- --------------- (1) The Company acquired UNICARE Specialty Services, Inc. on September 1, 1998.
(2) The Company acquired Industrial Indemnity Holdings, Inc. on August 1, 1997.
(3) The Company acquired Casualty Insurance Company on February 22, 1995.
(5) Company-obligated mandatorily redeemable preferred securities of subsidiary Trust holding solely Company junior subordinated debentures.
Substantially all of Fremont's property and casualty insurance operations are represented by the underwriting of workers' compensation insurance policies. The Company began its workers' compensation insurance operation in 1959 and continues to derive the majority of its revenues from this business. Fremont'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, Idaho, Alaska, Indiana, Montana, Utah and Wisconsin. At December 31, 1998 the Company had premiums inforce in thirty-nine states and the District of Columbia.
Consistent with its business strategy, the Company's workers' compensation insurance business has grown dramatically since 1994 through acquisitions. On September 1, 1998, Fremont acquired Unicare from Wellpoint Health Networks, Inc. Unicare underwrites workers' compensation insurance primarily in California, with a smaller presence in Georgia, Texas, and Indiana. On August 1, 1997, the Company acquired Industrial from Talegen Holdings, Inc. ("Talegen"), a subsidiary of Xerox Corporation. Industrial, which specializes in underwriting workers' compensation insurance, has a strong presence in the western United States dating back over seventy years. (See Note B of Notes to Consolidated Financial Statements.) On February 22, 1995, the Company acquired Casualty, the largest underwriter of workers' compensation insurance in Illinois, with additional operations in several other mid-western states. Over the last four years, the Company has focused on creating a broad national platform upon which to build its business, while providing geographic diversity to mitigate potential fluctuations in earnings from cyclical downturns in various regional economies. (See "Results of Operations -- Property and Casualty Insurance Operation.")
The operations of Fremont's financial services segment are consolidated within Fremont General Credit Corporation ("FGCC"), which is engaged in collateralized lending to businesses and individuals. Lending activities include: commercial and residential real estate lending, commercial finance, syndicated loans and insurance premium financing. Fremont's financial services business is developed through the Company's own marketing representatives and referrals from various financial intermediaries and financial institutions. The Company's financial services loan portfolio has grown significantly from $1.5 billion at December 31, 1994 to $3.0 billion at December 31, 1998. (See "Financial Services Operation.")
Fremont provides insurance premium finance loans, primarily to small businesses, which finances property and casualty insurance premiums. These loans are collateralized by the unearned premiums of the underlying insurance policies. At December 31, 1998, the insurance premium finance loan portfolio totaled $58.3 million.
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, regional, or national economic conditions. Such events could also significantly reduce the demand for loans and impair the value of the underlying collateral. If the collateral were to prove inadequate, Fremont's results of operations could be adversely affected.
December 31, 1994 to the year ended December 31, 1998, the Company's income before taxes grew at a compound annual rate of approximately 25% to $196.7 million for 1998. Fremont's book value increased from $351.0 million at December 31, 1994 to $950.9 million at December 31, 1998.
Prior to January 1, 1996, the Company offered life insurance products, including annuities, credit life and disability insurance and term life insurance for consumers, through a subsidiary. On December 31, 1995 and on January 1, 1996, the Company entered into reinsurance and assumption agreements with a reinsurer whereby assets and liabilities related to certain life insurance and annuity policies were ceded to the reinsurer. These reinsurance agreements are part of several other agreements which have collectively resulted in the substantial reduction of the Company's life insurance operations. The Company continues to remain primarily obligated for approximately $128 million of account value of annuities which, at December 31, 1998, have been fully co-insured with Great Southern Insurance Company. The effect on operations from these agreements was not material, and revenue and operating income from this subsidiary were not significant in 1998, 1997 or 1996.
Fremont has achieved growth in net income during the three years ended December 31, 1998 by providing diverse insurance and financial services to primarily small and medium-sized businesses nationwide. Higher revenues and net income were also achieved through the acquisitions of Unicare, Industrial and Casualty. The following table presents information for each of the three years in the period ended December 31, 1998 with respect to the Company's core business segments.
The property and casualty insurance operation posted income before taxes of $169.2 million for 1998, as compared to $144.7 million and $117.6 million for 1997 and 1996, respectively. The increase of 17% in income before taxes in 1998 as compared to 1997 is due primarily to the inclusion of a full year of Industrial's operating results and lower losses incurred resulting from the additional reinsurance purchased by the Company which became effective January 1, 1998. The increase in income before taxes of 23% in 1997 as compared to 1996 was due primarily to the recognition of continued lower claim frequency, mainly in the mid-west region and the acquisition of Industrial. The combined ratio for 1998 was 96.2% as compared to 93.0% and 94.8% for 1997 and 1996, respectively.
The financial services segment posted income before taxes of $55.5 million for 1998, as compared to $42.3 million and $36.6 million for 1997 and 1996, respectively. The 31% increase in 1998 is due mainly to the general growth in the average financial services loan portfolio to $2.4 billion in 1998 from $1.9 billion in 1997, as well as gains on residential real estate loan sales. The 16% increase in income before taxes in 1997 as compared to 1996 was due mainly to the growth in the average financial services loan portfolio, as well as to continued improvements in Fremont's loan charge-off experience. (See "Financial Services Operation.")
The following table represents information with respect to Fremont's property and casualty insurance operation:
Revenues from the property and casualty insurance operation consists primarily of workers' compensation insurance premiums earned and net investment income. Expenses consist primarily of loss and loss adjustment expenses, policy acquisition costs and other operating costs and expenses.
Loss and Loss Adjustment Expense. The property and casualty loss and loss adjustment expenses ("LAE") were $335.5 million, $389.2 million and $335.4 million in 1998, 1997 and 1996, respectively. In addition, the ratio of these losses and LAE to property and casualty insurance premiums earned ("loss ratio") was 60.8%, 64.7% and 68.9% in 1998, 1997 and 1996, respectively. The decrease in the loss ratio in 1998 as compared to 1997 is due predominately to the additional reinsurance purchased by Fremont and which became effective January 1, 1998, offset partially by higher loss ratios in 1998 associated with Industrial. (See "Item 1. Business -- Property and Casualty Insurance Operation -- Reinsurance Ceded" and "Premiums.") 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 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 and a subjective evaluation of external factors. (See "Item 1. Business -- Property and Casualty Insurance Operation -- Loss and Loss Adjustment Expense Reserves.")
compensation insurance in the nation, certain of its competitors are larger and have greater resources than Fremont. The Company cannot be certain that it will continue to maintain its market share in the future.
Workers' Compensation Regulation. The Company's workers' compensation insurance operations are concentrated in California and Illinois, with additional writings in 37 other states and the District of Columbia. Insurance companies are subject to supervision and regulation by the state insurance authority in each state in which they transact business. Such supervision and regulation relate to the numerous aspects of an insurance company's business and financial condition. The primary purpose of such supervision and regulation is the protection of policyholders rather than the investors or stockholders of an issuer. Fremont's multistate insurance operations require, and will continue to require, the Company to devote significant resources to comply with the regulations of each state in which the Company transacts business.
At December 31, 1998, approximately 65% of the Company's workers' compensation insurance policies inforce 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 (expected losses and expenses) or loss costs (expected losses only) which vary by job classification. Each insurance company determines its own rates based in part upon its particular loss experience and operating costs. Insurance companies generally set their premium rates below such advisory rates. This characteristic has resulted in continued price competition in Illinois, where overall average decreases in advisory premium rates of 0.2%, 7.9%, and 10.0% became effective January 1, 1999, 1998 and 1997, respectively. 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. The repeal of the minimum rate law has resulted in lower premiums and lower profitability on the Company's California workers' compensation insurance policies due to increased price competition. Most of the states in which Fremont writes premiums operate under some form of open rating system. (See "Item 1. Business -- Regulation -- Insurance Regulation.")
The following table presents information with respect to Fremont's financial services operation:
Revenues increased 30% and 19% in 1998 and 1997, respectively, due primarily to greater loan interest revenue attributable to growth in the average financial services loan portfolio. The average financial services loan portfolio grew in 1998 to $2.4 billion from $1.9 billion and $1.6 billion in 1997 and 1996, respectively. Additionally, higher revenues resulted in 1998 from increased gains on residential real estate loan sales. These loan sales are pursuant to a program, initiated by the Company in 1995 and expanded in 1997, of selling certain residential real estate loans to other financial institutions. This has allowed Fremont an opportunity to become more selective in its residential real estate loan portfolio, as well as to offer a broader range of residential real estate loans to its customers, primarily through independent brokers. These loan sales are made without recourse to the Company or its subsidiaries. Due to market disruption and oversupply, Fremont observed that prices for these loans began to decrease in late 1998. The Company, rather than sell the loans at prices lower than what it believed was the economic benefit to be derived, began a program to retain these benefits by either retaining the loans in its portfolio or by securitizing them. On March 23, 1999, the
Income before taxes in the financial services operation was $55.5 million, $42.3 million and $36.6 million for 1998, 1997 and 1996, respectively. The 31% and 16% increases in income before taxes in 1998 and 1997 respectively, are mainly due to the previously described growth in the average financial services loan portfolio, as well as lower loan loss provisions relative to loans receivable, which resulted from improved loan loss experience, partially offset by increases in operating expenses. Additionally, in 1998 higher income before taxes resulted from the increased gains on residential real estate loan sales.
The margin between the Company's interest income and expense ("net yield") decreased in 1998 and 1997 as compared to the respective prior year, due mainly to the offsetting effects of a decrease in the net yields on commercial finance loans and increases in syndicated loans which generally carry lower net yields, offset partially by an increase in the net yields on real estate loans. Net yields decreased on commercial finance loans due primarily to a continuation of the competitive environment. While the overall net yield on real estate loans increased, this was the combined result of increases in the net yields on commercial real estate loans, partially offset by decreases in the net yields on residential real estate loans.
The Company monitors the relationship of fixed and variable rate loans and interest bearing liabilities in order to minimize interest rate risk.
Fremont's financial services businesses maintain reserves for credit losses on its portfolio of finance receivables in amounts that Fremont believes is sufficient to provide adequate protection against potential losses. The Company attempts to minimize the impact that adverse economic developments could have on Fremont's finance services loan portfolio by concentrating primarily on lending on a senior and secured basis and by carefully monitoring the underlying collateral that secures these loans. Although the Company believes
Non-performing assets decreased to $28.7 million at December 31, 1998 from $42.0 million at December 31, 1997, despite total loans receivable increasing to $3.0 billion at December 31, 1998 from $2.0 billion at December 31, 1997. The increase in non-performing assets in 1997 as compared to 1996 is generally consistent with the increase in total loans receivable to $2.0 billion at December 31, 1997 from $1.7 billion at December 31, 1996.
The following table presents principal cash flows of the investment portfolio by expected maturity dates. The weighted-average interest rate is based on expected maturities for fixed interest rate investments. For variable interest rate investments, the weighted-average interest rate is based on implied forward rates from appropriate annual spot rate observations as of the reporting date.
Fremont's financial services operation is subject to interest rate risk resulting from differences between the rates on, and repricing characteristics of, interest-earning loans receivable and the rates on, and repricing characteristics of, interest-bearing liabilities used to finance its loans such as thrift deposits and debt. Interest rate gaps may arise when assets are funded with liabilities having different repricing intervals or different market indices to which the instruments' interest rate is tied and to this degree earnings will be sensitive to interest rate changes. Additionally, interest rate gaps could develop between the market rate and the interest rate on loans in the Company's financial services loan portfolio, which could result in borrowers' prepaying their loan obligations to Fremont. While the Company attempts to match the characteristics of interest rate sensitive assets and liabilities to minimize the effect of fluctuations in interest rates, Fremont does not currently utilize derivative financial instruments to meet these objectives. For the financial services operation, the expected maturity date does not necessarily reflect the net market risk exposure because certain instruments are subject to interest rate changes before expected maturity.
The property and casualty insurance operation must have cash and liquid assets available to meet their obligations to policyholders in accordance with contractual obligations, in addition to having the funds available to meet ordinary operating costs. The operation has several sources of funds to meet its obligations, including cash flow from operations, recoveries from reinsurance contracts and investment securities. By statute, the majority of the cash from the operation is required to be invested in investment grade securities to provide protection for policyholders. Fremont invests in fixed income and preferred equity securities with an objective of providing a reasonable return while limiting credit and liquidity risk. The Company's investment portfolio had an unrealized gain of $59.8 million and $81.4 million at December 31, 1998 and 1997, respectively.
The Company's thrift and loan subsidiary, which is engaged in commercial and residential real estate lending, syndicated loans and insurance premium financing, finances its lending activities primarily through customer deposits, which have grown to $2.13 billion at December 31, 1998 from $1.49 billion at December 31, 1997. The thrift is also eligible for financing through the Federal Home Loan Bank of San Francisco, which financing is available at varying rates and terms. As of December 31, 1998, $474 million was available under the facility of which $115 million was outstanding.
maximum amount available for payment of dividends by the property and casualty insurance subsidiaries at December 31, 1998 without prior regulatory approval is approximately $235.3 million.
To facilitate general corporate operations, Fremont General Corporation maintains a revolving line of credit with a syndicated bank group that currently permits borrowings of up to $400 million, of which $300 million was outstanding as of December 31, 1998. On March 17, 1999, Fremont General Corporation issued $425 million of Senior Notes consisting of $200 million of 7.70% Senior Notes due 2004 and $225 million of 7.875% Senior Notes due 2009. The notes were offered in a private placement to qualified institutional buyers and a limited number of institutional accredited investors and have not been registered under the Securities Act; however, Fremont General Corporation intends to do so during 1999. Net proceeds from the notes were used to repay all indebtedness outstanding under the revolving line of credit and for general corporate purposes, including working capital.
deferred income taxes is due predominately to this higher reduction in claims and policy liabilities. The decrease in net cash used in operating activities in 1997 as compared to 1996 was due primarily to an increase in net income and a decrease in other assets and an increase in other liabilities. 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 was due mainly to increases in accrued federal income taxes payable.
Net cash provided by (used in) financing activities was $936.1 million, $420.8 million, and $(118.0) million in 1998, 1997 and 1996, respectively. The increase in net cash provided by (used in) financing activities in 1998 as compared to 1997 is due mainly to increases in short-term and long-term debt proceeds, net of repayments and an increase in thrift deposits. These increases resulted primarily from the financing of the general growth of the Company's financial services loan portfolio. Net cash provided by (used in) financing activities increased in 1997 as compared to 1996, due primarily to an increase in long-term debt proceeds, net of short-term and long-term repayments; an increase in thrift deposits; and the payment in 1996 of $363.4 million in the settlement of certain reinsurance and assumption agreements that substantially reduced the Company's life insurance activities to an immaterial level. The increase in long-term debt proceeds, net of repayments, was due mainly to $140 million in net additional borrowings used in conjunction with the acquisition of Industrial. Partially offsetting these increases in financing activities were decreases in annuity receipts, net of contract withdrawals, which is consistent with the Company's substantial reduction in life insurance activities in 1996. Additionally, the Company's financing activities in 1996 were significantly impacted by the proceeds of $100 million from the sale of the Preferred Securities, which were issued on March 1, 1996.
The amortized cost of Fremont's invested assets were $2.33 billion and $2.36 billion at December 31, 1998 and 1997, respectively. The modest decrease in invested assets is due mainly to the offsetting effects of higher ceded reinsurance premium payments resulting from the additional excess of loss reinsurance purchased by Fremont that became effective January 1, 1998, offset partially by an increase in invested assets resulting from the acquisition of Unicare.
The Company's property and casualty premium to surplus ratio for the year ended December 31, 1998 was 1.0 to 1, which is within industry guidelines. The FDIC has established certain capital and liquidity standards for its member institutions, and Fremont's thrift was in compliance with these standards as of December 31, 1998. (See "Item 1. Business -- Regulation -- Thrift and Loan Regulation.") In December 1998, an additional $33 million was contributed to the capital of this subsidiary in response to the growth in the thrift's loan portfolio during 1998.
Internal Computer systems -- Considered the most important area to resolve, will the Company's computer systems operate properly in the year 2000 and beyond?
The following discussion establishes the extent of work performed, or to be performed, and results obtained as of January 31, 1999 in addressing the impact of the Year 2000 Problem on the above-described areas.
Finally, with regard to office equipment such as facsimile and copy machines, Fremont considers the risk minimal as to any significant cost or disruption to its operations resulting from a Year 2000 Problem impacting any of its office equipment (excluding telephone and computer systems). Accordingly, no significant work is currently being planned in this area.
In the financial services operation, Fremont's revenues could be impacted should a customer/borrower be unable to pay interest and/or principal when due because of the customers' inability to resolve its Year 2000 Problems. Regarding commercial and residential real estate loans, the risk of a significant impact to operating results is considered minimal since Fremont would utilize the collateral securing existing loans to mitigate any loan losses. Additionally for commercial real estate loans, the borrower's Year 2000 risk is further limited by the multiple tenant nature of most of the properties under collateral. The Company has focused its attention on those commercial properties that are single tenant, which are comprised of approximately fifty loans as of January 31, 1999. Fremont has been surveying these customers to determine their Year 2000 compliance. For commercial finance loans, the Company has been surveying its entire customer base to ascertain whether or not any significant Year 2000 issues exist with existing borrowers. With regard to new loan customers, the Company has adopted additional review procedures for both real estate and commercial finance loans to determine the extent of an applicant's Year 2000 compliance. Based on the results obtained to date, Fremont does not anticipate any significant impact to its financial services revenues due to the Year 2000 Problem. For Fremont's thrift deposits, the Company's effort to mitigate the risk of significant depositor withdrawals has been pursued through an educational program, as recommended by the FDIC, aimed at informing current and prospective depositors as to the thrift's Year 2000 compliance efforts and results.
In its property and casualty insurance operation, Fremont has determined the extent of procedures to employ in ascertaining the potential impact to its insurance premium revenues resulting from an insured's or agent's inability to resolve their Year 2000 Problems. The procedures primarily relate to surveying the Company's major insureds and agents as to the extent of any Year 2000 Problems which would significantly impact their operations. Fremont anticipates completing these procedures by June 30, 1999 and will develop appropriate contingency plans should a significant Year 2000 Problem be identified from these surveys.
As of January 31, 1999, significant Year 2000 compliance issues remain only within Fremont's property and casualty insurance operation. The Company's computer-based systems ("Systems") supporting the financial services operation, administrative systems (personnel, payroll and accounting) and treasury systems (cash management and investment portfolio management) have all been rendered substantially Year 2000 compliant.
Regarding administrative and back-office operations, Fremont believes that its personnel, payroll, accounting, and treasury Systems are Year 2000 compliant. The Company intends to test these Systems by June 30, 1999 to verify the vendors' representations.
budget which could result in a negative effect on results of operations in one or all of the Company's businesses, depending upon the specific nature of the problem or problems.