(1) The Company acquired Industrial Indemnity Holdings, Inc. on August 1, 1997.
(2) The Company acquired Casualty Insurance Company on February 22, 1995.
(4) Company-obligated mandatorily redeemable preferred securities of subsidiary Trust holding solely Company junior subordinated debentures.
Fremont General is a nationwide insurance and financial services holding company operating select businesses in niche markets. Fremont General's insurance business includes one of the largest underwriters of workers' compensation insurance in the nation. The Company's financial services business includes commercial real estate lending, residential real estate lending, commercial finance and insurance premium financing. The Company's reported assets as of December 31, 1997 were $6.1 billion, with 1997 pre-tax earnings of $159 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."
Consistent with its primary strategy, the Company's workers' compensation insurance operations have grown dramatically since 1994 through acquisitions. On August 1, 1997, the Company acquired Industrial Indemnity Holdings, Inc. ("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. On February 22, 1995, the Company acquired Casualty Insurance Company ("Casualty"), the largest underwriter of workers' compensation insurance in Illinois, with additional operations in several other mid-western states. These acquisitions have provided the Company with a broad national platform upon which to build its workers' compensation insurance 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 Operations" and Note B of Notes to Consolidated Financial Statements.)
The Company's balance sheet at December 31, 1997 was significantly impacted by the acquisition of Industrial. The purchase price consisted of $365 million in cash and $9.5 million in acquisition costs bringing the total cost of the acquisition to $374.5 million. Additionally, pursuant to the terms of the acquisition agreement, the Company paid-off a $79 million outstanding debt obligation that Industrial owed to Talegen. The acquisition was treated as a purchase for accounting purposes and five months of Industrial's operating results are included in the Company's results of operations for the year ended December 31, 1997. At the acquisition date, the assets acquired and liabilities assumed are summarized in the following table:
The Company's financial services operations, which are comprised primarily of the results of Fremont General Credit Corporation ("FGCC"), have grown significantly and are engaged primarily in commercial and residential real estate lending, mainly in California; commercial finance lending, principally to small and middle market companies nationwide; and insurance premium financing, primarily in California. The Company's financial services loan portfolio has grown significantly from $712 million at December 31, 1992 to $2.03 billion at December 31, 1997. (See "Financial Services Operations.")
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.
Between 1986 and 1991, the Company discontinued its domestic treaty reinsurance business, its other primary and excess property and casualty insurance operations and the underwriting of all remaining assumed reinsurance. In 1990, a single management group was put in charge of all discontinued operations, and it is the intention of the Company to complete the liquidation of these operations by the commutation of liabilities and as claims are paid. (See "Item 1. Business -- Discontinued Operations" and Note N of Notes to Consolidated Financial Statements.)
The financial services business segment posted increases of 16% and 2% in income before taxes for 1997 and 1996, respectively. The increase in 1997 is due mainly to the general growth in the average loan portfolio to $1.9 billion in 1997 from $1.6 billion in 1996, as well as to continued improvements in the Company's loan charge-off experience. (See "Financial Services Operations.") Although income before taxes was relatively flat in 1996 as compared to 1995, the results in 1996 were negatively impacted by the establishment of a specific loan loss associated with one loan in the commercial finance loan portfolio. Also impacting the financial services segment in 1996 was the substantial elimination of the Company's life insurance operations resulting from certain reinsurance and assumption agreements entered into between the Company and a reinsurer which became effective December 31, 1995 and January 1, 1996. This segment, which consists principally of real estate lending, commercial finance and insurance premium finance, recorded income before taxes of $42.3 million, $36.6 million and $35.7 million for 1997, 1996 and 1995, 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 $28.1 million, $25.9 million and $18.5 million for 1997, 1996 and 1995, respectively. The increase in the corporate loss before taxes in 1997 as compared to 1996 was due mainly to lower investment income and higher administrative expenses. 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
Revenues from the property and casualty insurance operations consist 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.
On January 1, 1998, the Company purchased additional excess of loss reinsurance for its workers' compensation insurance business in an effort to further reduce the volatility of operating results which occurs through fluctuations in loss costs. The additional reinsurance reduces the point at which reinsurers assume liability from $1 million per occurrence to $100,000 per occurrence. (See "Item 1. Business -- Property and Casualty Insurance Operations -- Reinsurance Ceded.") The impact of this additional reinsurance will be lower premiums earned and lower loss and loss adjustment expenses.
Policy Acquisition Costs and Other Operating Costs and Expenses. The ratio of policy acquisition costs and other operating costs and expenses to premiums earned is referred to as the expense ratio, which was 27.5%, 25.9% and 24.5% in 1997, 1996 and 1995, respectively. The increase in this ratio in 1997 is due primarily to higher agents' commission costs and higher operating costs and expenses. The increase in this ratio in 1996, as compared to 1995, was due primarily to higher operating costs and expenses, partially offset by lower agents' commission costs.
Variability of Operating Results. The Company's profitability can be affected significantly by many factors including competition, the severity and frequency of claims, interest rates, regulations, court decisions, the judicial climate, and general economic conditions and trends, all of which are outside of the Company's control. These factors have contributed, and in the future could contribute, to significant variation of results of operations in different aspects of the Company's business from quarter to quarter and year to year. With respect to the workers' compensation insurance business, changes in economic conditions can lead to reduced premium levels due to lower payrolls as well as increased claims due to the tendency of workers who are laid off to submit workers' compensation claims. Legislative and regulatory changes can also contribute to variable operating results for workers' compensation insurance businesses. For example, in 1995, the Company experienced the negative impact of lower premiums and lower profitability on the Company's California workers' compensation business due to increased price competition resulting from legislation enacted in California in July 1993 which, among other things, repealed the minimum rate law effective January 1, 1995. Additionally, price competition in Illinois, where the Company has a significant presence, continues to adversely impact the Company's profitability, where overall average decreases of 7.9%, 10.0% and 13.6% in
advisory premium rates, which workers' compensation insurance companies in Illinois tend to follow, became effective January 1, 1998, 1997 and 1996, respectively. (See "Workers' Compensation Regulation.") The acquisition of Industrial may mitigate the adverse effects of this price competition in Illinois by providing the Company with a broader geographic diversity of its premium writings. The Company anticipates that its results of operations and financial condition will continue to be adversely affected by the increased price competition in Illinois. Also, the establishment of appropriate reserves necessarily involves estimates, and reserve adjustments have caused significant fluctuations in operating results from year to year.
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 these legislative changes in California by increasing the geographic diversity of the Company's workers' compensation business, which tends to mitigate the impact of economic and regulatory changes within a regional marketplace. The Company further broadened its geographic diversity in 1997 with the acquisition of Industrial, whose premium writings were spread across several western states, including California. (See "Item 1. Business -- Regulation -- Insurance Regulation.")
The financial services operations of FGCC are principally engaged in commercial and residential real estate lending, commercial finance and insurance premium financing. The Company also has small life insurance operations included in this segment which were substantially reduced in 1996. Revenues consist principally of interest income and, to a lesser extent, life insurance premiums, fees and other income.
The following table presents information with respect to the Company's financial services operations:
Income before taxes in the financial services operations was $42.3 million, $36.6 million and $35.7 million for 1997, 1996 and 1995, respectively. The 16% increase in income before taxes in 1997 is mainly due to higher income before taxes in the real estate lending operation. Contributing to this higher income before taxes were higher loan interest revenue due to a greater average real estate loan portfolio and a lower loan loss provision relative to loans receivable, which resulted from improved loan loss experience. These conditions were partially offset by an increase in the cost of funds and increases in operating expenses. Income before taxes was relatively flat in the financial services segment for 1996 as compared to 1995, which was due to higher income before taxes in the real estate lending operation as lower loan loss experience resulted in a lower provision for loan losses. Substantially offsetting this was lower income in the commercial finance operation due primarily to a specific loan loss associated with one loan in the commercial finance loan portfolio. Additionally, lower income was earned in the life insurance operation due to certain reinsurance and assumption agreements which became effective on December 31, 1995 and January 1, 1996 and which resulted in a substantial reduction in the Company's life insurance operations in 1996.
The following table identifies the interest income, interest expense, average interest-bearing assets and liabilities, and interest margins for the Company's financial services operations:
net margins decreased in 1996 as compared to 1995, due primarily to an increase in lower yielding cash equivalents in the real estate lending operation and a decrease in the yields in the commercial finance operation resulting primarily from increased competition.
During 1997, the Company began originating both commercial and residential real estate loans outside of California. The Company intends to seek portfolio growth outside of California in order to achieve greater geographic diversity in its loan portfolio and thereby lessen the Company's exposure to regional economic conditions. The total amount of commercial and residential real estate loans outstanding on properties located outside of California at December 31, 1997 was $44 million and $58 million, respectively.
The following table describes the asset classifications, loss experience and reserve reconciliation of the financial services operations as of or for the periods ended as shown below:
The Company's financial services operations are subject to interest rate risk resulting from differences between the rates on, and repricing characteristics of, interest-earning real estate and commercial finance loans and the rates on, and repricing characteristics of, interest-bearing liabilities 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 loan portfolio, which could result in borrowers' prepaying their loan obligations to the Company. While the Company attempts to match the characteristics of interest rate sensitive assets and liabilities to minimize the effect of fluctuations in interest rates, the Company does not currently utilize derivative financial instruments to meet these objectives. For the financial services operations, 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 operations 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. These operations have several sources of funds to meet their obligations, including cash flow from operations, recoveries from reinsurance contracts and investment securities. By statute, the majority of the cash from these operations is required to be invested in investment grade securities to provide protection for policyholders. The Company 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 $81.4 million and $4.0 million at December 31, 1997 and 1996, respectively.
The Company's thrift and loan subsidiary, which is principally engaged in real estate lending, finances its lending activities primarily through customer deposits, which have grown from $1.114 billion at December 31, 1996 to $1.493 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, 1997, $325 million was available under the facility and no borrowings were outstanding.
and an increase in receipts from repayments of loans, net of originations. The significant decrease in short-term and other investments of $376.0 million and the significant level of securities purchased in 1995 was due primarily to the effects of investing the acquired short-term investment portfolio of Casualty into long-term securities.
The amortized cost of the Company's invested assets were $2.36 billion and $1.48 billion at December 31, 1997 and 1996, respectively. The approximately $880 million increase in the invested assets resulted primarily from the approximately $1.1 billion in invested assets acquired in the acquisition of Industrial. Partially offsetting the acquired investments was $225 million in internal funds which formed a part of the purchase price in acquiring Industrial. (See "General" and Note B of Notes to Consolidated Financial Statements.)
The Company's property and casualty premium to surplus ratio for the year ended December 31, 1997 was 1.5 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, 1997. (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.
The Company's Consolidated Financial Statements, including supplementary data, are set forth in the "Index" on page 49 hereof.