- --------------- (1) The Company acquired Casualty Insurance Company on February 22, 1995. (2) Company-obligated mandatorily redeemable preferred securities of subsidiary Trust holding solely Company junior subordinated debentures. (3) Effective January 1994, FASB 115 changed the accounting treatment afforded the Company's investment portfolio wherein unrealized gains and losses on securities designated by the Company as available for sale are included net of deferred taxes, as a component of stockholders' equity.
The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains certain forward-looking statements which involve risks and uncertainties. The Company's actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors including those set forth elsewhere in this Form 10-K.
Fremont General Corporation is engaged domestically in select insurance and financial services businesses. Fremont General's insurance business includes one of the largest underwriters of workers' compensation insurance in the nation. The Company also provides medical malpractice insurance. Fremont General's financial services business includes commercial real estate lending, residential real estate lending, commercial finance and premium financing. The Company's total assets as of December 31, 1996 were $4.3 billion, with 1996 pre-tax earnings of $128 million. The primary operating strategy of the Company is to build upon its core business units through acquisition opportunities and new business development. The Company's secondary strategy is to achieve income balance and geographic diversity among its business units in order to limit the exposure of the Company to industry, market and regional concentrations. The Company's stock is traded on the New York Stock Exchange under the symbol "FMT" (NYSE:FMT).
The Company began its workers' compensation insurance operations in 1959 and continues to derive the majority of its revenues from this business. The Company's workers' compensation insurance business has grown through internal expansion, as well as through the acquisition of other workers' compensation insurance companies. On February 22, 1995, the Company completed the acquisition of all outstanding stock of Casualty Insurance Company ("Casualty") and its wholly-owned subsidiary Workers' Compensation & Indemnity Company of California ("WCIC") from the Buckeye Union Insurance Company. Casualty underwrites workers' compensation insurance primarily in Illinois and several other mid-western states. Casualty currently is the largest underwriter of workers' compensation insurance in Illinois and has provided the Company with a significant presence in the mid-western region. The Casualty acquisition has provided geographic diversity within the Company's workers' compensation insurance business and approximately 63% of the Company's 1996 revenues from workers' compensation insurance premiums were generated in the mid-west region, with the remaining 37% emanating from the west region, primarily in California. The Company believes this geographic diversity mitigates potential fluctuations in earnings from cyclical downturns in various regional economies. (See Note B of Notes to Consolidated Financial Statements for additional information with respect to the acquisition of Casualty.)
In July 1993, California enacted legislation to reform the workers' compensation insurance system and to, among other things, adopt an open rating system through the repeal of the minimum rate law effective January 1, 1995. The repeal of the minimum rate law resulted in lower premiums and lower profitability on the Company's California workers' compensation insurance policies in 1995 and 1996 due to increased price competition. (See "Results of Operations -- Property and Casualty Insurance Operations -- Premiums.") The Company's acquisition of Casualty, with policies written primarily outside of California, lessened the impact of the repeal of the minimum rate law by providing geographic diversity, which mitigates the impact of economic and regulatory changes within a regional marketplace. In Illinois, where Casualty underwrites the majority of its workers' compensation insurance premiums, price competition continues to impact workers' compensation companies due in part to overall average decreases in advisory premium rates of 13.6% and 10.0% which became effective January 1, 1996 and 1997, respectively. Although insurance companies are not required to adopt such advisory premium rates, companies in Illinois generally follow such rates. (See "Results of Operations -- Property and Casualty Insurance Operations -- Workers' Compensation Regulation.")
In an effort to provide a clearer understanding of the Company's financial services business segment, the Company has consolidated the real estate lending operations of Fremont Investment & Loan, a California thrift and loan, and the commercial finance operations of Fremont Financial Corporation, under a newly
The Company's real estate lending operations, which began in 1990 through the acquisition of a California thrift and loan, now serves more than 28,000 customers through 11 branch offices. The thrift and loan operations are primarily engaged in commercial and residential real estate lending. For commercial real estate loans, principal amounts primarily range between $1 million to $5 million and for residential real estate loans, principal amounts are generally below $300,000. The Company's operating strategy is to pursue growth of the loan portfolio through origination of new loans and acquisition of loan portfolios that meet its underwriting guidelines applied to origination of new loans. Assets of the real estate lending operation grew from $278 million at the end of 1991 to $1.24 billion at the end of 1996, due primarily to increased loan originations and to the purchase of loan portfolios from other financial institutions. (See "Item 1. Business -- Financial Services Operations -- Real Estate Lending.") The ability of the Company to continue to originate loans, and of borrowers to repay outstanding loans, may be impaired by adverse changes in local or regional economic conditions which affect such areas or by adverse changes in the real estate market in those areas. Such events could also significantly impair the value of the underlying collateral. If the Company's collateral were to prove inadequate, the Company's results of operations could be adversely affected.
The commercial finance operation of FGCC provides working capital loans, primarily secured by accounts receivable and inventory, to small and middle market companies on a nationwide basis. Additionally, insurance premium financing is provided and is collateralized by security interests in return premiums. The total commercial finance loan portfolio grew from $189 million at December 31, 1991 to $612 million at December 31, 1996. This growth has been achieved primarily through development of the customer base through loan originations and through participation in syndicated loan transactions. (See "Item 1. Business -- Financial Service Operations -- Commercial Finance.") The lending market has become increasingly competitive for small to middle market commercial borrowers. As a result, FGCC has experienced decreasing yields on its commercial finance loans.
By providing diverse insurance and financial services to small and medium-sized businesses, the Company has achieved growth in net income during the three years ended December 31, 1996. Higher revenues and net income were also achieved through the acquisition of Casualty. The following table presents information for each of the three years in the period ended December 31, 1996 with respect to the Company's core business segments.
The Company generated revenues of $796 million for 1996, as compared to revenues of $924 million and $653 million for 1995 and 1994, respectively. Revenues were lower in 1996 as compared to 1995, due principally to lower workers' compensation insurance premiums and lower life insurance revenues in the financial services segment. The lower workers' compensation insurance premiums are due primarily to lower premiums earned in California and, to a lesser extent, lower premiums earned in Illinois. (See "Property and Casualty Insurance Operations -- Premiums.") The lower life insurance revenues in the financial services segment are due to certain reinsurance and assumption agreements with a reinsurer which became effective December 31, 1995 and January 1, 1996 and resulted in the sale of substantially all of the Company's life insurance operations. (See "Financial Services.") Revenues were higher in 1995 as compared to 1994, due primarily to higher workers' compensation insurance premiums, net investment income and loan interest income. The higher workers' compensation insurance premiums and net investment income are due primarily to the acquisition of Casualty, partially offset by lower insurance premiums earned in California. Realized investment gains (losses) were $(1,658,000), $1,000 and $(315,000) for 1996, 1995 and 1994, respectively.
The Company had net income of $87.3 million or $3.26 per share for 1996, as compared to $68.0 million or $2.61 per share and $55.8 million or $2.16 per share for 1995 and 1994, respectively. Income before taxes for 1996 was $128.3 million as compared to $100.3 million and $81.6 million for 1995 and 1994, respectively.
Corporate revenues consisted primarily of investment income, while corporate expenses consisted primarily of interest expense and general and administrative expense. The corporate loss before income taxes was $25.9 million, $18.5 million and $7.7 million for 1996, 1995 and 1994, respectively. The increase in the corporate loss before taxes in 1996 as compared to 1995 was due principally to increased interest expense and increased administrative expenses. The increase in interest expense is mainly due to additional debt incurred in the acquisition of Casualty, as well as to accrued dividends in connection with a public offering on March 1, 1996 of $100 million of 9% Trust Originated Preferred Securities(SM) (the "Preferred Securities") sold by a consolidated wholly-owned subsidiary of the Company. (See "Liquidity and Capital Resources.") The accrued dividends on the Preferred Securities have been classified in the Consolidated Statements of Income as interest expense. (See Note J of Notes to Consolidated Financial Statements.) The increase in the corporate loss before taxes in 1995 over 1994 was due primarily to increased interest expense and decreased investment income. The increase in interest expense is due primarily to additional debt incurred in the acquisition of Casualty, along with modest increases in administrative expenses.
Income tax expense of $41.0 million, $32.3 million and $25.8 million for 1996, 1995 and 1994, respectively, represents an effective tax rate of 32% each year on pretax income of $128.3 million, $100.3 million and $81.6 million for the corresponding periods. The Company's effective tax rates for all years presented are lower than the enacted federal income tax rate of 35%, due primarily to tax exempt investment income which reduces the Company's taxable income.
Revenues from the property and casualty insurance operations consist primarily of workers' compensation insurance premiums earned, medical malpractice premiums earned and net investment income. Expenses
The Company regularly reviews its reserving techniques, overall reserve position and reinsurance. In light of present facts and current legal interpretations, management believes that adequate provisions have been made for loss reserves. In making this determination, management has considered its claims experience to date, loss development history for prior accident years and estimates of future trends of claims frequency and severity. However, establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience.
Dividends to Policyholders. In 1996 and 1995 there were no dividends accrued. This is compared to $49.7 million accrued in 1994. The ratio of dividends accrued to workers' compensation insurance premiums earned therefore decreased to 0% in 1996 and 1995 from 12.4% in 1994. The significant decrease in dividends accrued is due in part to a change in the type of workers' compensation insurance policy written on and after January 1, 1995. In 1995, the Company's workers' compensation insurance policies, both in California and those underwritten by Casualty, were predominately written as non-participating, which does not include provisions for dividend consideration. In 1994 and prior, the Company's policies were predominately written as participating, thereby obligating the Company to consider the payment of dividends. This shift in policy type is due primarily to the increased competition in the California market which has resulted from the repeal of the minimum rate law, effective January 1, 1995. The Company anticipates that this shift to non-participating policies will continue and be a characteristic element of the competitive environment established by the July 1993 California legislation. (See "Workers' Compensation Regulation.")
Workers' Compensation Regulation. Illinois began operating under an open rating system in 1982 and California began operating under such a system effective January 1, 1995. In an open rating system, workers' compensation companies are provided with advisory premium rates by job classification and each insurance company determines its own rates based in part upon its particular operating and loss costs. Although insurance companies are not required to adopt such advisory premium rates, companies in Illinois generally follow such rates. This characteristic has resulted in price competition in Illinois, where overall average decreases in advisory premium rates of 13.6% and 10.0% became effective January 1, 1996 and 1997, respectively. However, insurance companies in California have, since the adoption of an open rating system, generally set their premium rates below such advisory premium rates. Before January 1, 1995, California operated under a minimum rate law, whereby premium rates established by the California Department of Insurance were the minimum rates which could be charged by an insurance carrier.
In July 1993, California enacted legislation to reform the workers' compensation insurance system and to, among other things, repeal the minimum rate law effective January 1, 1995. This repeal resulted in lower premiums and lower profitability in the Company's California workers' compensation insurance business due
to increased price competition. The Company's acquisition of Casualty, with policies written primarily outside of California, lessened the impact of the repeal of the minimum rate law by providing geographic diversity, which mitigates the impact of economic and regulatory changes within a regional marketplace. (See "Item 1. Business -- Regulation -- Insurance Regulation.")
The following table illustrates the maturities of the Company's loans receivable:
The lower provision for loan losses in 1996 as compared to 1995 is due primarily to improved loan loss experience in the real estate lending operation, offset partially by an additional specific loan loss in the commercial finance operation associated with one loan in the commercial finance portfolio. Substantially all of the charge-offs in the commercial finance operation in 1996 were related to this loan. The real estate lending operation has benefited from improved loan loss experience, as evidenced by the significant decrease in charge-offs in 1996 as compared to 1995. Overall, total charge-offs have decreased over the three years ended December 31, 1996 and these reductions occurred during a period in which loans receivable increased.
The Company's commercial finance operation funds its lending activities primarily through its asset securitization program, an unsecured revolving line of credit with a syndicated bank group and its capital. The asset securitization program was established in 1993 to provide a stable and cost effective source of funds to facilitate the expansion of this business. As of December 31, 1996, an aggregate $235 million of senior series and a $30 million subordinated series of asset-backed certificates were outstanding. The interest rate on the certificates, set monthly, ranged from LIBOR plus 0.34% to LIBOR plus 0.95% at December 31, 1996. The securities issued in this program have a scheduled maturity of three to five years, but could mature earlier depending on fluctuations in the outstanding balances of loans in the portfolio and other factors. As of December 31, 1996, up to $365 million in additional publicly offered asset-backed certificates may be issued pursuant to a shelf registration statement to fund future growth in the commercial finance loan portfolio. In February 1996, $135 million of the senior series certificates ("Series C") were issued. The proceeds were used, in conjunction with existing cash, to retire $200 million in Series A certificates, which were outstanding as of December 31, 1995. The $30 million subordinated certificates were issued by the Company in April 1995 via a private placement. In December 1995, a commercial paper facility was established as part of the asset securitization program. This facility provides for the issuance of up to $150 million in commercial paper, dependent upon the level of assets within the asset securitization program. This facility, which expires in December 1998, had approximately $15 million outstanding under it as of December 31, 1996. The commercial finance operation's unsecured revolving line of credit is with a syndicated bank group that
presently permits borrowings of up to $400 million, which includes a revolving credit facility of $300 million expiring August 1998 and a term loan of $100 million maturing 2001. The balance outstanding at December 31, 1996 of the revolving credit facility and the term loan was $123 million and $100 million, respectively, with a weighted average interest rate of 6.11%. This credit line is primarily used to finance assets which are not included in the Company's asset securitization program.
As a holding company, Fremont General pays its operating expenses, meets its other obligations and pays stockholders' dividends from its cash on hand, management fees paid by its subsidiaries and dividends paid by its subsidiaries. During 1996, stockholders' dividends totaling $15.0 million were paid. Stockholders' dividends declared aggregated $15.8 million, $13.1 million and $11.5 million during 1996, 1995 and 1994, respectively. Several of the Company's subsidiaries are subject to certain statutory and regulatory restrictions and various agreements, principally loan agreements, that restrict their ability to distribute dividends to the Company. The Company expects that during the next few years dividends from its subsidiaries will consist of dividends from its property and casualty subsidiaries and dividends on preferred stock of its thrift and loan holding company and commercial finance subsidiaries. The maximum amount available for payment of dividends by the property and casualty subsidiaries at December 31, 1996 without prior regulatory approval is approximately $62.6 million.
On February 22, 1995, the Company completed the acquisition of Casualty which resulted in the disbursement of funds totaling $256.5 million, comprised of $231.5 million in cash and $25 million in a note payable to the seller. In September 1995, the note payable to the seller was refinanced using the Company's existing revolving line of credit. The cash used to fund the acquisition includes $55 million in borrowings under the Company's existing line of credit and the remainder from internally generated funds. (See "General.")
Net cash provided by (used in) financing activities was $(118.0) million, $483.0 million and $485.6 million for 1996, 1995 and 1994, respectively. Net cash provided by (used in) financing activities decreased in 1996 as compared to 1995, due primarily to lower long-term debt proceeds, net of repayments; the payment in 1996 of $363.4 million in settlement of certain reinsurance and assumption agreements within the life insurance operation which became effective January 1, 1996 between the Company and a reinsurer (see "Financial Services"); a decrease in annuity contract receipts, net of contract withdrawals; and an increase in deferred compensation plans. These conditions were partially offset by a decrease in the repayments of short-term debt, net of proceeds, an increase in thrift deposits and the impact of the proceeds from the sale of 9% Trust Originated Preferred Securities(SM) on March 1, 1996 in a public offering by the Trust. The lower long-term debt proceeds and the decrease in repayments of short-term debt is due primarily to a reclassification in 1995 of the commercial finance operation's credit line from short-term debt to long-term debt as of December 31, 1995. This reclassification was made pursuant to the terms of the credit line, which was renegotiated in August 1995. The increase in repayments of long-term debt in 1996 is due principally to the repayment of $50 million in revolving bank line of credit indebtedness, which was paid out of the proceeds of the Company's sale of 9% Junior Subordinated Debentures in March 1996. The increase in deferred
compensation plans is due primarily to the repurchase by the Company of its Common Stock in the first quarter of 1996 pursuant to certain deferred compensation programs. Net cash provided by financing activities decreased modestly in 1995 as compared to 1994, due mainly to a lower increase in thrift deposits partially offset by a net increase in short-term and long-term debt and an increase in annuity contract receipts, net of contract withdrawals.
The amortized cost of the Company's invested assets were $1.48 billion, $1.91 billion, and $.99 billion at December 31, 1996, 1995 and 1994, respectively. The approximate $430 million decrease in 1996 is due principally to the $363.4 million settlement of certain reinsurance and assumption agreements within the life insurance operation which became effective January 1, 1996 (see "Financial Services"); $96.0 million in cash flow used in operating activities; $202.9 million in loan originations, net of loan repayments; $89.2 million in repayments of short-term and long-term debt, net of debt proceeds; and $28.2 million used to fund certain deferred compensation plans. These conditions were partially offset by $100 million in proceeds from the public offering on March 1, 1996 of 9% Trust Originated Preferred Securities(SM) by a subsidiary of the Company, $188.0 million in net thrift and loan deposit increases and $88.4 million in annuity contract receipts, net of withdrawals. Contributing to the 1995 $.92 billion increase in the invested assets was approximately $512 million resulting from the Casualty acquisition and $199 million increase in net annuity receipts in the Company's life insurance operation. As of July 1, 1995 the Company's held to maturity portfolio totaling $319.4 million was transferred to available for sale in accordance with the provisions of Financial Accounting Standards Board Statement 115 ("FASB 115"), "Accounting for Certain Investments in Debt and Equity Securities." (See Note C of Notes to Consolidated Financial Statements.)
The Company's property and casualty premium to surplus ratio for the year ended December 31, 1996 was 1.2 to 1, which is within industry guidelines. The FDIC has established certain capital and liquidity standards for its member institutions, and the Company's thrift and loan subsidiary was in compliance with these standards as of December 31, 1996. (See "Item 1. Business -- Regulation -- Thrift and Loan Regulation.") In August 1994 an additional $23 million was contributed to the capital of this subsidiary to support the growth in the loan portfolio during 1994.
In February 1997, the FASB issued Statement No. 128 ("FASB 128"), "Earnings Per Share and Disclosure of Information about Capital Structure" which is effective for periods ending after December 15, 1997. Under FASB 128, primary earnings per share, which currently includes the dilutive effect of stock options, will be replaced by basic earnings per share, which excludes the dilutive effect of stock options. Fully diluted shares would not change significantly but would be renamed diluted earnings per share. All previously