The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD & A") contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those projected in these forward looking statements as a result of certain risks and uncertainties, including those factors set forth in this MD & A section and elsewhere in this Form 10-K including, but not limited to "Item 1. Business -- Risk Factors."
Fremont's business strategy includes achieving income balance and geographic diversity among its business units in order to limit its exposure to market and regional concentrations. The Company's business strategy also includes growing its business through new business development and acquisitions. The Company's stock is traded on the New York Stock Exchange under the symbol "FMT".
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 Specialty Services, Inc. ("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 Indemnity Holdings, Inc. ("Industrial") from Talegen Holdings, Inc., 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 Insurance Company ("Casualty"), the largest underwriter of workers' compensation insurance in Illinois, with additional operations in several other midwestern states. Over the last five 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.")
Fremont has interests in large syndicated commercial loans which are originated and serviced by other financial institutions. These syndicated loans are senior obligations of the borrower and are secured by substantially all of the assets of the borrower and, if applicable, its subsidiaries. The syndicated loans are variable rate loans and are originated on both a revolving and fixed-term basis. The term loans are generally issued with terms not in excess of seven years. The Company funds these loans using thrift deposits. The syndicated loan portfolio was $332 million at December 31, 1999, as compared to $360 million at December 31, 1998. The Company establishes its lending relationships through referrals from various financial institutions.
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. As of January 1, 1996, the Company had 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 were part of several other agreements which have collectively resulted in the substantial reduction of the Company's life insurance operation. The Company continues to remain primarily obligated for approximately $110 million of account value of annuities which, at December 31, 1999, have been fully co-insured with Great Southern Insurance Company. Revenue and operating results from this subsidiary were not significant in 1999, 1998 or 1997.
Fremont's discontinued operations consist primarily of assumed treaty and facultative reinsurance business that was discontinued between 1986 and 1991. In 1990 the Company established a management group to actively manage the liquidation of this business by the commutation of liabilities and as claims are paid. The liabilities associated with this business are long term in duration and, therefore, the Company continues to be subject to claims being reported. Claims under these reinsurance treaties include professional liability, product liability and general liability which include asbestos and environmental claims.
During the third quarter of 1999, the Company incurred an after tax charge for its discontinued operations of $25 million in recognition of an increase in asbestos and environmental claims reserves over previous estimates. This charge is represented by the Company's contribution of $25 million to the discontinued operations to ensure that sufficient funds are available to discharge estimated liabilities as they become due.
Fremont has achieved growth in revenues during the three years ended December 31, 1999 through the development of its insurance and financial services customer base, which includes small and medium-sized businesses and individuals nationwide. Higher revenues and net income were also achieved through the acquisitions of Unicare and Industrial. The following table presents information for each of the three years in the period ended December 31, 1999 with respect to the Company's core business segments.
Fremont posted a net loss from continuing operations of $40.4 million or $0.64 diluted loss per share for 1999, as compared to net income from continuing operations of $133.0 million or $1.90 diluted earnings per share and $108.3 million or $1.62 diluted earnings per share for 1998 and 1997, respectively. Loss before taxes for 1999 was $66.3 million as compared to income before taxes of $196.7 million and $158.9 million for 1998 and 1997, respectively. Additionally, in 1999 Fremont recorded a net loss from discontinued operations of $25 million or $0.39 diluted loss per share. (See "General.")
The property and casualty insurance operation posted a loss before taxes of $116.2 million for 1999, as compared to income before taxes of $169.2 million and $144.7 million for 1998 and 1997, respectively. The loss before taxes in 1999 was due primarily to the combined effect of a significant decrease in the second half
Income tax (benefit) expense of $(25.9) million, $63.7 million and $50.6 million for 1999, 1998 and 1997, respectively, represents effective tax rates of 39%, 32% and 32%, respectively on (loss) income before taxes of $(66.3) million, $196.7 million and $158.9 million for the corresponding periods. The Company's effective tax rates on (loss) income before taxes for all years presented are different than the enacted federal income tax rate of 35%, due primarily to tax exempt investment income which either reduces the Company's taxable income or increases a taxable loss. At December 31, 1999, the Company has a net loss carryforward of $230.1 million for income tax purposes that expire in years 2015 through 2019. The majority of this net loss carryover was generated in 1999, resulting mainly from the losses recognized in the Company's property and casualty insurance segment. (See Note G of Notes to Consolidated Financial Statements.)
Revenues from the property and casualty insurance operation consist 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.
With regard to the lower than expected reinsurance recoverables, in the third and fourth quarters of 1999, the Company lowered its estimate of reinsurance recoverables on unpaid losses for the 1998 and 1999 accident years by approximately $147 million. This decrease was in recognition of a lower than actuarially predicted level of incurred losses ceded under certain reinsurance contracts that were in effect from January 1, 1998 through December 31, 1999. These reinsurance contracts reduced the Company's net loss exposure from a historical retention of $1 million per occurrence to $50,000 per occurrence. (See "Item 1. Business -- Property and Casualty Insurance Operation -- Reinsurance Ceded.") Prior to entering into these reinsurance agreements, the Company had estimated its expected gross incurred loss and LAE. Estimates of incurred loss and LAE, net of reinsurance recoveries, were then established utilizing actuarial indications based upon historical experience and other factors considered appropriate to forecast incurred losses to be ceded under these reinsurance agreements. During the third quarter of 1999 and pursuant to its regular review of net incurred loss and LAE estimates, the Company observed a deterioration in these net loss and LAE estimates as compared to the actuarial predictions. To assist the Company in its determination of net loss and LAE reserve estimates, the Company retained outside actuarial consultants who performed an independent actuarial analysis of the Company's net loss and LAE reserves as of June 30, 1999. These actuarial indications were reaffirmed at September 30, 1999 and further re-evaluated by the independent outside actuaries at December 31, 1999, which resulted in the Company's recognition of the deterioration in reinsurance recoverables in the third and fourth quarters of 1999. Based on the Company's review of these actuarial indications and consequent recognition of the deterioration in estimated reinsurance recoverables, the Company believes its estimates of reinsurance recoverables on unpaid losses are an adequate provision for loss recoveries under reinsurance agreements. (See "Variability of Operating Results.") While the upward development in the Company's estimates of net loss and LAE reserves during calendar year 1999 was comprised primarily of adjustments to reinsurance recoverables on unpaid losses, the Company has observed for its primary regions relative stability in its workers' compensation gross loss and allocated loss adjustment expense ratios derived from the actuarial indications of reserves for loss and allocated loss adjustment expense, gross of reinsurance recoverables.
compensation reinsurance programs brokered for Reliance by Unicover Managers, Inc. The Company evaluated the adequacy of the expected cash settlement under the agreement through an independent actuarial analysis of the expected losses and allocated loss adjustment expenses to be paid under the Reliance reinsurance contract after December 31, 1999. A range of expected loss payments was estimated and then discounted to a present value basis using investment yields considered appropriate. Based on these indications, the cash settlement is within the range of present values. The $75 million decrease in reinsurance recoverables represents primarily the adjustment necessary to bring the estimated reinsurance recoverables relating to the 1998 and 1999 accident years under the reinsurance contract with Reliance to a present value basis at December 31, 1999. (See "Item 1. Business -- Property and Casualty Insurance Operation -- Reinsurance Ceded.")
The lower insurance premiums in 1998 as compared to 1997 were due mainly to the offsetting effects of higher workers' compensation insurance premiums resulting from the acquisitions of Unicare and Industrial, more than offset by additional ceded reinsurance premiums in 1998. These additional ceded reinsurance premiums were due mainly to additional excess of loss reinsurance purchased for the Company's workers' compensation insurance business, which was in effect from January 1, 1998 through December 31, 1999. This additional reinsurance reduced the point at which reinsurers assume liability from $1 million per loss occurrence to $50,000 per loss occurrence. With the expiration of these reinsurance agreements, the Company's ceded premium expense in the future is expected to be significantly lower than the ceded premium expense levels recognized in 1999 and 1998. (See "Item 1. Business -- Property and Casualty Insurance Operation -- Reinsurance Ceded" and Note F of the Notes to Consolidated Financial Statements.)
Fremont's property and casualty insurance operation is required to maintain reserves to cover the Company's ultimate liability for losses and LAE with respect to reported and unreported claims incurred as of the end of each accounting period. 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 and LAE reserves, net of reinsurance recoverables. These reserves do not represent an exact calculation of liabilities, but instead are estimates involving actuarial projections at a given time of what the ultimate settlement and administration of claims will cost, including estimates of reinsurance recoveries associated with the estimated claims costs. These projections are based on facts and circumstances then known, predictions of future events, estimates of future trends in claims frequency and severity, and judicial theories of liability, as well as other factors. The establishment of appropriate gross loss and LAE reserves and reinsurance recoverables is an inherently uncertain process and there can be no certainty that currently established gross loss and LAE reserves and reinsurance recoverables will prove to be adequate in light of subsequent actual experience. Subsequent actual experience has resulted, and could result, in net loss and LAE reserves being too high or too low. Fremont's future loss and LAE development could require an increase in its gross loss and LAE reserves or a decrease in its reinsurance recoverables from prior periods, which would adversely affect the Company's earnings in future periods.
Dividends to Policyholders. The Company's policyholder dividends ratio was 4.4%, 0.9% and 0.8% in 1999, 1998 and 1997, respectively. The low ratios are due primarily to the type of workers' compensation insurance policies written by the Company. Fremont's workers' compensation insurance policies are generally written as non-participating, which means that they do not include provisions for dividend consideration. (See "Item 1. Business -- Regulation -- Workers' Compensation Regulation.")
Variability of Operating Results. The Company's profitability can be affected significantly by many factors including competition, the severity and frequency of claims, fluctuation in interest rates and the rate of inflation, legislation and regulations, court decisions, the judicial climate and general economic conditions and trends, all of which are outside of the Company's control. In addition, Fremont's results may be affected by its ability to assess and integrate successfully the operations of acquired companies, as well as the Company's ability to contain expenses and to implement appropriate technological changes. Any of these factors could contribute to significant variation in the Company's results of operations within the different aspects of its business, or businesses taken as a whole, from quarter to quarter and from year to year. Also, the establishment of appropriate loss and LAE reserves, net of reinsurance recoverables, necessarily involves estimates, and reserve adjustments have caused significant fluctuations in operating results from year to year.
With respect to Fremont's 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 insurance claims. Changes in market interest rates can affect the amount of interest income that the Company earns on its investment portfolio, as well as the amount of realized and unrealized gains or losses on specific holdings within the Company's investment portfolio. Legislative and regulatory changes can also cause the operating results of the Company's workers' compensation insurance businesses to vary.
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 or that the Company will be able to obtain adequate pricing for its insurance products. Over the past several years, the Company has observed a reduction in the number of competitors resulting from the consolidation of companies into other entities, companies who are forced to terminate underwriting activities through regulatory actions by state insurance authorities, as well as from companies electing to reduce or discontinue the writing of workers' compensation insurance in certain jurisdictions.
The financial services operation of Fremont General Credit Corporation is principally engaged in commercial and residential real estate lending, syndicated loans and insurance premium financing. Revenues consist principally of interest income and, to a lesser extent, gains on whole loan sales, fees and other income. Prior to the December 20, 1999 sale of the Company's commercial finance subsidiary, Fremont provided commercial finance loans, primarily secured by accounts receivable, inventory, and machinery and equipment, to small and middle market companies on a nationwide basis.
Income before taxes in the financial services operation was $79.9 million, $55.5 million and $42.3 million for 1999, 1998 and 1997, respectively. The 44% and 31% increases in income before taxes in 1999 and 1998 respectively, are mainly due to the previously described growth in the average financial services loan portfolio and the gain on the sale of the Company's commercial finance subsidiary. Additionally, the Company recognized higher gains on residential real estate whole loan sales in 1998, as compared to both 1999 and 1997.
- --------------- (1) Average loan balances include non-accrual loan balances, and exclude residual interest in securitized loans.
Loans Receivable and Reserve Activity. The following table shows loans receivable in the various financing categories and the percentages of the total represented by each category:
The Company monitors the relationship of fixed and variable rate loans and interest bearing liabilities in order to minimize interest rate risk. (See "Variability of Operating Results.")
Residential Real Estate Loan Securitizations. As previously discussed, the Company's residential real estate operation began a program in 1999 of selling loans through securitization. In the Company's securitizations, the Company sells residential real estate loans to a special purpose entity, which is established for the limited purpose of purchasing the loans and issuing interest bearing securities that represent interests in the loans. The securitization is treated as a sale and the loans sold are removed from the Company's balance sheet. The securities issued to third party investors are collateralized by the underlying pool of residential real estate loans. The investors and the special purpose entity have no recourse to the Company for failure of the residential loan borrowers to pay when due. The Company retains a residual interest, which represents the right to receive certain future cash flows which are generally equal to the value of the principal and interest to be collected on the loans in excess of: (i) the principal and interest to be paid on the securities; and (ii) various contractual net servicing fees and other expenses. Most of the Company's residual interests, however, are generally restricted until investors and other expenses have been paid or otherwise are subordinate to investor's interests. Upon completion of the securitization, the Company records its residual interests as an asset on the balance sheet. Gains or losses on a securitization are based on the estimated fair value of the proceeds from the sale, net of related transaction costs and the allocated carrying value of the loans sold. Fair value is determined by computing the net present value of the estimated cash flows retained, using the dates that such cash flows are expected to be released to the Company (the cash-out method), at a discount rate considered commensurate with the risks associated with the cash flows. The amounts and timing of the cash flows are estimated after considering various economic factors and other factors, including prepayment speeds and delinquency, default and loss rates. The outstanding balance of the Company's residual interests at December 31, 1999 was $63 million. Since the value of the residual interests is subject to substantial credit, prepayment, and interest rate risks on the loans sold, the Company has recognized no gain on the residual interests it has retained. This reduces the amounts of gain recognized in the current period; however, income may be recognized in future periods if the Company's original assumptions develop favorably. (See "Variability of Operating Results.")
The Company's financial services businesses maintain reserves for credit losses on its portfolio of finance receivables in amounts that the Company believes are sufficient to provide adequate protection against potential losses. The finance receivables that Fremont primarily originates, both for its portfolio and for securitization, are generally non-conventional and non-investment grade loans. To mitigate for the somewhat higher potential risk of the lending that the Company is primarily engaged in and for the impact that adverse economic developments could have on the Company's finance receivables, Fremont lends primarily on a senior and secured basis and employs a proactive asset management approach. The Company also attempts to
carefully evaluate the underlying collateral that secures these loans and to maintain underwriting standards that are designed to effect appropriate loan to collateral valuations and cash flow coverages. Although the Company believes that its consolidated level of reserves is sufficient to cover potential credit losses, these reserves could prove to be inadequate due to unanticipated adverse changes in economic conditions or discrete events that adversely affect specific borrowers, industries or markets. Any of these changes could impair the Company's ability to realize the expected value of the collateral securing certain of its finance receivables or the timing of the realization thereof.
The Company's financial services businesses compete in markets that are highly competitive and are characterized by factors that vary based upon product and geographic region. The markets in which Fremont competes are typically characterized by a large number of competitors who compete based primarily upon price, terms and loan structure. The Company primarily competes with banks and mortgage and finance companies, many of which are larger and have greater financial resources than Fremont. The competitive forces of these markets could adversely affect the Company's net finance income, loan origination volume or net credit losses.
While the Company attempts to diversify its loan origination by geographic region, the Company's geographic concentration of commercial and residential real estate loans in California may subject its loan portfolio and securitized loans to higher rates of delinquencies, defaults and losses in an economic downturn in California than the rates experienced in loan portfolios having greater geographic diversity. At December 31, 1999, approximately half of Fremont's commercial and residential real estate loans, both in its portfolio and those loans that have been securitized, were collateralized by properties located in California. Adverse events in California, such as real estate market declines or the occurrence of natural disasters upon property located therein, may have a more significant adverse effect upon the Company's operating results and financial condition than if a higher percentage of its loans were collateralized by properties located outside California.
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 following table provides information about the assets and liabilities of the Company's financial services operation 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 the historical behavior of its financial services loan portfolio. Thrift deposits that have no contractual maturity are presented as maturing in 2000.
Fremont develops assumptions to value its residual interests by analyzing past portfolio performance, current loan characteristics and current market and interest rate conditions.
The property and casualty insurance operation must have cash and liquid assets available to meet its 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 (loss) gain of $(106.3) million and $59.8 million at December 31, 1999 and 1998, respectively.
Fremont's property and casualty insurance subsidiaries are required in certain states to maintain on deposit investments meeting specified standards that have an aggregate market value equal to the Company's workers' compensation loss reserves. At December 31, 1999, the Company had approximately $500 million in cash and investment securities at amortized value that exceeded this requirement.
terms. As of December 31, 1999, $364 million was available under the facility from the FHLB of which $10 million was outstanding. In October 1999, the thrift established a warehouse financing facility that may be used to finance certain residential real estate loans held for sale through securitization or whole loan sale. The facility permits secured borrowings up to $200 million with a variable interest rate of LIBOR plus 0.375%. As of December 31, 1999, there were no borrowings under this facility. Additionally in 1999, the thrift obtained a line of credit with the Federal Reserve Bank of San Francisco, and at December 31, 1999 had a borrowing capacity of $272.5 million, with no amounts outstanding.
As a holding company, Fremont General Corporation ("the holding company") 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. Stockholders' dividends declared aggregated $21.7 million, $20.9 million and $18.9 million during 1999, 1998 and 1997, respectively. Several of Fremont'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 holding company. The holding company expects that during the next few years dividends from its subsidiaries will consist of dividends from its property and casualty insurance subsidiaries. The maximum amount available for payment of dividends by the property and casualty insurance subsidiaries at December 31, 1999 without prior regulatory approval is approximately $56.3 million.
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. Net proceeds from the Senior Notes were used to repay all indebtedness outstanding under a revolving line of credit and for general corporate purposes, including working capital. The Senior Notes were offered in a private placement to qualified institutional buyers and a limited number of institutional accredited investors. The Company subsequently filed a Registration Statement on Form S-4, which was declared effective by the Securities and Exchange Commission on May 11, 1999, in connection with an exchange offer by the Company and the issuance of an equal principal amount of exchange notes upon tender of the initial $425 million of Senior Notes. The exchange notes consist of $200 million of 7.70% Series B Senior Notes due 2004 and $225 million of 7.875% Series B Senior Notes due 2009. The form and terms of the exchange notes are substantially identical to those of the initial notes, except that the exchange notes have been registered under the Securities Act and therefore, do not bear legends restricting their transfer and are not entitled to registration rights or additional interest as did the initial notes. As of June 11, 1999, the closing date for the exchange offer, all outstanding Senior Notes had been exchanged for Series B Senior Notes. The exchange notes evidence the same debt as the initial notes and both the initial notes and the exchange notes are governed by the same indenture.
In December 1999, the Company discontinued its commercial finance lending activities through the sale on December 20, 1999 of Fremont Financial Corporation, its commercial finance subsidiary, to FINOVA Capital Corporation, a subsidiary of The FINOVA Group, Inc. for approximately $708 million in cash including the refinancing and assumption of existing debt. (See "Financial Services Operation.")
During 1999, an aggregate $3.7 million principal amount at maturity of Liquid Yield Option (TM) Notes due October 12, 2013 (Zero Coupon-Subordinated) ("LYONs") were converted into 141,000 shares of Fremont General Corporation's common stock. The effect of these conversions was an increase in stockholders' equity and a decrease in long-term debt of $1.7 million. During 1998, an aggregate $21.0 million principal amount at maturity of LYONs were converted into 809,000 shares of Fremont General Corporation's common stock. The effect of the conversions was an increase in stockholders' equity and a decrease in long- term debt of $10 million. During 1997, an aggregate $266.7 million principal amount at maturity of LYONs were converted into 10.3 million shares of Fremont General Corporation's common stock. The effect of the 1997 conversions was an increase in stockholders' equity and a decrease in long-term debt of $117 million.
The Company's property and casualty premium to surplus ratio for the year ended December 31, 1999 was 1.6 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, 1999. (See "Item 1. Business -- Regulation -- Thrift and Loan Regulation.")
In prior years, the Company discussed the nature and progress of its Year 2000 readiness plans. In late 1999 Fremont completed its remediation and testing of those systems considered at risk for potential failure from a Year 2000 problem. As a result of its planning and implementation efforts, the Company experienced no significant disruptions in critical information technology and non-information technology systems and believes those systems successfully responded to the Year 2000 date change. The Company expensed approximately $5 million in connection with remediating its systems, of which approximately $4.5 million was expensed through December 31, 1998. Fremont is not aware of any material problems resulting from Year 2000 issues, either with its products, its internal systems, or the products and services of third parties. The