(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 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 and currently has major market positions in California, Illinois, Arizona, Wisconsin, Idaho and Alaska. At December 31, 1997 the Company had business in thirty-nine states and the District of Columbia.
Allocation of the purchase price is subject to valuations and other studies which are not yet complete. Accordingly, the final allocation of the purchase price may be different from the amounts summarized in the preceding table.
The Company's real estate lending operations, which began in 1990 through the acquisition of a California thrift, currently consists of more than 3,300 residential real estate accounts, 500 commercial real estate accounts, 13,300 insurance premium finance accounts and 42,000 deposit accounts serviced through 13 branch offices in California. The thrift operations are primarily engaged in commercial and residential real estate lending. For commercial real estate loans, principal amounts primarily range between $1 million to $8 million and for residential real estate loans, principal amounts are generally below $300,000. Additionally, insurance premium financing is provided and is collateralized by security interests in return premiums. The Company's operating strategy is to grow its loan portfolio through origination of new loans and acquisition of loan portfolios that meet its underwriting guidelines applied to origination of new loans. The loan portfolio of the real estate lending operation grew from $376 million at the end of 1992 to $1.5 billion at the end of 1997, due 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 Company's commercial finance operation provides working capital loans, primarily secured by accounts receivable, inventory and machinery and equipment, to small and middle market companies on a nationwide basis. The total commercial finance loan portfolio grew from $282 million at December 31, 1992 to $547 million at December 31, 1997. 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 continues to be competitive for small to middle market commercial borrowers. As a result, the commercial finance operation has experienced decreasing yields on its commercial finance loans.
The Company has achieved growth in net income during the three years ended December 31, 1997 by providing diverse insurance and financial services to primarily small and medium-sized businesses. Higher revenues and net income were also achieved through the acquisition of Industrial and Casualty. The following table presents information for each of the three years in the period ended December 31, 1997 with respect to the Company's core business segments.
Insurance Operations.") Higher revenues in the financial services segment in 1997 were achieved primarily from increased loan interest revenues which resulted from significant growth in the average loan portfolios of the combined real estate lending and commercial finance operations. (See "Financial Services Operations.") Revenues were lower in 1996 as compared to 1995, due principally to lower workers' compensation insurance premiums in the property and casualty insurance segment and lower life insurance revenues in the financial services segment. The lower workers' compensation insurance premiums were due primarily to lower premiums earned in California and to a lesser extent lower premiums earned in Illinois. The lower life insurance revenues in the financial services segment were due to certain reinsurance and assumption agreements with a reinsurer which became effective December 31, 1995 and January 1, 1996 and resulted in the substantial reduction of the Company's life insurance operations. Realized investment gains (losses) were $(1,964,000), $(1,658,000), and $1,000 for 1997, 1996 and 1995, respectively.
Up until January 1, 1998 the Company maintained a small medical malpractice insurance operation within the property and casualty insurance segment. On January 1, 1998, the Company entered into reinsurance and assumption agreements with a reinsurer whereby substantially all of the assets and liabilities related to the medical malpractice policies were ceded to the reinsurer. These reinsurance agreements are part of several other agreements which collectively result in the sale of the Company's medical malpractice operations effective January 1, 1998. The effect on the Company's results of operations from these agreements was not material. Revenues from medical malpractice operations were $32.6 million, $31.6 million and $34.3 million for 1997, 1996 and 1995, respectively.
The Company had net income of $108.3 million or $3.23 diluted earnings per share for 1997, as compared to $87.3 million or $2.73 diluted earnings per share and $68.0 million or $2.18 diluted earnings per share for 1996 and 1995, respectively. Income before taxes for 1997 was $158.9 million as compared to $128.3 million and $100.3 million for 1996 and 1995, respectively.
The property and casualty insurance operations, consisting primarily of workers' compensation insurance, posted income before taxes of $144.7 million for 1997, as compared to $117.6 million and $83.1 million for 1996 and 1995, respectively. The increase of 23% in income before taxes in 1997 as compared to 1996 is due primarily to the recognition of continued lower claim frequency, mainly in the mid-west region and the acquisition of Industrial. The increase in income before taxes of 41% in 1996 as compared to 1995 was due predominately to lower claim frequency and the acquisition of Casualty, offset partially by lower income on the Company's California business. The combined ratio for 1997 was 93.0% compared to 94.8% and 100.5% for 1996 and 1995, respectively.
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.)
Income tax expense of $50.6 million, $41.0 million and $32.3 million for 1997, 1996 and 1995, respectively, represents an effective tax rate of 32% each year on pretax income of $158.9 million, $128.3 million and $100.3 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.
Premiums. Premiums earned from the Company's property and casualty insurance operations were $601.2 million for 1997, as compared to $486.9 million and $606.9 million for 1996 and 1995, respectively. The higher premiums in 1997 were due primarily to the acquisition of Industrial. With this acquisition, the Company has broadened the geographic diversity of its premium writings. Using the Company's estimated annual premiums on policies in effect at December 31, 1997 (referred to as "inforce premium"), the percentage of the Company's inforce premium in California and Illinois totaled 61%, down from 75% at December 31, 1996. Premiums were significantly lower in 1996 as compared to 1995, due primarily to lower premiums earned in California and to a lesser extent lower premiums earned in Illinois. The lower premiums in California were due primarily to the increased price competition resulting from California's adoption of an open rating system effective January 1, 1995. The Company has recently observed a moderation of price competition in California. In the fourth quarter of 1997, the Company also observed some moderation of price competition in Illinois where competitive pressures also resulted in lower premiums in 1996. (See "Item 1. Business -- Property and Casualty Insurance Operations -- Workers' Compensation Insurance" and "Variability of Operating Results" and "Workers' Compensation Regulation.") The Industrial acquisition has also afforded the Company a significant presence in the western United States, in addition to California. These western states, excluding California, have collectively exhibited relatively stable competitive environments.
Net Investment Income. Net investment income within the property and casualty insurance operations was $138.9 million, $111.6 million and $101.3 million in 1997, 1996 and 1995, respectively. Significantly higher invested assets, due primarily to the acquisition of Industrial, resulted in increased investment income in 1997 as compared to 1996. (See "Item 1. Business -- Investment Portfolio.")
Loss and Loss Adjustment Expense. The property and casualty loss and loss adjustment expenses ("LAE") were $389.2 million, $335.4 million and $461.3 million in 1997, 1996 and 1995, respectively. In addition, the ratio of these losses and LAE to property and casualty insurance premiums earned ("loss ratio") was 64.7%, 68.9% and 76.0% in 1997, 1996 and 1995, respectively. The decrease in the loss ratio in 1997 is due mainly to the recognition of a decrease in the frequency of reported claims on the 1996 and 1995 accident years in the Company's mid-west region, offset partially by higher loss ratios associated with Industrial on the 1997 accident year. Additionally, the Company's management believes that its implementation of more effective claims handling procedures in the mid-west region has contributed to the reduction in loss and loss adjustment expenses during calendar year 1997 and relating to the 1996 and prior accident years. The decrease in the loss ratio in 1996 as compared to 1995 was due principally to the recognition of lower claim frequency and severity in the Company's mid-west region. The Company is not able to determine with certainty the specific cause or causes of increases and decreases in reported claims experience, but has reached its own conclusions based on a review of its internal data base and a subjective evaluation of external factors. (See "Item 1. Business -- Property and Casualty Insurance Operations -- Loss and Loss Adjustment Expense Reserves.")
Dividends to Policyholders. The policyholder dividends ratio for the Company's property and casualty insurance operations was 0.8% in 1997 and there were no dividends accrued in 1996 or 1995. The Company believes that these ratios are low by industry standards. The low ratios are due primarily to the type of workers' compensation insurance policies written by the Company. The Company's workers' compensation insurance policies are predominately written as non-participating, which means that they do not include provisions for dividend consideration. The dividends accrued in 1997 were due mainly to the acquisition of Industrial. (See "Item 1. Business -- Property and Casualty Insurance Operations -- Policyholders' Dividends.")
Workers' Compensation Regulation. At December 31, 1997, approximately 61% of the Company's inforce premiums were in California and Illinois. 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 increased price competition in Illinois, where overall average decreases in advisory premium rates of 7.9%, 10.0% and 13.6% became effective January 1, 1998, 1997 and 1996, respectively. In contrast, 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. Most of the states in which the Company writes premiums operate under some form of open rating system.
Revenues increased 19% in 1997 due primarily to greater loan interest revenue attributable to the growth in the average loan portfolio of the commercial and residential real estate lending operations. Revenues decreased 8% in 1996 as compared to 1995, due primarily to lower life insurance revenues. Effective January 1, 1996, the Company substantially reduced its life insurance operations through certain reinsurance and assumption agreements entered into between the Company and a reinsurer. The effect on income before taxes and net income from these reinsurance agreements was not material. (See Note F of Notes to
The margin between the Company's interest income and expense decreased slightly in 1997 due to a decrease in the yields in the commercial finance segment as increases in the credit quality of the commercial finance portfolio and continued competition resulted in lower yields. Partially offsetting this was a slight increase in the net margins in the real estate lending operation, due primarily to an increase in the yields on commercial real estate loans, which was offset partially by lower yields on the residential real estate loans. The
Adverse economic developments can negatively affect the Company's financial services business and results of operations in a number of ways. Such developments can reduce the demand for loans, impair the ability of borrowers to pay loans and impair the value of the underlying collateral.
Non-performing assets increased to $42.0 million at December 31, 1997 from $31.2 million at December 31, 1996. Overall, these increases are generally consistent with the significant increase in total loans receivable to $2.03 billion at December 31, 1997 from $1.73 billion at December 31, 1996. In 1996, non-performing assets decreased to $31.2 million at December 31, 1996 from $41.4 million at December 31, 1995. This decrease is due primarily to decreases in non-accrual loans in the real estate lending and commercial
The lower provision for loan losses over the three years ended December 31, 1997 are due primarily to improved loan loss experience in the real estate lending operation. Additionally, a lower loan loss provision occurred in the commercial finance operation in 1997 as the Company was adversely impacted in 1996 by a specific loan loss provision associated with one loan in the commercial finance loan portfolio. Substantially all of the charge-offs in the commercial finance operation in 1996 were related to this loan. The Company's overall improved loan loss experience is evidenced by the decreases in the ratio of net charge-offs to average total loans receivable over the three years ended December 31, 1997, as well as the relative stability of the ratio of non-performing assets to total loans receivable in the preceding table. The reductions in the charge-off ratio occurred during a period in which loans receivable increased.
The Company is subject to market risk resulting primarily from fluctuations in interest rates arising from balance sheet financial instruments such as investments, loans and debt. In the property and casualty insurance operations, the greatest interest rate risk exposure occurs where the interest rate of the financial instrument is fixed in nature and there is a difference between the fixed rate of the financial instrument and the market rate. The greatest interest rate risk exposure in the financial services operations occurs when interest rate gaps arise wherein assets are funded with liabilities having different repricing intervals or different market indices to which the instruments' interest rates are tied. Changes in interest rates will affect the Company's net investment income, loan interest, interest expense and total stockholders' equity. The objective of the Company's asset and liability management activities is to provide the highest level of net interest income and to seek cost effective sources of capital, while maintaining acceptable levels of interest rate and liquidity risk. The Company has designated its entire investment portfolio as investments that would be available for sale in response to changing market conditions, liquidity requirements, interest rate movements and other investment factors. (See "Item 1. Business -- Investment Portfolio.") The Company currently owns no derivative financial instruments and, consequently, is not subject to market risk for such off-balance sheet financial instruments. Furthermore, the Company does not have exposure to foreign currency or commodity price risk.
The following table provides information about the assets and liabilities of the Company's financial services operations that are sensitive to changes in interest rates. For loans, investments, thrift deposits and other liabilities with contractual maturities, the table presents principal cash flows and related weighted-average interest rates by contractual maturity, adjusted for estimated loan prepayments based upon historical behaviors of its loan portfolio. Thrift deposits that have no contractual maturity are presented as maturing in 1998.
Fremont General Corporation (parent only) is also subject to interest rate exposure related to LIBOR and U.S. prime interest rates because of its long-term debt and other obligations with both fixed and variable interest rates. For fixed rate obligations, the Company runs the risk that if market rates decline, the related required payments will exceed those based on the current market rates. For obligations with variable interest rates, fluctuations in the market rates will directly affect interest expense.
The following table provides information about interest rate sensitive assets and liabilities of Fremont General Corporation (parent only). For short-term investments with variable interest rates, the table presents principal cash flows by expected maturity dates. The weighted-average interest rates are based on implied forward rates as derived from appropriate annual spot rate observations as of the reporting date.
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, 1997, an aggregate of $235 million of senior series and an aggregate of $39 million of subordinated series of term asset-backed certificates were outstanding. The interest rate on the certificates, set monthly, ranged from LIBOR plus 0.23% to LIBOR plus 0.95% at December 31, 1997. The securities issued in this program have a scheduled maturity of two to four years, but could mature earlier depending on fluctuations in the outstanding balances of loans in the portfolio and other factors. As of December 31, 1997, up to $265 million in additional publicly offered term 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. In April 1997, $109 million in certificates ("Series D") were issued, comprised of $100 million in senior certificates and $9 million in subordinated certificates. The Series D certificates were issued to retire $100 million in maturing Series B certificates. In December 1995, a commercial paper facility was established as part of the asset securitization program. This facility, which expires in December 1998, provides for the issuance of up to $150 million in commercial paper, dependent upon the level of assets within the asset securitization program. As of December 31, 1997, $13 million in commercial paper was outstanding under this facility. The commercial finance operation also has an unsecured revolving line of credit with a syndicated bank group that presently permits borrowings of up to $450 million, which includes a revolving credit facility of $350 million and a term loan of $100 million. The revolving credit facility converts to a term loan in August 2000, with ultimate maturity of the term loan in June 2002. The $100 million term loan matures July 2001. The balance outstanding at December 31, 1997 of the revolving credit facility and the term loan was $66 million and $100 million, respectively, with a weighted average interest rate of 6.32%. This credit line is primarily used to finance assets which are not included in the Company's asset securitization program. (See "Item 1. Business -- Financial Services Operations -- Commercial Finance.")
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 1997, stockholders' dividends totaling $17.8 million were paid. Stockholders' dividends declared aggregated $18.9 million, $15.8 million and $13.1 million during 1997, 1996 and 1995, 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 insurance 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 insurance subsidiaries at December 31, 1997 without prior regulatory approval is approximately $67.8 million.
To facilitate general corporate operations, the Company maintains a revolving line of credit with a syndicated bank group that currently permits borrowings of up to $400 million, of which $240 million was outstanding as of December 31, 1997.
On August 1, 1997, the Company completed the acquisition of Industrial which resulted in the disbursement of funds totaling $453.5 million, comprised of $365 million in purchase price, $79 million in the pay-off of an outstanding debt obligation that Industrial owed to Talegen, and $9.5 million in costs incurred in connection with the acquisition. The disbursement of cash used to fund the acquisition includes $219 million in borrowings under the Company's existing line of credit and the remainder from internally generated funds. (See "General.")
On February 22, 1995, the Company completed the acquisition of Casualty for $256.5 million, which consisted 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.")
During 1997, an aggregate $266.7 million principal amount at maturity of Liquid Yield Option(TM) Notes due October 12, 2013 (Zero Coupon-Subordinated) ("LYONs") were converted into 5.1 million shares of the Company's Common Stock. The effect of these conversions was an increase in stockholders' equity and a decrease in long-term debt of $117 million. During 1996, an aggregate $72.5 million principal amount at maturity of LYONs were converted into 1.4 million shares of the Company's Common Stock. The effect of the 1996 conversions was an increase in stockholders' equity and a decrease in long-term debt of $31 million.
On March 1, 1996, Fremont General Financing I, a statutory business trust (the "Trust") and consolidated wholly-owned subsidiary of the Company, sold $100 million of 9% Trust Originated Preferred Securities(SM) ("the Preferred Securities") in a public offering. The Preferred Securities represent preferred undivided beneficial interests in the assets of the Trust. The proceeds from the sale of the Preferred Securities were invested in 9% Junior Subordinated Debentures of the Company ("the Junior Subordinated Debentures"). The proceeds from the sale of the Junior Subordinated Debentures were used to repay approximately $50 million in revolving bank line of credit indebtedness, with the remainder used for general corporate purposes. The $100 million Junior Subordinated Debentures are the sole asset of the Trust. The Preferred Securities will be redeemed upon maturity of the Junior Subordinated Debentures in 2026, subject to the election available to the Company to extend the maturity up to 2045, and they may be redeemed, in whole or in part, at any time on or after March 31, 2001 and under certain specified circumstances. The Junior Subordinated Debentures rank pari passu with the Company's $34,501,000 aggregate principal amount at maturity of Liquid Yield Option(TM) Notes due 2013, and subordinate and junior to all senior indebtedness of the Company. Payment of distributions out of cash held by the Trust, and payments on liquidation of the Trust or the redemption of the Preferred Securities are guaranteed by the Company.
Net cash provided by (used in) operating activities of continuing operations was $(18.0) million, $(96.0) million and $39.5 million for 1997, 1996 and 1995, respectively. Net cash used in continuing operations decreased in 1997 as compared to 1996, due primarily to an increase in net income; a decrease in other assets and an increase in other liabilities; and an increase in depreciation and amortization. Partially offsetting these conditions were higher policy acquisition costs deferred, net of amortization and a lower provision for deferred taxes. The significant decrease in other assets was due mainly to a $45 million collection on a policyholder receivable classified in other assets and the increase in other liabilities is due mainly to increases in accrued federal income taxes payable. Net cash provided by (used in) operating activities decreased in 1996 as compared to 1995 due primarily to a decrease in claims and policy liabilities, a lower amortization of policy acquisition costs, higher discount amortization on fixed maturity investments, and a decrease in other liabilities due primarily to the settlement of accrued operating costs. These conditions were partially offset by higher net income, lower policy acquisition costs deferred, higher depreciation and amortization, and an increase in the change in accrued investment income. The decrease in claims and policy liabilities, the lower amortization of policy acquisition costs, and the lower policy acquisition costs deferred resulted primarily from lower premium volume in the Company's workers' compensation insurance business. The higher discount amortization on fixed maturity investments is due mainly to an acceleration of discount amortization on certain mortgage-backed securities during 1996. The significant increase in the change in accrued investment income in 1996 as compared to 1995 is due primarily to the 1995 acquisition of Casualty which resulted in a significant increase in the accrual of investment income for 1995 and thereby negatively impacted net cash provided by operating activities in 1995.
Net cash provided by (used in) investing activities was $(393.2) million, $229.8 million and $(514.0) million for 1997, 1996 and 1995, respectively. The decrease in net cash provided by (used in) investing activities was due mainly to the August 1, 1997 acquisition of Industrial for a cash disbursement of $303.0 million (net of cash acquired); an increase in investment purchases, net of sales, maturities and short-term investment activity; and an increase in loan originations, net of repayments. The increase in loan originations is consistent with the general growth in the Company's financial services' loan portfolio. The decrease in short-term investments is due primarily to the investing of the acquired short-term investment portfolio of Industrial into long-term investments. The increase in net cash provided by (used in) investing activities in 1996 as compared to 1995 is due principally to a decrease in investment purchases, net of sales, maturities, and calls; the February 1995 purchase of Casualty for a net cash disbursement of $255.8 million;
The Company believes that its existing cash, its bank lines of credit, revenues from operations and other available sources of liquidity will be sufficient to satisfy its liquidity needs for the next several years.
With regard to the workers' compensation operation, the Company developed an action plan in 1996 to render its workers' compensation Systems Year 2000 compliant. Based on an evaluation of the progress made as of December 31, 1997, the Company estimates that its workers' compensation Systems, excluding those Systems supporting Industrial which were acquired August 1, 1997, will be Year 2000 compliant by September 30, 1998. The Industrial Systems are expected to be converted to Year 2000 compliant systems by June 30, 1999. The costs to be incurred by the Company in completing these Year 2000 initiatives are not expected to have a material impact on the Company's results of operations.
In February 1997, the FASB issued Statement No. 128 ("FASB 128"), "Earnings Per Share" which is effective for periods ending after December 15, 1997. Under FASB 128, primary earnings per share, which included the dilutive effect of stock options, has been replaced by basic earnings per share, which excludes the dilutive effect of stock options as well as certain shares of the Company's Common Stock awarded under the Company's Restricted Stock Award Plan. (See Note K of Notes to Consolidated Financial Statements.) Additionally, fully diluted earnings per share has been replaced by diluted earnings per share. All previously recorded earnings per share amounts have been restated to conform to the new standard. See Note P for the computation of earnings per share.
In June 1997, the FASB issued Statement No. 130 ("FASB 130"), "Reporting Comprehensive Income" and Statement 131 ("FASB 131"), "Disclosures about Segments of an Enterprise and Related Information." Both standards are effective for periods beginning after December 15, 1997. FASB 130 requires most companies to report "Comprehensive Income" a new, additional measure of income, to include foreign currency translation gains and losses and other unrealized gains and losses that are today excluded from net income and reflected instead in equity. FASB 131 changes the disclosure guidelines for reporting operating segments. These new standards will affect presentation of financial statements, however, will not have an effect on reported net income or stockholders' equity.
The information set forth under the subheadings "Market Risk," "Property and Casualty Insurance Operations -- Interest Rate Risk, "Financial Services Operations -- Interest Rate Risk," and "Fremont General Corporation (Parent-only) -- Interest Rate Risk" in the Company's Management's Discussion and Analysis is incorporated herein by reference.