------------------------------------------------------------------
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
------------------------------------------------------------------------------------------------------
1996
Total revenue                                           $48,684      $39,762      $39,859      $20,375
Net income (loss)                                        13,294        5,922        8,258      (31,800) (d)
Comprehensive income (loss)                              13,840        5,922        8,258      (31,800) (d)
------------------------------------------------------------------------------------------------------
Basic net income (loss) per common share (a)              $5.50        $2.22        $3.26     $ (14.55)
Basic comprehensive income (loss) per common share (a)     5.75         2.22         3.26       (14.56)
------------------------------------------------------------------------------------------------------
</TABLE>

(a)  After deducting dividends on preferred stock.
(b)  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.
(c)  Includes a $3.7 million loss related to the February 1997 servicing
     sale and related assumption of subservicing and $1.4 million pretax of
     various one-time charges.
(d)  Includes a $29.1 million pretax write-off of the Company's goodwill
     and other intangible assets.



                                       46
<PAGE>   47

BOARD AND SENIOR OFFICERS


                               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

                                 John J. Cleary
                             Senior Vice President
                              Loan Administration

                             Kathleen M. DeFrances
                             Senior Vice President
                              Residential Division

                                E. Roger Everett
                             Senior Vice President
                             Production Operations

                               Patrick D. Gillies
                             Senior Vice President
                           Delinquency Administration

                                 John L. Jansen
                             Senior Vice President
                                Human Resources

                               William C. Manasco
                             Senior Vice President
                              Information Services

                               Pablo Sanchez, Jr.
                             Senior Vice President
                               Subprime Division

                               Phillip W. Shepard
                             Senior Vice President
                              Residential District





                               Charles D. Taylor
                             Senior Vice President
                              Information Services

                        Central Pacific Mortgage Company

                                John A. Courson
                     President and Chief Executive Officer



                                       47

<PAGE>   48

CORPORATE ADDRESS


  Source One Mortgage Services Corporation

  27555 Farmington Road

  Farmington Hills, Michigan 48334-3357

  (248) 488-7000





                                       48