UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-8993 FUND AMERICAN ENTERPRISES HOLDINGS, INC. (Exact name of Registrant as specified in its charter) DELAWARE 94-2708455 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 80 SOUTH MAIN STREET, HANOVER, NEW HAMPSHIRE 03755-2053 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (603) 643-1567 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- Common Stock, par value $1.00 New York Stock Exchange per share Securities registered pursuant to section 12(g) of the Act: None Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of voting shares (based on the closing price of those shares listed on the New York Stock Exchange and the consideration received for those shares not listed on a national or regional exchange) held by non-affiliates of the Registrant as of March 22, 1999, was $720,239,846. As of March 22, 1999, 5,843,731 shares of Common Stock, par value of $1.00 per share, were outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Notice of 1999 Annual Meeting of Shareholders and Proxy Statement dated March 29, 1999 (Part III) FUND AMERICAN TABLE OF CONTENTS PART I ITEM 1. Business....................................................... 1 a. General................................................... 1 b. Insurance Operations...................................... 1 c. Mortgage Banking Operations............................... 15 d. Investment Portfolio Management........................... 19 e. Certain Business Conditions............................... 20 f. Regulation................................................ 20 g. Employees................................................. 21 h. Forward-Looking Statements................................ 21 ITEM 2. Properties .................................................... 22 ITEM 3. Legal Proceedings.............................................. 22 ITEM 4. Submission of Matters to a Vote of Security Holders............ 22 PART II ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters ......................................... 22 ITEM 6. Selected Financial Data........................................ 24 ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................... 26 ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk..... 52 ITEM 8. Financial Statements and Supplementary Data.................... 52 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ......................... 52 PART III ITEM 10. Directors and Executive Officers............................... 53 ITEM 11. Executive Compensation......................................... 54 FUND AMERICAN ITEM 12. Security Ownership of Certain Beneficial Owners and Management .................................................. 54 ITEM 13. Certain Relationships and Related Transactions................. 54 PART IV ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ................................................ 65 PART I ITEM 1. BUSINESS GENERAL Fund American Enterprises Holdings, Inc., (the "Company"), is a Delaware corporation which was organized in 1980. Within this report, the consolidated organization is referred to as "Fund American". Fund American's principal businesses are conducted through White Mountains Holdings, Inc. and its operating subsidiaries ("White Mountains"). White Mountains' consolidated and unconsolidated insurance operations are conducted through its subsidiaries and affiliates in the businesses of property and casualty insurance, property and casualty reinsurance and financial guaranty insurance. White Mountains' mortgage banking operations are conducted through Source One Mortgage Services Corporation and its subsidiaries ("Source One"). The Company's principal office is located at 80 South Main Street, Hanover, New Hampshire, 03755-2053, and its telephone number is (603) 643-1567. INSURANCE OPERATIONS CONSOLIDATED REINSURANCE OPERATIONS FOLKSAMERICA HOLDING COMPANY, INC. ("FOLKSAMERICA"). Folksamerica, through its wholly-owned subsidiary, Folksamerica Reinsurance Company (a New York corporation), is a multi-line broker-market reinsurance company which provides reinsurance to insurers of property and casualty risks in the United States, Canada, Latin America and the Carribean. Folksamerica is rated "A" (Excellent) by A.M. Best Company. During 1998, 1997 and 1996, Folksamerica had net written premiums of $212.6 million, $232.4 million and $171.9 million, respectively. At December 31, 1998 and 1997, Folksamerica had total assets $1.2 billion and $1.2 billion, respectively, and shareholders' equity of $302.0 million and $255.0 million, respectively. In June 1996 White Mountains purchased a 50.0% economic interest in Folksamerica for $79.9 million from a group of European mutual insurance companies (the "European Mutuals") who continued to own the remaining 50.0% interest. White Mountains' initial investment in Folksamerica consisted of 6,920,000 shares of ten-year 6.5% voting preferred stock having a liquidation preference of $79.4 million ("Folksamerica Preferred Stock") and ten-year warrants ("Folksamerica Warrants") to purchase up to 6,920,000 shares of the common stock of Folksamerica ("Folksamerica Common Stock") for $11.47 per share, subject to certain adjustments. In November 1997 White Mountains and the European Mutuals each purchased an additional 1,563,907 shares of Folksamerica Common Stock for $20.8 million which maintained White Mountains 50% economic ownership position. 1 On August 18, 1998, White Mountains acquired all of the remaining outstanding shares of the Folksamerica Common Stock from the European Mutuals for $169.1 million which resulted in Folksamerica becoming a wholly-owned consolidated subsidiary of Fund American as of that date. Following the August 18, 1998 transaction, Folksamerica retired the Folksamerica Preferred Stock and issued White Mountains an equivalent amount of Folksamerica Common Stock. As of December 31, 1998, White Mountains owned all of the outstanding shares of Folksamerica Common Stock. REINSURANCE OVERVIEW Reinsurance is an arrangement in which a reinsurance company (the "reinsurer") agrees to indemnify an insurance company (the "ceding company") for all or a portion of the insurance risks underwritten by the ceding company under one or more insurance policies. Reinsurance can benefit a ceding company in a number of ways, including reducing net liability exposure on individual risks, providing catastrophe protections from large or multiple losses, stabilizing financial results and assisting in maintaining acceptable operating leverage ratios. Reinsurance also provides a ceding company with additional underwriting capacity by permitting it to accept larger risks and underwrite a greater number of risks without a corresponding increase in its capital or surplus. Reinsurers may also purchase reinsurance, known as retrocessional reinsurance, to cover their own risks assumed from primary ceding companies. Reinsurance companies enter into retrocessional agreements for many of the same reasons that ceding companies enter into reinsurance agreements. Folksamerica writes both treaty and facultative reinsurance. Treaty reinsurance is an agreement whereby the ceding company is obligated to cede, and the reinsurer is obligated to assume, a specified portion or category of risk under all qualifying policies issued by the ceding company during the term of a treaty. In the underwriting of treaty reinsurance, the reinsurer does not evaluate each individual risk assumed and generally accepts the original underwriting decisions made by the ceding insurer. Facultative reinsurance is underwritten on a risk-by-risk basis whereby Folksamerica applies its own pricing to an individual exposure. Facultative reinsurance is normally purchased by insurance companies for individual risks not covered under reinsurance treaties or for amounts in excess of limits on risks covered under reinsurance treaties. The majority of Folksamerica's assumed premiums are derived from treaty reinsurance contracts. Folksamerica obtains virtually all of its business through brokers and reinsurance intermediaries which seek its participation on reinsurance being placed for their customers. Reinsurance is provided both on an excess of loss and quota share basis, which in 1998 amounted to 30.2% and 69.8% of its business, respectively. Folksamerica derives its business from a spectrum of ceding insurers including national, regional, specialty and excess and surplus lines writers. Folksamerica selects transactions based solely on 2 anticipated underwriting results of the transaction which are evaluated on a variety of factors including the quality of the reinsured, the attractiveness of the reinsured's insurance rates, policy conditions and the adequacy of the proposed reinsurance terms. A significant period of time normally elapses between the receipt of reinsurance premiums and the disbursement of reinsurance claims ("float"). The claims process generally begins upon the occurrence of an event causing an insured loss followed by: (i) the reporting of the loss to the ceding company; (ii) the reporting of the loss by the ceding company to Folksamerica; (iii) the ceding company's adjustment and payment of the loss; and (iv) the payment to the ceding company by Folksamerica. During this time, Folksamerica earns investment income on the float. Therefore, Folksamerica's combined ratio can generally be higher than that of Fund American's consolidated property and casualty insurance operations and yet may still earn an equivalent or superior return on equity. LINES OF BUSINESS AND GEOGRAPHIC LOCATION The following tables set forth information regarding Folksamerica's net written premiums by lines of business and geographic location: Year Ended December 31, ------------------------------------------------------- Millions 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------- Liability $122.0 $123.6 $ 79.6 $ 71.9 $ 63.0 Property 87.2 104.9 85.9 87.9 89.9 Marine 3.4 3.9 6.4 - - ------------------------------------------------------- Total $212.6 $232.4 $171.9 $159.8 $152.9 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Year Ended December 31, ------------------------------------------------------- Millions 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------- United States $190.9 $208.6 $155.2 $159.8 $152.9 Canada 13.9 10.1 4.2 - - Latin America 7.8 13.7 12.5 - - ------------------------------------------------------- Total $212.6 $232.4 $171.9 $159.8 $152.9 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 3 UNDERWRITING Folksamerica's primary underwriting objective is to carefully assess reinsurance opportunities to determine the probability of a particular transaction providing an underwriting profit. Those risks that do not provide a reasonable likelihood of delivering an underwriting profit are rejected. Underwriting opportunities presented to Folksamerica are evaluated based on a number of factors including historical analysis of results, estimates of future loss costs, a review of other programs displaying similar exposure characteristics, the primary insurers underwriting and claims experience and the primary insurer's financial condition. Folksamerica regularly conducts underwriting and claims audits of ceding companies to assist it in evaluating the information submitted by the ceding companies. Folksamerica's most senior underwriters and executives are responsible for its underwriting policy and quality standards and informing Folksamerica's board of directors of current and anticipated market conditions and underwriting results. MARKETING Folksamerica generally obtains all its reinsurance business through brokers and reinsurance intermediaries which represent the ceding company in negotiations for the purchase of reinsurance. The process of effecting a brokered reinsurance placement typically begins when a ceding company enlists the aid of a reinsurance broker in structuring a reinsurance program. Often the ceding company and the broker will consult with one or more lead reinsurers as to the pricing and contract terms for the reinsurance protection being sought. Once the ceding company has approved the terms quoted by the lead reinsurer, the broker will offer participations to qualified reinsurers until the program is fully subscribed by reinsurers at terms agreed to by all parties. Folksamerica pays its reinsurance brokers commissions representing negotiated percentages of the premium it writes. These commissions, which generally average 5% of premium, constitute part of Folksamerica's total acquisition costs and are included in its underwriting expenses. During the year ended December 31, 1998, Folksamerica received approximately 67% of its gross reinsurance premiums written from three major reinsurance brokers as follows: (i) E. W. Blanch - 25%; (ii) Guy Carpenter and affiliates - 23%; and (iii) AON Re, Inc. - 19%. During the year ended December 31, 1998, Folksamerica received no more than 10% of its gross reinsurance premiums from any individual ceding company. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES Insurers and reinsurers establish loss and loss adjustment expense reserves representing estimates of future amounts needed to pay claims and related expenses with respect to insured events that have occurred. 4 Loss and loss adjustment expense reserves have two components: case reserves, which are reserves for reported losses, and incurred but not reported ("IBNR") reserves, which are reserves for losses not yet reported. Reserve estimates reflect the judgement of both the ceding company and the reinsurer, based on the experience and knowledge of its claims personnel, regarding the nature and value of the claim. The ceding company may periodically adjust the amount of the case reserves as additional information becomes known or partial payments are made. Upon notification of a loss from a ceding company, Folksamerica establishes case reserves, including loss adjustment expense reserves, based upon Folksamerica's share of the amount of reserves established by the ceding company and Folksamerica's independent evaluation of the loss. Where appropriate, Folksamerica establishes case reserves in excess of its share of the reserves established by the ceding company. Folksamerica uses a combination of actuarial methods to determine its IBNR reserves. These methods fall into two general categories: (1) methods by which ultimate claims are estimated based upon historical patterns of reported claim development experienced by Folksamerica, as supplemented by reported industry data, and (2) methods in which the level of Folksamerica's IBNR claim reserves are established based upon the IBNR claim reserves relative to earned premium applied by accident year, line of business and type of reinsurance written by Folksamerica. Due to the inherent uncertainties of estimating claim reserves, actual losses and loss adjustment expenses may deviate, perhaps substantially, from estimates of Folksamerica's reserves reflected in its consolidated financial statements. 5 During the claims settlement period, which may extend over a long period of time, additional facts regarding claims and trends may become known which may cause Folksamerica to adjust its estimates of the ultimate liability. The revised estimates of ultimate liability may prove to be less than or greater than the actual settlement or award amount for which the claim is finally discharged. REINSURANCE INDUSTRY AND COMPETITION Folksamerica commenced writing business in 1980 as one of a host of newly formed, foreign-owned reinsurers capitalized with minimum surplus. In 1991, recognizing that surplus size and critical mass would become an increasingly important business issue, Folksamerica launched an aggressive strategy to increase its resources and capacity through the acquisition of select broker-market companies. Since 1991, Folksamerica has acquired three such reinsurers which has raised Folksamerica's surplus and contributed a number of important business relationships. In general, competition among primary companies has caused primary insurers to reduce their own premium writings or restructure their reinsurance programs, reducing the amount of reinsurance they purchase. As a result of consolidation within the industry, many ceding companies are now larger and financially stronger, enabling them to retain more risk. In addition, increasingly intense competition in the reinsurance markets has driven reinsurance prices on a number of accounts below pricing levels which Folksamerica will accept. Folksamerica's management believes that the reinsurance industry, including the intermediary market, will continue to undergo further consolidation. Management further believes that, although size and financial strength will continue to be factors in selecting reinsurance partners, product pricing has become the most telling competitive factor. CONSOLIDATED INSURANCE OPERATIONS Since 1995 White Mountains has been acquiring and developing various insurance operating interests. In December 1995 White Mountains acquired Valley Group, Inc. ("VGI") of Albany, Oregon and Charter Group, Inc. ("CGI") of Richardson, Texas for $41.7 million in cash less $3.0 million of purchase price adjustments. In September 1995, White Mountains formed White Mountains Insurance Company ("WMIC") which is a New Hampshire-based midsize commercial property and casualty company. In December 1995 CGI and WMIC were contributed to VGI thereby making them wholly-owned subsidiaries of VGI. VALLEY INSURANCE COMPANIES. Valley Insurance Company ("VIC"), Valley Property & Casualty Insurance Company ("Valley P&C"), Valley National Insurance Company ("Valley National") and certain related non-insurance affiliates, collectively ("Valley"), write personal and commercial lines as further described below: 6 VIC: A Northwest-based property and casualty company which writes personal and commercial lines. In 1998, 1997 and 1996, VIC had $86.7 million, $77.7 million and $75.1 million of net written premiums, respectively, primarily in Oregon, California and Washington. At December 31, 1998 and 1997, VIC had $158.2 million and $146.6 million of total admitted assets, respectively, and $56.5 million and $61.2 million of policyholders' surplus, respectively. VIC was established in 1982 and began writing insurance policies in 1985. VIC is rated "A" or "excellent" by A.M. Best. VALLEY P&C: On December 5, 1996, VGI formed Valley P&C to specifically write property and casualty insurance within Oregon. Valley P&C wrote its first policies in February 1997 and had $6.2 million and $5.2 million in net written premiums during 1998 and 1997, respectively. At December 31, 1998 and 1997, Valley P&C had $13.0 million and $7.7 million of total admitted assets, respectively, and $7.3 million and $3.7 million of policyholders' surplus, respectively. Valley P&C is rated "A" or "excellent" by A.M. Best. VALLEY NATIONAL: On January 19, 1996, Valley purchased an inactive insurance company for $13.2 million, net of cash balances acquired. The newly acquired insurance company, which was renamed Valley National, is licensed to write property and casualty insurance in 48 states. Assets acquired pursuant to the purchase of Valley National included an investment portfolio, consisting principally of fixed maturity investments, totalling $6.7 million. Valley National wrote its first policies in December 1996 and had $10.9 million and $2.7 million in gross written premiums ($1.4 million and $.3 million of net written premiums) during 1998 and 1997, respectively. In the future, Valley National may further expand its operations to certain other states in which it is currently licensed. At December 31, 1998 and 1997, Valley National had $13.2 million and $11.5 million of total admitted assets, respectively, and $11.9 million and $11.1 million of policyholders' surplus, respectively. Valley National is a wholly-owned subsidiary of VIC and shares its A.M. Best's "A" rating through a combination of a reinsurance arrangement with VIC and its ownership structure. Valley markets insurance products principally through independent agents. Valley's primary business focus is to establish strong long-term relationships with its agents and insured customers by focusing on providing quality insurance products to families and family-owned businesses. This approach has resulted in an established track record of growth: Year Ended December 31, -------------------------------------------- Statutory Basis(a), in Millions 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------- Gross written premiums $ 95.8 $ 89.2 $ 81.9 $ 73.1 $ 64.8 Ending total assets 171.2 154.3 138.2 126.8 80.4 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- Ending policyholders' surplus 63.8 64.9 57.8 58.5 23.5 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- 7 (a) The term "statutory" as contained herein refers to a basis of accounting other than generally accepted accounting principles ("GAAP") that is prescribed by the individual states that an insurance company transacts business in. In 1998, 1997 and 1996 Valley wrote $95.8, $89.2 million and $81.9 million, respectively, of gross premiums within the following states, through approximately 317 independent agents: Year Ended December 31, 1998 ---------------------------------------- Gross Written Policies Dollars in millions Premiums In Force* Agents* - --------------------------------------------------------------------------- Oregon $ 44.5 30,876 99 California 27.7 12,084 90 Washington 16.6 6,983 62 Arizona, Idaho, Utah and other 7.0 5,372 66 ---------------------------------------- Totals $ 95.8 55,315 317 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Year Ended December 31, 1997 ---------------------------------------- Gross Written Policies Dollars in millions Premiums In Force* Agents* - --------------------------------------------------------------------------- Oregon $ 43.1 30,789 98 California 26.2 12,333 80 Washington 17.2 6,960 69 Arizona, Idaho, Utah and other 2.7 2,180 38 ---------------------------------------- Totals $ 89.2 52,262 285 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Year Ended December 31, 1996 ---------------------------------------- Gross Written Policies Dollars in millions Premiums In Force* Agents* - --------------------------------------------------------------------------- Oregon $ 40.9 31,118 99 California 27.5 12,910 74 Washington 13.2 4,554 63 Arizona, Idaho, Utah and other .3 222 9 ---------------------------------------- Totals $ 81.9 48,804 245 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- * Determined at year end. 8 Valley's focus on delivering insurance products to families and family-owned businesses has resulted in a book of business which is balanced between personal lines and commercial lines. Gross written premiums for Valley's primary lines of business are shown below: Year Ended December 31, ------------------------------------------------ Millions 1998 1997 1996 1995 1994 - --------------------------------------------------------------------------------- Personal lines: Automobile $ 33.1 $ 29.3 $ 25.9 $ 23.9 $ 22.5 Homeowners 14.0 13.4 12.0 10.4 8.3 Other 1.0 1.5 1.3 1.1 .8 ------------------------------------------------ Total personal lines 48.1 44.2 39.2 35.4 31.6 ------------------------------------------------ Commercial lines: Multiple peril 45.2 42.2 39.1 34.3 30.2 Other 2.5 2.8 3.6 3.4 3.0 ------------------------------------------------ Total commercial lines 47.7 45.0 42.7 37.7 33.2 ------------------------------------------------ Total gross written premiums $ 95.8 $ 89.2 $ 81.9 $ 73.1 $ 64.8 - --------------------------------------------------------------------------------- - --------------------------------------------------------------------------------- The long-term relationships cultivated by Valley with its agents and insured customers, along with superior customer service and convenient premium billing and payment systems, have produced a relatively high level of persistency in Valley's "package" book of business. In 1998, 1997 and 1996, package business represented approximately 73.6%, 79.1% and 80.0% of Valley's premium writings, respectively, for both personal and commercial lines: Year Ended December 31, ------------------------------------------------ Renewal retention ratios 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------------------- Personal automobile/homeowners packages 91.0% 91.4% 89.4% 88.2% 87.8% Commercial multiple peril packages 74.6% 78.9% 75.5% 76.5% 84.5% - -------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------- Renewal persistency can be a significant indicator of an insurance company's long-term prospects for successful underwriting. An insurance company typically incurs more marketing and underwriting costs to write new business (e.g., policies written for new customers) 9 than it does to write "seasoned" business (e.g., policy renewals). Additionally, losses and loss adjustment expenses are typically higher and less predictable for new business than for seasoned business. CHARTER INSURANCE COMPANIES. CGI, through its wholly-owned subsidiary Charter Indemnity Company, its controlled affiliate Charter County Mutual Insurance Company and certain related non-insurance subsidiaries (collectively "Charter"), markets and underwrites nonstandard automobile insurance to individuals primarily in the states of Texas and Oklahoma. For the years ended December 31, 1998, 1997 and 1996, Charter's net written premiums totalled $64.3 million, $62.9 million and $69.9 million, respectively, and its earned premiums totalled $64.2 million, $62.4 million and $37.7 million, respectively. Written premiums (and related expenses and losses) for Charter's policies written prior to January 1, 1996, were entirely ceded to Charter's former parent and are now fully retained, therefore, Charter's 1996 earned premiums are not directly comparable to its 1998 and 1997 earned premiums. Charter writes all its business through independent agents. At December 31, 1998 Charter had approximately 1,600 agents. During 1998 Charter began to write policies in California and Missouri and is expected to expand its operations to other states. Charter is rated "A-" or "excellent" by A.M. Best. The nonstandard automobile insurance market consists of drivers who are unable to obtain coverage from standard carriers due to their prior driving records, other underwriting criteria or market conditions. Management believes that opportunities in the nonstandard automobile insurance market are influenced by many factors including the market conditions for standard automobile insurance, residual market plans, and the extent to which state motor vehicle laws are enforced. The nonstandard automobile insurance market has grown in recent years as the result of tightening of underwriting standards by underwriters of standard and preferred automobile insurance, and increased enforcement of motor vehicle laws including driving while intoxicated and uninsured motorist laws. Charter offers both liability and physical damage coverage in its nonstandard automobile insurance markets, generally with policies having terms of 6 months or 12 months. Most of Charter's policyholders choose basic limits of liability coverage, typically $20,000 per person and $40,000 per accident for bodily injury, and $15,000 for property damage. For the year ended December 31, 1998, Charter's net written premiums totalled $43.1 million for liability coverages and $21.2 million for physical damage coverages. Management pursues a strategy of establishing Charter as a low cost provider of nonstandard automobile insurance while maintaining a commitment to provide "service beyond expectation" to both agents and the insured. Management believes that Charter has become a low cost provider of nonstandard automobile insurance. Increased automation of certain marketing, underwriting, claims and administrative functions has provided Charter with the ability to process more business without a corresponding increase in costs, while maintaining a high level of service to its agents and insured customers. 10 Management believes that most classes of nonstandard automobile insurance can be underwritten profitably if they are priced adequately. Charter seeks to classify risks into narrowly defined segments through the utilization of available underwriting criteria and internal performance statistical data. Charter maintains a proprietary database which contains statistical records with respect to its agents and the insured. Management believes this database enhances Charter's ability to analyze loss experience, and to underwrite and price its products based on a number of variables. Charter utilizes many factors and analyses to determine its rates including: type, age and location of the vehicle; number of vehicles per policyholder; number and type of traffic violations or accidents; limits of liability; deductibles; and age, sex and marital status of the insured. Automobile damage claims are normally settled in a timely manner which limits the amount of investment income that can be generated on the earned and unearned insurance premiums that it has received from its policyholders. Therefore, Charter's combined ratio must generally be lower than that of Fund American's other consolidated property and casualty insurance operations in order to earn an equivalent return on equity. WHITE MOUNTAINS INSURANCE COMPANY. WMIC is currently licensed to write insurance in Maine, New Hampshire, Vermont, Massachusetts, New York, Rhode Island and Texas and is expected to expand its operations to other states as additional regulatory approvals are obtained. WMIC markets its products principally through independent agents and had gross written premiums during 1998, 1997 and 1996 of $7.5 million, $5.2 million and $2.4 million ($6.3 million, $4.7 million and $2.0 million of net written premiums), respectively. At December 31, 1998 and 1997, WMIC had $33.3 million and $31.4 million of total admitted assets, respectively, and $30.3 million and $29.1 million of policyholders' surplus, respectively. WMIC is a wholly-owned subsidiary of VIC and shares its A.M. Best's "A" rating through a combination of a reinsurance arrangement with VIC and its ownership structure. UNDERWRITING Valley, Charter and WMIC's primary underwriting objective is to carefully assess insurance risks to determine the likelihood of a particular risk providing an underwriting profit. Those risks that do not provide a reasonable likelihood of delivering an underwriting profit are rejected. Valley, Charter and WMIC's Underwriting Committee, composed of its most senior underwriters and executives, is responsible for its underwriting policy, quality standards and for informing their boards of directors of current and anticipated market conditions and its actual underwriting results. MARKETING In the United States, property and casualty insurance can be obtained through national and regional companies that use an agency distribution system, direct writers, brokers or through self-insurance including the use by corporations of subsidiary captive insurers. Valley, Charter and WMIC market their products principally through independent agents. 11 Valley, Charter and WMIC pay their independent agents commissions representing negotiated percentages of the premium they write. These commissions, which currently range from 10.0% to 17.5% of premium, depending on the line of business, constitute part of total acquisition costs and are included in underwriting expenses. COMPETITION The principal competitive factors that affect Valley, Charter and WMIC are: (i) pricing; (ii) underwriting; (iii) quality of claims and policyholder services; (iv) appointing and retaining high quality independent agents; (v) operating efficiencies; and (vi) product differentiation and availability. No single company or group of affiliated companies dominates the insurance industry. The highly competitive environment in the property and casualty insurance market during the past several years has intensified due to increased capacity resulting from growing capital supporting the industry and robust investment returns achieved in recent years. Valley, Charter and WMIC strive to be low cost operators within their sectors of the insurance industry while maintaining superior levels of customer service. Valley, Charter and WMIC each maintain a disciplined approach to pricing and underwriting of insurance risks. Application of this disciplined approach in a highly competitive environment results in a lower volume of insurance premiums than would result from a less disciplined approach, but should produce better overall financial returns from the business over long periods of time. Perception of financial strength, as reflected in the ratings assigned to an insurance company, especially by A.M. Best, is also a factor in determining an insurance company's competitive position. Valley, Charter and WMIC have consistently maintained adequate capitalization and claims payment ratings to effectively conduct its business and management believes that such strength will continue to be maintained in the future. INVESTMENTS IN UNCONSOLIDATED INSURANCE AFFILIATES White Mountains' investments in unconsolidated insurance affiliates represent strategic operating investments in other insurers in which White Mountains has a significant voting and economic interest but does not own greater than 50% of the entity. Since 1994, Fund American has been active in accumulating its investments in unconsolidated affiliates which are further described below: FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ("FSA"). FSA, through its wholly-owned subsidiary, Financial Security Assurance Inc., guarantees scheduled payments of principal and interest on municipal bonds and asset-backed securities, including residential mortgage-backed securities. FSA's guaranty on investment-grade securities helps issuers lower their funding costs and provides bondholders with the highest-quality investments. FSA's claims-paying ability is rated Triple-A by Fitch IBCA, Inc., Moody's Investors Service, Inc., Standard & Poor's Rating Services and Nippon Investors Service Inc. For 1998, 1997 and 1996 FSA's gross premiums written totalled $319.3 million, $236.4 million and $177.0 million, respectively, and its net income was $117.0 million, $100.5 million and $80.8 million, respectively. As of December 31, 1998 and 1997, FSA's total assets were $2.4 billion and 12 $1.9 billion, respectively, and its shareholders' equity was $1,073.4 million and $882.4 million, respectively. In May 1994 Fund American purchased 2,000,000 shares of the common stock of FSA ("FSA Common Stock") from MediaOne Capital Corp. ("MediaOne", formerly U S WEST Capital Corp.), a wholly-owned subsidiary of MediaOne Group, Inc. (formerly U S WEST, Inc.). The purchase was part of an initial public offering of 8,082,385 shares of FSA Common Stock at the offering price of $20.00 per share. In September 1994 Fund American acquired various fixed price options and shares of convertible preferred stock ("FSA Options and Preferred Stock") which, in total, give Fund American the right to acquire up to 4,560,607 additional shares of FSA Common Stock for aggregate consideration of $125.7 million. In 1995 and 1996, respectively, Fund American purchased an additional 460,200 shares of FSA Common Stock on the open market for $8.8 million and an additional 1,000,000 shares of FSA Common Stock in a private transaction for $26.5 million. All shares of and rights to FSA Common Stock owned or acquired by Fund American as described above (other than those acquired on the open market) are subject to certain restrictions on transfer, voting provisions and other limitations and requirements set forth in a Registration Rights Agreement and a Voting Trust Agreement. As of December 31, 1998, 1997 and 1996 Fund American's economic interest in FSA was approximately 25.1%, 26.2% and 25.1%, respectively, and Fund American's voting interest in FSA was approximately 23.1%, 24.0% and 23.0%, respectively. During 1997 Fund American transferred all of its interests in FSA to Source One. Mr. John J. ("Jack") Byrne (Chairman of the Company) is Vice Chairman of FSA and Mr. K. Thomas Kemp (President and CEO of the Company) and Mr. James H. Ozanne (President of Fund American Enterprises, Inc. ("FAE"), a wholly-owned subsidiary of White Mountains) are directors of FSA. In addition to being FSA directors, Mr. Kemp is Chairman of FSA's Human Resources Committee and Mr. Ozanne is Chairman of FSA's Underwriting Committee. Fund American's investment in FSA Common Stock is accounted for using the equity method. FSA Common Stock is publicly traded on the New York Stock Exchange ("NYSE"). The market value of the FSA Common Stock as of December 31, 1998 and 1997, as quoted on the NYSE, exceeded Fund American's carrying value of the FSA Common Stock under the equity method. Fund American's investments in FSA Options and Preferred Stock are accounted for under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115 whereby the investments are reported at fair value as of the balance sheet date, with related unrealized investment gains and losses, after tax, reported as a net amount in a separate component of shareholders' equity and reported on the income statement as a component of comprehensive net income. MAIN STREET AMERICA HOLDINGS, INC. ("MSA"). MSA is a subsidiary of National Grange Mutual Insurance Company of Keene, New Hampshire ("NGM"). NGM insures property and casualty risks located primarily in New York, Massachusetts, Connecticut, Pennsylvania, New Hampshire, Virginia and Florida. NGM's principal lines of business and approximate percentage of total written premiums are personal 13 automobile (45%), homeowners (15%), commercial multi-peril (15%), commercial automobile (10%) and all other (15%). MSA participates in NGM's property and casualty business through a reinsurance agreement. MSA's net written premiums totalled $258.5 million, $156.6 million and $147.2 million in 1998, 1997 and 1996, respectively, and its net income was $13.4 million, $11.9 million and $9.7 million, respectively. MSA's total assets as of December 31, 1998 and 1997 were $588.6 million and $337.2 million, respectively, and its shareholders' equity was $232.5 million and $120.6 million, respectively. In December 1994 the Company (who subsequently transferred the MSA investment to White Mountains) acquired 90,606 shares of the common stock of MSA ("MSA Common Stock") for $25.0 million in cash plus $1.2 million in subsequent purchase price adjustments. White Mountains initial investment in MSA represented approximately 33.1% of the MSA Common Stock outstanding at that time. From 1994 to 1997 MSA participated in 40% NGM's property and casualty business through a reinsurance agreement. In March 1998 White Mountains acquired an additional 131,487 shares of MSA Common Stock for $70.3 million (subject to certain purchase price adjustments which are not expected to exceed $3.5 million) which raised White Mountains ownership of MSA to 50.0%. As a result of White Mountains' additional investment in MSA during 1998, MSA's reinsurance pooling agreement was increased from 40% to 60% and NGM contributed certain of its insurance, reinsurance and financial services subsidiaries to MSA. Fund American's investment in MSA Common Stock is accounted for using the equity method. Messrs. Raymond Barrette (Executive Vice President and Chief Financial Officer of the Company), Terry L. Baxter (President of White Mountains), Morgan W. Davis (Executive Vice President of White Mountains) and Kemp are directors of MSA. AMLIN PLC ("AMLIN") FORMERLY ML (BERMUDA) LIMITED ("MURRAY LAWRENCE"). Amlin is a managing agency group in the Lloyd's insurance market. On December 8, 1997, White Mountains purchased approximately 15.8% of the common stock of Murray Lawrence for $23.6 million. At December 31, 1997 White Mountains carried this investment as an "investment in unconsolidated insurance affiliate" and valued it at its original cost of $23.6 million which approximated its fair value at that date. During 1998 Murray Lawrence merged with Angerstein Underwriting and the combined entity was named Amlin. Amlin is publicly traded on the London Stock Exchange. White Mountains owns 13,980,861 shares of the common stock of Amlin, which represents an approximate 6.5% ownership stake as of December 31, 1998. As a result of White Mountains' decreased ownership percentage of this investment resulting from the merger, White Mountains recharacterized its investment in Amlin as an "other investment" and carried the investment at its fair value of $25.1 million at December 31, 1998. Mr. Kemp is a director of Amlin. 14 MORTGAGE BANKING OPERATIONS Source One was incorporated in 1972 and is the successor to Citizens Mortgage Corporation which was organized in 1946. As a mortgage banker, Source One engages primarily in the business of producing and selling residential mortgage loans and servicing and subservicing residential mortgage loans for third parties. Through subsidiaries, Source One also markets credit-related insurance products (such as life, disability, health, accidental death and property and casualty insurance). Source One's principal office is located in Farmington Hills, Michigan. Source One is a wholly-owned subsidiary of Fund American whereby the Company currently owns 3% of the outstanding common stock of Source One and White Mountains owns the remaining 97% of the outstanding common stock of Source One. MORTGAGE BANKING OVERVIEW Mortgage banking is the business of serving as a financial intermediary in the origination and purchase of mortgage loans, the holding of such loans while aggregating sufficient loans to form appropriate mortgage-backed security pools, selling such loans through pools or directly to investors and servicing or subservicing such loans during the repayment period. The origination process involves providing competitive mortgage loan rates, soliciting loan applications, reviewing title and credit matters, and funding loans at closing. Mortgage loans can also be purchased from other originating mortgage bankers. Marketing or selling mortgage loans requires matching the needs of the production market (homebuyers and homeowners seeking new mortgages) with the needs of the secondary market for mortgage loans (securities broker-dealers, depository institutions, insurance companies, pension funds and other investors). Conventional mortgage loans (e.g., those not guaranteed or insured by agencies of the Federal government) which are secured by residential properties, and which comply with applicable requirements, are packaged for direct sale or conversion to a mortgage-backed security. Such mortgage-backed securities are guaranteed by the Federal Home Loan Mortgage Corporation ("FHLMC") or the Federal National Mortgage Association ("FNMA"). Mortgage loans insured by the Federal Housing Administration ("FHA") and the Veterans Administration ("VA") are packaged in the form of modified pass-through mortgage-backed securities guaranteed by the Government National Mortgage Association ("GNMA") for sale primarily to securities broker-dealers. In addition, private entities may pool mortgage loans in various forms and offer the resulting mortgage-backed securities to the public through securities broker-dealers. Servicing involves collecting principal, interest and funds to be escrowed for tax and insurance payments from mortgage loan borrowers, remitting principal and interest collections to mortgage loan investors, paying property taxes and insurance premiums on mortgaged property and performing all related accounting and reporting 15 activities. Servicing may also involve advancing uncollected payments to mortgage loan investors, administering delinquent loans and supervising foreclosures in the event of unremedied defaults. Servicing generates cash income in the form of fees, which represent a percentage of the declining outstanding principal amount of the loans serviced and are collected from each mortgage loan payment received plus any late charges. Subservicing involves the administrative servicing of loans owned by others for a fee. MORTGAGE LOAN PRODUCTION Source One produces residential mortgage loans through: (i) a correspondent network of more than 200 banks, thrift institutions and other mortgage lenders; (ii) 163 retail branch offices in 31 states and Puerto Rico; (iii) approximately 425 mortgage brokers; and (iv) a specialized marketing and affinity program. Source One primarily produces fixed rate mortgage loans. Generally speaking, fixed rate mortgages tend to capture a large share of origination volumes in a declining interest rate environment. Additionally, fixed rate mortgage loans are inherently less susceptible to prepayment risk than adjustable rate mortgages. During periods of increasing interest rates, the likely adverse effects of lower fixed rate mortgage loan originations are mitigated by a reduction in the prepayment risk on the fixed rate mortgage loans Source One services. During 1998 and 1997, fixed rate mortgage loan production accounted for approximately 98% and 88%, respectively, of Source One's total mortgage loan production. The following table sets forth selected information regarding Source One's mortgage loan production: Year Ended December 31, ----------------------------------------------------------- Millions 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------- Loan production by type of loan: FHA insured and VA guaranteed $ 3,009 $ 2,985 $ 2,035 $ 1,565 $ 2,065 Conventional 7,857 1,418 1,796 1,287 2,521 ----------------------------------------------------------- Total $10,866 $ 4,403 $ 3,831 $ 2,852 $ 4,586 ----------------------------------------------------------- ----------------------------------------------------------- Loan production by origination source: Correspondent network acquisitions $ 6,880 $ 2,552 $ 1,640 $ 1,157 $ 1,081 Retail branch office originations 2,692 1,339 1,590 1,347 2,005 Mortgage broker originations 872 390 369 196 696 Specialized marketing program originations 290 122 232 152 804 Subprime and other 132 -- -- -- -- ----------------------------------------------------------- Total $10,866 $ 4,403 $ 3,831 $ 2,852 $ 4,586 ----------------------------------------------------------- ----------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------- 16 During 1997 Source One broadened its product line by offering higher profit margin products such as FHA home improvement ("203(k)") loans, manufactured housing loans, subprime loans and 125% loan to value second mortgage ("125% LTV") loans. The 203(k) loans and manufactured housing loans produced by Source One are sold to third parties with servicing retained whereby the subprime loans and 125% LTV loans produced by Source One are sold to third parties on a servicing released basis. Source One is currently expanding its capability to service and subservice subprime loans and to subservice 125% LTV loans. These new products did not account for a significant portion of Source One's total mortgage loan production during 1998 or 1997. SALES OF LOANS Source One sells mortgage loans either through mortgage-backed securities issued pursuant to programs of GNMA, FNMA and FHLMC, or to institutional investors. Most mortgage loans are aggregated in pools of $1.0 million or more, which are purchased by institutional investors after having been guaranteed by GNMA, FNMA or FHLMC. During 1998 approximately 71.1%, 20.6% and 5.3% of the principal amount of Source One's loans were sold in pools through GNMA, FNMA and FHLMC, respectively. During 1997 approximately 65.5%, 23.3% and 6.7% of the principal amount of Source One's loans were sold in pools through GNMA, FNMA and FHLMC, respectively. During 1996 approximately 42.8%, 35.3% and 11.6% of the principal amount of Source One's loans were sold in pools through GNMA, FNMA and FHLMC, respectively. Since 1993, substantially all GNMA securities have been sold without recourse to Source One for loss of principal in the event of a subsequent default by the mortgage borrower. Servicing agreements relating to mortgage-backed securities issued pursuant to the programs of GNMA, FNMA or FHLMC require Source One to advance funds to make the required payments to investors in the event of a delinquency by the borrower. Source One expects that it would recover most funds advanced upon cure of default by the borrower or at foreclosure. However, in connection with VA partially guaranteed loans and certain conventional loans (which may be partially insured by private mortgage insurers), funds advanced may not cover losses due to potential declines in collateral value. To minimize interest rate risk associated with mortgage loans whose interest rate is "locked" but has not yet been sold, Source One obtains mandatory forward commitments of up to 120 days to sell mortgage-backed securities with respect to all loans which have been funded and a substantial portion of loans in process (the "Pipeline") which it believes will close. Source One's risk management function closely monitors the Pipeline to determine appropriate forward commitment coverage on a daily basis. 17 LOAN SERVICING Source One generally retains the rights to service the mortgage loans it produces. In addition, Source One may purchase servicing rights from banks, thrift institutions and other mortgage lenders. There were no significant purchases of mortgage servicing rights by Source One during 1998 and 1997. Source One also sells servicing rights when management deems it economically advantageous. During 1998 Source One sold the rights to service $10.6 billion of nonrecourse mortgage loans and continues to subservice a large portion of these loans pursuant to a subservicing agreement. During 1997 Source One sold the rights to service a $17.0 billion portfolio of nonrecourse mortgage loans and continues to subservice a portion of these loans pursuant to a subservicing agreement. The following table summarizes the changes in Source One's mortgage loan servicing portfolio, excluding loans sold but not transferred: Year Ended December 31, --------------------------------------------------- Billions 1998 1997 1996 1995 1994 - ------------------------------------------------------------------------------------------------------- Servicing portfolio owned at beginning of year $ 11.6 $ 26.4 $ 27.8 $ 35.3 $ 38.4 --------------------------------------------------- Mortgage loan production 10.9 4.4 3.8 2.9 4.6 Servicing acquisitions and other -- -- 2.8 4.7 3.7 Total servicing in 10.9 4.4 6.6 7.6 8.3 Regular payoffs 1.6 1.2 3.0 2.3 4.7 Sales of servicing 10.6 17.0 3.3 11.0 3.9 Principal amortization, foreclosures and other 1.1 1.0 1.7 1.8 2.8 Total servicing out 13.3 19.2 8.0 15.1 11.4 Servicing portfolio owned 9.2 11.6 26.4 27.8 35.3 Subservicing portfolio 15.9 14.9 2.8 4.0 4.3 Balance at end of year $ 25.1 $ 26.5 $ 29.2 $ 31.8 $ 39.6 - ------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------- COMPETITION 18 Source One competes nationally and locally for loan production with other mortgage banks, state and national banks, thrift institutions and insurance companies. National banks and thrift institutions have substantially more flexibility in their loan origination programs than Source One, which generally originates loans meeting the standards of the secondary market. Mortgage lenders compete primarily with respect to price and service. Competition may also occur on mortgage terms and closing costs. Source One competes, in part, by using its commissioned sales force to maintain close relationships with real estate brokers, builders and developers and members of its correspondent and broker network. It is the opinion of the management of Source One that no single mortgage lender dominates the industry. INVESTMENT PORTFOLIO MANAGEMENT Fund American's philosophy is to invest all assets to maximize their after tax total return over extended periods of time. Under this approach, each dollar of after tax investment income, realized capital gains and unrealized appreciation is valued equally. Management further believes that insurance company float generated should be invested in a "balanced portfolio" consisting of a mixture of fixed income investments, equity securities and occasionally other investments in order to maximize returns over extended periods of time. This investment philosophy of Fund American is established and administered by the Fund American and White Mountains Finance Committees. The Finance Committees also regularly monitor the overall investment results of Fund American, review the results of each of Fund American's various investment managers, review compliance with established investment guidelines, approve all purchases and sales of investment securities and ultimately report the overall investment results to the Company's Board of Directors (the "Board"). The fixed income portfolios of Valley, Charter and WMIC are actively managed by an affiliate of MSA pursuant to discretionary management agreements. The fixed income and equity investment portfolio and other investments of Folksamerica are managed internally by employees of Folksamerica. The equity investment portfolios and other investments of the Company, White Mountains, Valley, Charter and WMIC are managed by a small group of employees located in Hanover, New Hampshire and various internal and external portfolio managers pursuant to discretionary management agreements. FAE's investment portfolio is primarily managed by a small group of employees located in White River Junction, Vermont. As previously stated, the investment portfolios of Fund American's insurance operations consist, in part, of common equity securities and related investments as follows: (i) $143.0 million at Folksamerica or approximately 15% of Folksamerica's total investment portfolio at December 31, 1998; (ii) $48.5 million at Valley and Charter or approximately 28% of Valley and Charter's total investment portfolio at 19 December 31, 1998; and (iii) $26.7 million at WMIC or approximately 83% of WMIC's total investment portfolio at December 31, 1998. Management believes that modest investments of equity securities within the investment portfolios of its insurance operations will enhance their after tax returns without significantly increasing the risk profile of the portfolio when considered over long periods of time. CERTAIN BUSINESS CONDITIONS Inflation and changes in market interest rates can have significant effects on White Mountains' insurance operations. Inflation increases the costs of settling insurance claims over time. Increases in market interest rates, which often occur during periods of high inflation, reduce the market value of the insurance operations' fixed-income investments. Conversely, reductions in market interest rates increase the market value of White Mountains' fixed-income investments. Changes in the economy or prevailing interest rates can also have significant effects, including material adverse effects, on the mortgage banking industry including Source One. Inflation and changes in interest rates can have differing effects on various aspects of Source One's business, particularly with respect to marketing gains and losses from the sale of mortgage loans, mortgage loan production, the value of Source One's servicing portfolio and net interest revenue. Historically, Source One's loan originations and loan production income have increased in response to falling interest rates and have decreased during periods of rising interest rates. Periods of low inflation and falling interest rates tend to reduce loan servicing income and the value of Source One's mortgage loan servicing portfolio because prepayments of mortgages increase and the average life of mortgage servicing rights is shortened. Conversely, periods of increasing inflation and rising interest rates tend to increase loan servicing income and the value of Source One's mortgage servicing rights because prepayments of mortgages decline and the average life of loan servicing rights is lengthened. In an attempt to mitigate Source One's exposure to changes in market interest rates, Source One utilizes various derivative financial instruments. See "Management's Discussion and Analysis". REGULATION Folksamerica, Valley, Charter and WMIC are subject to regulation and supervision of their operations in each of the jurisdictions where they conduct business. Regulations vary between jurisdictions but, generally, they provide regulatory authorities with broad supervisory, regulatory and administrative powers over such matters as licenses, standards of solvency, premium rates, policy forms, investments, security deposits, methods of accounting, form and content of financial 20 statements, reserves for unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends and other distributions to shareholders, periodic examinations and annual and other report filings. Over the last several years most states have, and continue to implement, laws which establish standards for current, as well as continued, state accreditation. In addition, the National Association of Insurance Commissioners has adopted risk-based capital ("RBC") standards for property and casualty companies. The RBC ratios for Folksamerica, Valley, Charter and WMIC, as of December 31, 1998 and 1997, were above the levels which would require regulatory action. Source One is subject to the rules and regulations of, and examinations by, investors and insurers including FNMA, FHLMC, GNMA, FHA and VA with respect to the origination and selling and servicing of mortgage loans. Lenders are required to submit audited financial statements annually and to maintain specified net worth levels which vary depending on the amount of loans serviced and annual production. Mortgage loan origination activities are also subject to fair housing laws, the Equal Credit Opportunity Act, the Federal Truth-in-Lending Act, the Real Estate Settlement Procedures Act, the Fair Credit Reporting Act, licensing laws, usury laws, the Home Mortgage Disclosure Act, and other regulations which, among other things, prohibit discrimination in residential lending and require disclosure of certain information to borrowers. There are various other state laws and regulations affecting Source One's mortgage banking operations. Source One's internal audit function (which is managed by Source One but is outsourced to a third party) and quality control departments monitor compliance with all these laws and regulations. Fund American is not aware of any current recommendations by regulatory authorities that would be expected to have a material effect on its results of operations or liquidity or any other matters that would require disclosure herein. EMPLOYEES As of December 31, 1998, the Company employed 11 persons and White Mountains employed 2,825 persons (including 261 persons at Valley, 186 persons at Charter, 34 persons at WMIC, 2,212 persons at Source One, 125 persons at Folksamerica and 3 persons at FAE). None of Fund American's employees are covered by a collective bargaining agreement. Management believes that Fund American's employee relations are good. FORWARD-LOOKING STATEMENTS From time to time, the Company may publish forward-looking statements relating to such matters as anticipated financial 21 performance, business prospects, new products and similar matters. This information is often subject to various risks and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that numerous factors could cause actual results and experience to differ materially from anticipated results or other expectations expressed in its forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company's business include those discussed elsewhere herein (such as those involving competition, regulation and certain business conditions). ITEM 2. PROPERTIES The Company leases 8,600 square feet of space at 80 South Main Street, Hanover, New Hampshire, under a lease expiring in 2006, which serves as its corporate office. Folksamerica leases 40,000 square feet of office space in New York, New York, under a lease expiring 2004, which serves as its principal office. Charter leases 56,000 square feet of office space in Richardson, Texas under a lease expiring in 2007, which serves as its principal office. Valley and Source One own their principal offices in Albany, Oregon and Farmington Hills, Michigan, respectively. Fund American leases several other office facilities and operating equipment under cancelable and noncancelable agreements. Most leases contain renewal clauses. ITEM 3. LEGAL PROCEEDINGS Various claims have been made against Fund American in the normal course of its business. In management's opinion, the outcome of such claims will not, in the aggregate, have a material effect on Fund American's financial position or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of Fund American's shareholders during the fourth quarter of 1998. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS As of March 22, 1999, there were 470 registered holders of shares of the Company's Common Stock, par value $1.00 per share ("Shares"). During 1998 and 1997 the Company declared and paid quarterly cash dividends of $.40 per Share and $.20 per Share, respectively. The Board currently intends to reconsider from time to time the declaration of regular periodic dividends on Shares with due consideration given to the financial characteristics of Fund American's remaining invested 22 assets and operations and the amount and regularity of its cash flows at the time. The Company's Common Stock (symbol FFC) is listed on the NYSE. The quarterly trading range for Shares during 1998 and 1997 is presented below: 1998 1997 ----------------------- ----------------------- High Low High Low - --------------------------------------------------------------------- Quarter ended: December 31 $144 3/8 $117 $124 $105 1/4 September 30 153 1/4 119 108 99 1/2 June 30 150 1/4 135 9/16 110 1/2 98 March 31 137 5/16 120 1/8 109 3/4 94 - --------------------------------------------------------------------- - --------------------------------------------------------------------- 23 ITEM 6. SELECTED FINANCIAL DATA Selected consolidated income statement data and ending balance sheet data for each of the five years ended December 31, 1998, follows: Year Ended December 31, -------------------------------------------------------------------------- Millions, except per share amounts 1998(a) 1997 1996 1995 1994 -------------------------------------------------------------------------- INCOME STATEMENT DATA: Revenues $ 578 $ 310 $ 325 $ 222 $ 228 Expenses 519 329 336 234 219 Pretax operating earnings (loss) 59 (19) (11) 4 9 Net realized investment gains 71 97 39 39 39 Pretax earnings 130 78 28 43 48 Income tax provision 48 29 19 17 21 After tax earnings 82 49 9 26 27 Loss on early extinguishment of debt, after tax -- (6) -- -- -- Gain from sale of discontinued operations, after tax -- -- -- 66(b) -- Cumulative effect of accounting change - purchased mortgage servicing, after tax -- -- -- -- (44)(c) Net income (loss) 82 43 9 92 (17) Other comprehensive income (loss), after tax (9) 42(d) 54 18 (55) Comprehensive net income (loss) $ 73 $ 85 $ 63 $ 110 $ (72) Basic earnings per share: After tax earnings $ 13.38 $ 6.89 $ .66 $ 1.88 $ 1.27 Net income (loss) 13.38 5.98 .66 10.30 (3.72) Comprehensive net income (loss) 11.87 12.33(d) 8.01 12.64 (9.89) Diluted earnings per share: After tax earnings 11.94 6.22 .60 1.71 1.20 Net income (loss) 11.94 5.40 .60 9.36 (3.51) Comprehensive net income (loss) 10.58 11.15(d) 7.33 11.48 (9.34) Cash dividends paid per share of common stock 1.60 .80 .80 .20 -- ENDING BALANCE SHEET DATA: Total assets $ 3,281 $ 2,010(d) $ 1,981 $ 1,872 $ 1,807 Short-term debt 749 571 408 445 254 Long-term debt 360 304 424 407 547 Minority interest - preferred stock of subsidiary 44 44 44 44 100 Shareholders' equity 703 659(d) 687(e) 700(e) 661(e) Book value per common and equivalent share (f) 109.68(g) 100.08(d) 90.81 83.28 68.95 24 (a) Includes the ending balance sheet and the interim period results of operations of Folksamerica which was acquired by Fund American on August 18, 1998. (b) Reflects the settlement of certain tax liabilities relating to the sale of Fireman's Fund Insurance Company ("Fireman's Fund") for less than the previously accrued amount. (c) Reflects the prior years' cumulative effect of a change in Source One's methodology used to measure impairment of its purchased mortgage servicing rights asset. (d) Restated as a result of Fund American's acquisition of Folksamerica during 1998. See Note 2. (e) Reflects significant redemptions of the Company's Voting Preferred Stock Series D, par value $1.00 per share and repurchases of Shares. (f) Book value per common share as adjusted for the after tax dilutive effects of outstanding options and warrants to acquire Shares. (g) Excludes a $37.1 million unamortized deferred credit associated with Fund American's purchase of Folksamerica which will serve to increase the Company's future book value per common and equivalent share by $5.43 over an approximate five year period. See Note 2. 25 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS: YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 CONSOLIDATED RESULTS Fund American reported comprehensive net income of $73.3 million for the year ended December 31, 1998, which compares to comprehensive net income of $84.7 million and $63.2 million for 1997 and 1996, respectively. Comprehensive net income for 1998 includes after tax unrealized investment holding gains of $37.2 million versus $104.6 million and $79.6 million for 1997 and 1996, respectively. Net income, which does not include comprehensive income items (primarily unrealized investment holding gains and losses), for 1998 was $82.2 million versus $43.0 million and $8.6 million for 1997 and 1996, respectively. Net income for 1998 includes after tax realized investment gains of $46.1 million versus $62.9 million and $25.0 million for 1997 and 1996, respectively. Net income applicable to common stock (which is net of preferred stock dividends) for 1998, 1997 and 1996 was $78.5 million, $39.3 million and $4.9 million, respectively. Book value per common and common equivalent share was $109.68 at December 31, 1998 ($115.11 including the after tax unamortized deferred credit associated with Fund American's purchase of Folksamerica in August 1998), which compares to $100.08 at December 31, 1997. Strong operating results at the Company's reinsurance and mortgage banking subsidiaries and favorable investment portfolio results produced most of the increase in book value per share from 1997 to 1998. INSURANCE OPERATIONS REINSURANCE OPERATIONS Folksamerica contributed $10.0 million to net income during 1998, which includes $4.5 million of net income from January 1, 1998 to August 18, 1998 during which Folksamerica was an unconsolidated affiliate and $5.5 million of net income during which Folksamerica was consolidated. Folksamerica contributed $5.2 million and $2.4 million to net income as an unconsolidated insurance affiliate during 1997 and 1996, respectively. Folksamerica's results for the three years ended December 31, 1998, 1997 and 1996 included $238.1 million, $238.0 million and $181.4 million of earned reinsurance premiums, respectively, and $170.3 million, $165.6 million and $138.6 million of losses and loss adjustment expenses, respectively. For 1998 Folksamerica's combined ratio was 108.0% versus a combined ratio of 102.9% and 108.9% for the comparable 1997 and 1996 periods. 26 A summary of Folksamerica's 1998, 1997 and 1996 underwriting results follows: Year Ended December 31, -------------------------------------- Dollars in millions 1998 1997 1996 - ---------------------------------------------------------------------------- Net written premiums $ 212.6 $ 232.4 $ 171.9 -------------------------------------- Earned premiums 238.1 238.0 181.4 Losses and loss adjustment expenses 170.3 165.6 138.6 Underwriting expenses 92.6 81.6 54.8 Underwriting loss $ (24.8) $ (9.2) $ (12.0) Combined ratios: Loss and loss adjustment expense 71.5% 69.6% 76.4% Underwriting expense 36.5 33.3 32.5 -------------------------------------- Combined 108.0% 102.9% 108.9% - ---------------------------------------------------------------------------- - ---------------------------------------------------------------------------- 27 During 1998, Folksamerica's written premium volume decreased approximately 9% versus 1997 premium levels reflecting an increase in non-renewed business due to deteriorating terms and conditions. Folksamerica's combined ratio for 1998 was higher than that of 1997 due primarily to two property events experienced during the year (Canadian ice storms and Hurricane Georges) and higher asbestos and environmental losses. During 1997, Folksamerica's premium volume increased approximately 35% versus 1996 premium levels reflecting its acquisition of Christiania General Insurance Corporation in June 1996. As previously mentioned, Folksamerica underwrites each reinsurance contract anticipating an element of underwriting profit. The anticipated degree of underwriting profit varies by contract and is based on a variety of factors which can include some degree of float. Despite this expectation on an individual contract basis, Folksamerica's reported results for the years ended December 31, 1998, 1997 and 1996 included overall underwriting losses due to the following: (i) actual results on some accounts or classes have produced higher than anticipated loss costs. Considering the highly competitive market conditions, there has been insufficient margin in profitable accounts to absorb higher loss costs produced by other accounts; (ii) higher than anticipated property catastrophe losses, particularly during 1998; and (iii) continued strengthening of reserve portfolios relating to acquired companies, particularly for claims related to mass torts. In this regard, Folksamerica has built ample protections into its prior acquisition structures which partially mitigate the underwriting losses. The financial benefits of those protections are generally not reflected in the underwriting results, rather, such benefit is included in "other insurance operations revenue" in the income statement. Since Folksamerica's claims settlement period generally extends over a long period of time, Folksamerica earns significant amounts of investment income on the float generated by its reinsurance operations. When considering investment income and certain other items at the Folksamerica holding company level (primarily interest expense and income taxes), Folksamerica reported net income of $27.3 million, $35.9 million and $17.1 million for the three years ended December 31, 1998, 1997 and 1996, respectively, and reported comprehensive net income of $53.3 million, $50.9 million and $18.4 million during those periods, respectively. This resulted in Folksamerica attaining an after tax return on its beginning equity of 20.9%, 29.9% and 16.0% for 1998, 1997 and 1996, respectively. The following table presents the subsequent development of the year-end reinsurance losses for the ten year period from 1988 to 1998. Section I of the table shows the estimated liabilities that were recorded at the end of each of the indicated years for all current and prior year unpaid losses and loss adjustment expenses ("lae"). Section II shows the re-estimate of the liabilities made in each succeeding year. Section III shows the cumulative liabilities paid of such previously recorded liabilities. Section IV shows the cumulative deficiency representing the aggregate change in the liability from the original balance sheet dates: 28 Reinsurance Losses and Loss Adjustment Expenses (a) Year Ended December 31, ---------------------------------------------------------------------------------------------------- Dollars in Millions 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------------------------- I. Liability for unpaid losses and lae $267.7 $312.7 $355.2 $425.2 $647.1 $670.6 $709.7 $760.8 $740.8 $739.1 $723.2 II. Liability re-estimated as of: 1 year later 276.7 321.5 388.8 456.3 695.4 701.1 768.7 786.4 765.2 755.8 - 2 years later 279.0 353.1 413.3 462.2 717.0 757.3 797.8 810.4 785.4 3 years later 301.4 376.1 415.4 476.9 759.2 779.2 818.6 833.0 4 years later 326.5 378.0 424.9 496.6 770.4 800.1 837.5 5 years later 328.7 391.0 438.2 499.2 795.0 817.1 6 years later 344.2 400.5 441.7 509.6 808.9 7 years later 351.4 403.7 450.4 516.0 8 years later 354.5 410.4 456.8 9 years later 364.6 415.7 10 years later 370.3 III. Cumulative amount of liability paid through: 1 year later 66.0 84.5 93.8 119.4 220.8 201.5 203.1 214.1 183.1 175.0 - 2 years later 103.5 135.4 154.7 179.1 338.1 324.9 341.4 339.5 305.6 3 years later 131.7 171.5 191.7 233.9 416.5 422.6 432.4 424.5 4 years later 156.1 195.5 226.8 278.3 487.2 487.7 494.5 5 years later 172.1 221.6 258.3 312.4 534.0 529.4 6 years later 193.5 243.7 285.0 339.1 563.1 7 years later 211.4 265.5 304.7 353.0 8 years later 229.2 278.6 314.4 9 years later 242.8 286.4 10 years later 250.2 IV. Cumulative deficiency $102.6 $103.0 $101.6 $ 90.8 $161.8 $146.4 $127.9 $72.2 $44.6 $16.8 - Percent deficient 38% 33% 29% 21% 25% 22% 18% 9% 6% 2% - - --------------------------------------------------------------------------------------------------------------------------------- (1) For the years 1988 through 1991 liabilities are shown net of reinsurance recoverable. For the years 1992 through 1998 liabilities are shown without regard to reinsurance recoverable in accordance with SFAS No. 113. The table excludes 29 the insurance operations of VGI whose liability for unpaid losses and lae totalled $88.5 million, $71.9 million and $65.4 million as of December 31, 1998, 1997 and 1996, respectively. Historic data for VGI is not considered to be meaningful due to Charter reinsuring all of its business to its former owner for periods prior to 1996. During 1998 and 1996, VGI's losses and loss adjustment expenses relating to prior years developed unfavorably by $6.7 million and $3.5 million, respectively. During 1997, VGI's losses and loss adjustment expenses relating to prior years developed favorably by $2.5 million pretax. The table above has been prepared in accordance with prescribed instructions, however, management believes that this information is not indicative of Folksamerica's actual loss development history for the following reasons: (i) with respect to 1992 through 1998, the information is presented prior to considering the benefit of significant amounts of ceded reinsurance recovered (and recoverable) from Folksamerica's reinsurers; (ii) the information includes the complete loss development history for companies acquired by Folksamerica for all periods presented, including periods prior to Folksamerica's acquisition of such companies; and (iii) the structure of each of Folksamerica's acquisitions has provided effective economic protections to offset potential post-acquisition loss development. The form of these protections has included deferred and adjustable purchase consideration and favorable purchase prices. In consideration of such factors, the table presented below is management's attempt to adjust the deficiencies presented above for the most recent five years: Year Ended December 31, --------------------------------------- Percent of deficit to carried 1994 1995 1996 1997 1998 reserves: - ---------------------------------------------------------------------- Deficiency as reported 18% 9% 6% 2% -% Deficiency as adjusted for the effects described above 3% 2% 1% -% -% - ---------------------------------------------------------------------- - ---------------------------------------------------------------------- INSURANCE OPERATIONS Valley, Charter and WMIC represent Fund American's consolidated insurance subsidiaries. Valley, Charter and WMIC's results for the years ended December 31, 1998, 1997 and 1996, included $160.6 million, $145.3 million and $109.7 million of property and casualty insurance premiums earned, respectively, and $115.1, $97.1 million and $85.9 million of losses and loss adjustment expenses, respectively. A summary of 1998, 1997 and 1996 underwriting results for Valley, Charter and WMIC follows: Year Ended December 31, 1998 ------------------------------------- Dollars in millions Valley Charter WMIC - --------------------------------------------------------------------------- Net written premiums $ 94.3 $ 64.3 $ 6.3 ------------------------------------- Earned premiums 91.1 64.2 5.3 Losses and loss adjustment expenses 67.8 43.7 3.6 Underwriting expenses 31.3 15.5 3.5 Underwriting profit (loss) $ (7.9) $ 5.0 $ (1.8) Combined ratios: Loss and loss adjustment expense 74.4% 68.0% 67.3% Underwriting expense 33.5 23.8 61.1 ------------------------------------- Combined 107.9% 91.8% 128.4% - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- 30 Year Ended December 31, 1997 ------------------------------------- Dollars in millions Valley Charter WMIC - --------------------------------------------------------------------------- Net written premiums $ 83.2 $ 62.9 $ 4.7 ------------------------------------- Earned premiums 79.6 62.4 3.3 Losses and loss adjustment expenses 51.8 41.8 3.5 Underwriting expenses 28.3 17.1 2.0 Underwriting profit (loss) $ (.5) $ 3.5 $ (2.2) Combined ratios: Loss and loss adjustment expense 65.0% 66.9% 107.8% Underwriting expense 34.8 27.3 53.1 ------------------------------------- Combined 99.8% 94.2% 160.9% - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Year Ended December 31, 1996 ------------------------------------- Dollars in millions Valley Charter WMIC - --------------------------------------------------------------------------- Net written premiums $ 75.1 $ 69.9 $ 2.0 ------------------------------------- Earned premiums 70.7 37.7 1.3 Losses and loss adjustment expenses 54.4 30.3 1.2 Underwriting expenses 24.8 8.0 .9 Underwriting loss $ (8.5) $ (.6) $ (.8) Combined ratios: Loss and loss adjustment expense 76.8% 80.4% 95.8% Underwriting expense 34.9 18.9 50.4 ------------------------------------- Combined 111.7% 99.3% 146.2% - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- 31 Valley's 1998 underwriting results suffered from losses in certain of its commercial lines business (primarily within Washington) which resulted in an underwriting ratio of 107.9% for the year and an underwriting loss of $7.9 million. Charter's 1998 underwriting results produced a satisfactory 91.8% combined ratio and a $5.0 million underwriting profit. For 1998, Charter's policy counts increased strongly but total premiums were down due to price reductions, a shift towards liability-only policies and a shift towards six-month policies. WMIC's loss and loss adjustment expense ratio for 1998 of 67.3% shows significant improvement over prior year results but its expense ratio for 1998 of 61.1% will not be meaningful for some time. WMIC's premium volumes must grow significantly from current levels to provide sufficient expense ratio economies of scale. Valley and Charter's 1997 underwriting results produced satisfactory combined ratios and an overall underwriting profit. However, premium growth at both Valley and Charter suffered during 1997 as a result of increased competition in the marketplace which illustrates Fund American's underwriting discipline in a highly competitive market. WMIC's 1997 results were adversely impacted by several large workers' compensation claims although underwriting results on this small and growing book of business are not yet considered to be meaningful. Valley's 1996 underwriting results were adversely impacted by severe fourth quarter storm-related losses and by $3.5 million in reserve strengthening for losses and loss adjustment expenses incurred in prior years. Charter's earned premiums trailed net written premiums during 1996 because Charter began to retain virtually all its written premiums. Charter's policies written prior to 1996 were fully ceded to a former affiliate of Charter. Valley, Charter and WMIC's claims are normally settled in a more timely manner than those of Folksamerica which limits the amount of investment income that can be generated on the earned and unearned insurance premiums that it has received from its policyholders. When considering investment income and certain other items of VGI (primarily interest expense, income taxes and goodwill amortization), VGI reported net income (loss) of $5.0 million, $7.2 million and $(2.6) million for the three years ended December 31, 1998, 1997 and 1996, respectively, and reported comprehensive net income (loss) of $11.4 million, $13.6 million and $(1.8) million during those periods, respectively. This resulted in VGI attaining an after tax return (loss) on equity of 11.0%, 14.8% and (1.9)% for 1998, 1997 and 1996, respectively. INVESTMENTS IN UNCONSOLIDATED INSURANCE AFFILIATES FSA and MSA represented Fund American's investments in unconsolidated insurance affiliates at December 31, 1998. Fund American's investment in FSA increased $42.0 million during 1998 which consisted of $13.8 million of pretax earnings from FSA Common Stock, $26.6 million of pretax unrealized investment gains from FSA Options and Preferred Stock, $3.1 million of pretax unrealized investment gains 32 from FSA's investment portfolio, less $1.5 million of dividends received from FSA Common Stock. White Mountains' investment in MSA increased $9.0 million during 1998 (excluding White Mountains' additional purchase of MSA Common Stock for $70.3 million in February 1998) which consisted of $4.9 million of pretax earnings from MSA Common Stock and $4.1 million of pretax unrealized investment gains from MSA's investment portfolio. FSA, MSA, Folksamerica and Murray Lawrence represented Fund American's investments in unconsolidated insurance affiliates as of December 31, 1997. Fund American's investment in FSA increased $80.0 million during 1997 which consisted of $11.4 million of pretax earnings from FSA Common Stock, $68.0 million of pretax unrealized investment gains from FSA Options and Preferred Stock, $2.1 million of pretax unrealized investment gains from FSA's investment portfolio, less $1.5 million of dividends received from FSA Common Stock. White Mountains' investment in MSA increased $6.2 million during 1997 which consisted of $3.8 million of pretax earnings from MSA Common Stock and $2.4 million of pretax unrealized investment gains from MSA's investment portfolio. White Mountains' investment in Folksamerica increased $2.7 million during 1997 (excluding White Mountains' purchase of Folksamerica Common Stock for $20.8 million during December 1997) which consisted of $.9 million of pretax earnings from Folksamerica Common Stock and $1.8 million of pretax unrealized investment gains from Folksamerica's investment portfolio. White Mountains investment in Murray Lawrence, which was acquired on December 8, 1997, remained at its cost of $23.6 million during 1997. FSA, MSA and Folksamerica represented Fund American's investments in unconsolidated insurance affiliates as of December 31, 1996. Fund American's investment in FSA increased $23.1 million during 1996 (excluding Fund American's purchase of 1,000,000 additional shares of FSA Common Stock for $26.5 million during 1996) which consisted of $7.8 million of pretax earnings from FSA Common Stock, $17.3 million of pretax unrealized investment gains from FSA Options and Preferred Stock, less $1.0 million of pretax unrealized investment losses from FSA's investment portfolio, less $1.0 million of dividends received from FSA Common Stock. White Mountains' investment in MSA increased $1.0 million during 1996 which consisted of $1.5 million of pretax earnings from MSA Common Stock offset by $.5 million of pretax unrealized investment losses from MSA's investment portfolio. White Mountains' investment in Folksamerica increased $.2 million from June 1996 to December 31, 1996. MORTGAGE BANKING OPERATIONS For the year ended December 31, 1998, Source One's mortgage banking operations contributed $33.2 million of net income to Fund American versus net losses of $22.1 million and $8.0 million for during 1997 and 1996, respectively. Source One's 1998 results include a $15.2 million 33 pretax, $9.9 million after tax, gain on sales of mortgage servicing rights. Source One's 1997 results included the following charges: (i) a $6.0 million after tax extraordinary loss on early extinguishment of debt, (ii) restructuring and compensation charges of $3.1 million pretax, $2.0 after tax, associated with Source One's plan to reduce its operating costs and improve its financial performance, (iii) an $8.0 million pretax, $5.2 million after tax, loss on sales of mortgage servicing rights and assumption of subservicing and (iv) a $17.7 million pretax, $11.5 million after tax, charge to Source One's valuation allowance for impairment of their capitalized mortgage loan servicing portfolio. Source One's 1996 results include a $29.1 million pretax ($25.9 after tax) write-off of goodwill and certain other intangible assets which was partially offset by a $10.1 million pretax, $6.6 million after tax, gain on sales of mortgage servicing rights. Gross mortgage servicing revenue was $78.1 million for the year ended December 31, 1998 which compares to $94.9 million in 1997 and $139.6 million in 1996. The decrease in gross mortgage servicing revenue from 1996 to 1998 is primarily the result of sales of mortgage servicing rights with respect to $10.6 billion and $17.0 billion of mortgage loans during 1998 and 1997, respectively. Source One's net mortgage servicing revenue was $43.3 million for the year ended December 31, 1998 which compares to $38.2 million in 1997 and $70.3 million in 1996. Net mortgage servicing revenue for the year ended December 31, 1998 was enhanced by $20.4 million of pretax net gains on financial instruments versus gains of $11.3 million for 1997 and $9.9 million for 1996. Source One utilizes interest rate floor contracts, interest rate swap agreements and principal only swap agreements to mitigate the effect on earnings of higher amortization and impairment of the capitalized servicing asset caused by changes in market interest rates. These financial instruments are carried at fair value on the balance sheet with unrealized and realized gains reported as net gains on financial instruments on the income statement. Source One's management believes that these financial instruments have proven to be an effective means to substantially offset fluctuations in the value of Source One's mortgage servicing asset caused by changes in market interest rates. Net gains on sales of mortgages were $86.8 million for the year ended December 31, 1998, versus $21.5 million in 1997 and $38.3 million in 1996. The increase in gains from 1997 to 1998 reflects significant increases in Source One's correspondent production and related mortgage sales volumes during the period. The decrease in gains from 1996 to 1997 are due primarily to a change in Source One's loan production mix which included a proportionately higher volume of correspondent production during 1997 versus 1996 (which generates lower originated mortgage servicing rights income). During 1998 Source One sold the rights to service $10.6 billion of nonrecourse mortgage loans for cash proceeds of $227.9 million, resulting in a pretax gain of $15.2 million. During 1997 Source One 34 sold the rights to service $17.0 billion of nonrecourse mortgage loans for cash proceeds of $266.9 million, resulting in a pretax loss of $8.0 million. As part of the 1998 and 1997 servicing sales, Source One retained the right to subservice $4.1 billion and $17.0 billion of these loans, respectively, for a contracted fee through 2001. During 1996 Source One sold the rights to service $3.3 billion of mortgage loans for net proceeds of $55.9 million, resulting in a pretax gain of $10.1 million. Total mortgage loan production for the years ended December 31, 1998, 1997 and 1996, was $10.9 billion, $4.4 billion and $3.8 billion, respectively. The increase in production from 1996 to 1998 is reflective of overall lower market interest rates and a corresponding increase in refinancing activities during the period. Production related to refinancing activities made up 61%, 40% and 33% of total production during 1998, 1997 and 1996, respectively. INVESTMENT OPERATIONS The total return from Fund American's investment activities (excluding net unrealized investment holding gains and losses from Fund American's investments in unconsolidated insurance affiliates) is shown below: Year Ended December 31, ---------------------------------- Millions 1998 1997 1996 - ---------------------------------------------------------------------------- Net investment income: Mortgage banking operations $ 81.6 $ 43.5 $ 40.8 Insurance operations, reinsurance operations and other 36.8 21.6 16.5 ---------------------------------- Total net investment income 118.4 65.1 57.3 Net unrealized investment holding gains arising during the period 26.8 86.6 106.5 ---------------------------------- Total net investment return, before tax $ 145.2 $ 151.7 $ 163.8 - ---------------------------------------------------------------------------- - ---------------------------------------------------------------------------- Fund American's investment income is comprised primarily of interest income earned on mortgage loans originated by Source One, interest income associated with the fixed maturity investments of its consolidated insurance and reinsurance operations and dividend income from its equity investments. The increase in net investment income from mortgage banking operations from 1996 to 1998 is mainly attributable to an increase in interest income from mortgage loans held for sale due to higher mortgage loan production experienced during 35 those periods, particularly during 1998. The increase in net investment income from insurance, reinsurance and other from 1997 to 1998 is primarily the result of the addition of Folksamerica's sizable fixed income portfolio in August 1998. The increase in net investment income from insurance, reinsurance and other from 1996 to 1997 is a result of increases in investment income from White Mountains' growing portfolio of fixed maturity investments. Net realized investment gains of $71.0 million recorded during 1998 resulted principally from the sale of all Fund American's holdings (1,014,250 common shares) of White River Corporation for net proceeds of $92.1 million. The total cash received by Fund American included the sales proceeds associated with shares which were being held for delivery upon the exercise of existing employee stock options (295,432 common shares or $17.8 million) and is payable to the recipient at a future date pursuant to the Company's nonqualified retirement plan. Net realized investment gains of $96.7 million recorded during 1997 included $37.2 million of pretax gains from the sale of 1,980,982 shares of the common stock of Travelers Property Casualty Corp. for net proceeds of $69.2 million, $24.3 million of pretax gains from the sale of 5,000,000 units of beneficial interest of San Juan Basin Royalty Trust for net proceeds of $45.7 million, $10.3 million of pretax gains from the sale of 388,140 shares of the common stock of Mid Ocean Limited ("Mid Ocean") for net proceeds of $22.6 million and $15.5 million of pretax gains from the sale of 834,895 shares of the common stock of Veritas DGC Inc. for net proceeds of $20.9 million. Net realized investment gains of $38.5 million recorded during 1996, before tax, included $27.2 million of pretax gains from the sale of 2,928,100 shares of the common stock of The Louisiana Land & Exploration Company common stock for net proceeds of $125.1 million, $1.4 million of pretax gains from the sale of 2,042,572 shares of the common stock of Zurich Reinsurance Centre Holdings, Inc. for net proceeds of $61.8 million and $9.3 million of pretax gains from the sale of 600,000 of the shares of common stock of Mid Ocean for net proceeds of $28.2 million. EXPENSES Insurance losses and loss adjustment expenses totalled $174.8 million for 1998 versus $97.1 million for 1997 and $85.9 million for 1996. Insurance and reinsurance acquisition expenses totalled $54.8 million for 1998 versus $23.2 million for 1997 and $15.2 million for 1996. The increase in these insurance expenses from 1997 to 1998 is primarily attributable to the inclusion of Folksamerica in the Company's consolidated results during the 1998 third quarter. The 36 increase in these insurance expenses from 1996 to 1997 is due to an increase in insurance premium volumes at Valley, Charter and WMIC. During 1998 and 1996, losses and loss adjustment expenses relating to prior years developed unfavorably by $6.7 million and $3.5 million, respectively. During 1997, losses and loss adjustment expenses relating to prior years developed favorably by $2.5 million pretax. Compensation and benefits expenses totalled $130.2 million for 1998 versus $101.8 million for 1997 and $91.3 million for 1996. The increase in compensation and benefits expense from 1997 to 1998 is due to an increase in production-related compensation at Source One and the inclusion of $7.1 million of Folksamerica's compensation and benefits expenses for 1998. The increase in compensation and benefits expense from 1996 to 1997 is primarily due to an increase in stock-based compensation accruals associated with certain of the Company's long-term compensation plans and its qualified and nonqualified retirement plans. During 1997 the market value of the Company's common stock rose 26%. Interest expense of $83.9 million for 1998 compares to $46.0 million for 1997 and $46.3 million for 1996. The increase in interest expense from 1997 to 1998 reflects: (i) an increase in average indebtedness outstanding during 1998 at Source One as a result of significantly higher mortgage loan production volumes; (ii) the inclusion of $1.4 million of Folksamerica's interest expense for 1998; and (iii) an increase in average indebtedness under White Mountains' $50.0 million revolving credit facility associated with its 1998 acquisition of Folksamerica and its 1998 increase in its investment in MSA. General expenses of $75.4 million for 1998 compares to $60.5 million for 1997 and $64.9 million for 1996. The increase in compensation and benefits expense from 1997 to 1998 is due to an increase in production-related general expenses at Source One and the inclusion of $1.3 million of Folksamerica's general expenses for 1998. Source One's provision for mortgage loan losses, included in general expenses, was $3.8 million in 1998 which compares to $4.7 million for 1997 and $3.0 million for 1996. The decrease in provision for loan losses from 1996 to 1998 primarily reflects significant reductions in the size of Source One's owned mortgage servicing portfolio during the period. Source One has established an allowance for mortgage loan losses which totalled $11.5 million and $12.8 million as of December 31, 1998 and 1997, respectively. In addition, Source One has established a $5.2 million and $8.2 million pretax reserve for estimated losses on its principal recourse portfolio as of December 31, 1998 and 1997, respectively. Source One believes that its total allowances are adequate to provide for estimated uninsured losses on the mortgage servicing portfolio. INCOME TAXES 37 The income tax provision related to pretax earnings for 1998, 1997 and 1996 represents an effective tax rate of 36.8%, 37.5% and 68.7%, respectively. The primary reason for the high effective tax rate experienced in 1996 was the write-off of goodwill and certain other intangible assets related to Source One. The total pretax write-off of these assets was $32.6 million and the related tax benefit was $3.2 million. Fund American recorded a net deferred Federal income tax asset of $7.8 million as of December 31, 1998. The 1998 net deferred tax asset includes $142.9 million of deferred tax assets (relating primarily to various operating items) partially offset by $135.1 million of deferred tax liabilities (relating primarily to net unrealized investment holding gains). Fund American recorded a net deferred Federal income tax liability of $19.6 million as of December 31, 1997. The 1997 net deferred tax liability includes $108.0 million of deferred tax liabilities (relating primarily to net unrealized investment holding gains) partially offset by $88.4 million in net deferred tax assets (relating primarily to various operating items). 38 On January 2, 1991, the Company sold Fireman's Fund to Allianz of America, Inc. The $1.3 billion gain from the sale as reported in 1991 included a $75.0 million tax benefit related to the Company's estimated tax loss from the sale. Since 1991 the Company has carried an estimated reserve related to tax matters affecting the amount of the deductible tax loss from the sale and other tax matters. The amount of tax benefit from the sale of Fireman's Fund ultimately realized by the Company may be significantly more or less than the Company's current estimate due to possible changes in or new interpretations of tax rules, possible amendments to Fund American's 1991 or prior years' Federal income tax returns, the results of further IRS audits and other matters affecting the amount of the deductible tax loss from the sale. LIQUIDITY AND CAPITAL RESOURCES PARENT COMPANY The primary sources of cash inflows for the Company are investment income, sales of investment securities and dividends received from its operating subsidiaries. In August 1998 the Company entered into a $35.0 million revolving credit agreement with a syndicate of banks which served to replace an expiring arrangement in the same amount. Under the agreement, through August 12, 1999, the Company may borrow up to $35.0 million at short-term market interest rates. The credit agreement contains certain customary covenants and conditions. At December 31, 1998 the Company was in compliance with all covenants under the facility and had no borrowings outstanding under the agreement. At December 31, 1997 the Company had no outstanding borrowings under the former facility. During 1993 the Company issued $150.0 million in principal amount of medium-term notes for net cash proceeds of $148.0 million after related costs. During 1995 and 1994 the Company repurchased $8.8 million and $24.9 million, respectively, in principal amount of the notes due in February 2003. At December 31, 1998 the $116.3 million of remaining outstanding notes had an average maturity of 4.4 years and a yield to maturity of 7.82%. During 1998 and 1997 the Company repurchased 151,916 Shares for $19.8 million and 924,739 Shares for $103.5 million, respectively. All Shares repurchased during 1998 and 1997 have been retired. During 1998 and 1997 the Company declared and paid quarterly cash dividends of $.40 per Share and $.20 per share, respectively. The Company's repurchases of Shares and dividends paid during 1998 and 1997 represent returns of excess capital to its shareholders. In connection with Source One's 1997 sale of approximately $17.0 billion of mortgage servicing rights to a third party, the Company has made a collection, payment and performance guaranty to the buyer for a 39 period of no more than ten years. The aggregate amount of the Company's guaranty is initially limited to $20.0 million and amortizes down to $15.0 million as mortgage loans serviced under agreement are repaid. During 1998, the Company permitted the third party to include an additional $2.9 billion of mortgage servicing rights that it purchased from Source One during 1998 to be included in the guaranty, however, the inclusion of the 1998 servicing rights sold did not serve to change the maximum amount of the guaranty or the original term of the agreement. The Company estimates that its aggregate guaranty under this arrangement is currently approximately $15.0 million. WHITE MOUNTAINS, FOLKSAMERICA, VALLEY AND CHARTER In November 1996 White Mountains and Valley entered into a five year credit facility under which they may borrow up to $50.0 million and $15.0 million, respectively, at market interest rates. The facility contains certain customary covenants and conditions but does limit White Mountains' ability to pay dividends to its shareholders. As of December 31, 1998 and 1997, White Mountains and Valley were in compliance with all covenants under the facility. At December 31, 1998 White Mountains had $50.0 million of borrowings outstanding under the facility which were used to partially fund White Mountains additional investment in MSA and its acquisition of Folksamerica during 1998. White Mountains 1998 borrowings had a weighted average interest rate of 6.20%. White Mountains had no borrowings outstanding at December 31, 1997 under the facility. During 1998 and 1997 Valley had $15.0 million of borrowings outstanding under the facility with a weighted average interest rate of 6.14% and 6.09%, respectively. In November 1995 Charter issued two notes totalling $20.2 million. Certain of the notes were due in 1996 and $3.2 million of notes were extended to be payable in three equal installments in 1997, 1998 and 1999. As of December 31, 1998 $1.1 million of the notes remained outstanding. The notes are collateralized by certain assets of Charter. During 1997 the Company reorganized its structure in order to strengthen Source One and make it a part of Fund American's operating group under White Mountains. Pursuant to this reorganization plan, White Mountains was merged into FAE and the combined entity was immediately renamed White Mountains. In addition, Source One received $139 million of capital infusions, consisting primarily of Fund American's investments in FSA, in order to improve Source One's debt ratings and reduce its borrowing costs. As a result of the reorganization plan, the Company currently owns 3% of the outstanding common stock of Source One and White Mountains owns the remaining 97% of the outstanding common stock of Source One. As part of the August 18, 1998 Folksamerica acquisition, Fund American agreed to repay or refinance Folksamerica's $55.6 million of outstanding long-term indebtedness during February 1999. On February 24, 1999, White Mountains repayed and replaced its $50.0 million five 40 year credit facility with a new $100 million facility at Folksamerica. The new credit agreement contains certain customary covenants and conditions. On February 11, 1999, White Mountains entered into a definitive agreement to sell VGI (which includes Valley, Charter and WMIC but excludes Valley National) to Unitrin, Inc. for total proceeds of approximately $215 million (consisting of approximately $130 million in cash upon closing and a special dividend consisting primarily of investment securities of approximately $85 million prior to close). The transaction is subject to certain Federal and state approvals and is expected to close during the 1999 second quarter. White Mountains expects to record an approximate $90 million pretax gain on the sale of VGI. In a separate transaction, White Mountains has entered a definitive contract to sell Valley National to Executive Risk Indemnity for an amount to be determined upon closing. The transaction is subject to certain Federal and state approvals and is expected to close during the 1999 second quarter. White Mountains expects to record an approximate $8 million pretax gain on the sale of Valley National. On March 25, 1999, Fund American and Citicorp Mortgage, Inc. ("Citicorp") reached a definitive agreement (the "Citicorp Agreement") under which Citicorp will acquire a substantial amount of Fund American's mortgage-banking related assets and certain of its mortgage banking liabilities. Fund American will retain the Source One legal entity which will continue to own all of Fund American's investments in FSA and certain other mortgage-related and other assets and liabilities. Fund American will likely sell or run-off the residual mortgage-banking assets remaining after the sale and extinguish the remaining liabilities. Fund American expects to record an after tax gain of approximate $15.0 million gain on the Citicorp Agreement. The amount of prospective gain on the sale of Source One's residual net mortgage-banking assets cannot be accurately determined at this time. Under the insurance laws of the various states under which Folksamerica, Valley, Charter and WMIC are incorporated or licensed to write business, an insurer is restricted with respect to the amount of dividends it may pay without prior approval by state regulatory authorities. Accordingly, there is no assurance that dividends may be paid by Folksamerica, Valley, Charter and WMIC in the future. SOURCE ONE Source One's primary cash flow requirements relate to funding mortgage loan production and investments in mortgage servicing rights. To meet these financing needs, Source One relies on various short-term and long-term credit facilities, early funding programs and cash flow from operations. Source One's investments, mortgage loans held for sale and mortgage loan servicing portfolio provide a liquidity reserve since these assets may be sold to meet cash needs. 41 During 1998 Source One sold the rights to service $10.6 billion of nonrecourse mortgage loans for cash proceeds of $227.9 million. During 1997 Source One sold the rights to service $17.0 billion of nonrecourse mortgage loans for cash proceeds of $266.9 million. As part of the 1998 and 1997 servicing sales, Source One retained the right to subservice $4.1 billion and $17.0 billion, respectively, of these loans for a contracted fee through 2001. The proceeds of the 1997 and 1998 servicing sales were used by Source One to retire debt and to distribute its excess capital to common shareholders. During 1996 Source One sold the rights to service $3.3 billion of mortgage loans for cash proceeds of $55.9 million. In July 1998 Source One amended and restated its $600.0 million secured revolving credit agreement to increase its borrowing capacity and flexibility. The provisions of the amended agreement increased Source One's borrowing capacity to $800.0 million. The facility expires on July 9, 1999. At December 31, 1998, Source One had $650.5 million of borrowings outstanding under this facility. In July 1997 Source One amended and restated its secured revolving credit agreement to decrease its borrowing capacity from $750.0 million to $600.0 million and to reduce its borrowing costs by lowering the facility fee. At December 31, 1997, Source One had $559.0 million of borrowings outstanding under this facility. During the second quarter of 1998 Source One entered into two additional secured credit agreements whereby it may borrow up to $35.0 million and $175.0 million through July 1999 and April 1999, respectively. At December 31, 1998, Source One had a total of $21.6 million in borrowings outstanding under these agreements. In April 1998 Source One replaced its existing $15.0 million unsecured revolving credit agreement under which it can borrow up to $40.0 million through April 15, 1999. As of December 31, 1998, there was $25.2 million outstanding under the revolving credit agreement. In May 1997 Source One entered into a unsecured revolving credit agreement under which it can borrow up to $15.0 million through June 1, 1998. As of December 31, 1997, there was $10.5 million outstanding under the revolving credit agreement. In December 1995, Source One exchanged and retired 2,239,061 shares of preferred stock (the "Source One Preferred Stock") for $56.0 million in principal amount of 9.375% subordinated debentures. The subordinated debentures are due in 2025 but are redeemable at the option of Source One, in whole or part, at any time on or after May 1, 1999. Dividends paid on the Source One Preferred Stock were $3.7 million for 1998, 1997 and 1996. Dividends on the Source One Preferred Stock accrue at an annual rate of 8.42% or $2.105 per share of Source One Preferred Stock outstanding. 42 In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in 2001 of which $138.4 million remained outstanding at December 31, 1996. During 1997 Source One repurchased and retired in principal amount $119.7 million of these notes leaving $18.7 million outstanding at December 31, 1997 and 1998. In 1992 Source One issued $100.0 million of 9% debentures due in 2012 pursuant to a $250.0 million shelf registration statement. The debentures may not be redeemed by Source One prior to maturity. The proceeds from issuance were used for general corporate purposes. Source One must comply with certain financial covenants provided in its secured and unsecured revolving credit facilities, including restrictions relating to tangible net worth and leverage. In addition, the secured facility contains certain covenants which limit Source One's ability to pay dividends or make distributions of its capital in excess of preferred stock dividends and subordinated debt interest requirements each year. Source One is currently in compliance with all such covenants. 43 MARKET RISK Fund American's consolidated balance sheet includes a substantial amount of assets and liabilities whose fair values are subject to market risk. The term market risk refers to the risk of loss arising from adverse changes in: interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates and prices such as prices for common equity securities. Due to Fund American's sizable investments in fixed maturity investments and common equity securities at its insurance and reinsurance subsidiaries, derivative securities and mortgage-related assets and liabilities at its mortgage banking subsidiary and its use of medium and long-term debt financing at the Company and certain of its operating companies, market risk can have a significant affect on Fund American's consolidated financial position. INTEREST RATE RISK FIXED MATURITY PORTFOLIO. In connection with the Company's consolidated insurance and reinsurance subsidiaries, Fund American invests in interest rate sensitive securities, primarily debt securities. Fund American's strategy is to purchase fixed maturity investments that are attractively priced in relation to perceived credit risks. Fund American's investments in fixed maturity investments are held as available for sale and, accordingly, Fund American accepts that realized and unrealized losses on these instruments may occur. Fund American does not use derivative securities to manage its interest rate risk associated with its fixed maturity investments, rather it manages the average duration of the fixed maturity portfolio in the anticipation of achieving an adequate yield without subjecting the portfolio to an unreasonable level of interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of fixed maturity investments, respectively. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. These investments are carried at fair value on the balance sheet with unrealized gains reported net of tax in a separate component of shareholders equity. DERIVATIVE SECURITIES. In connection with its mortgage banking operations, Source One utilizes derivative contracts, consisting of interest rate floor contracts, interest rate swap agreements and principal-only swap agreements, in an attempt to offset the effect on earnings of impairment of its capitalized servicing asset caused by changes in market interest rates. Increases and decreases in prevailing interest rates generally translate into increases and decreases in fair values of these financial instruments, respectively. These financial instruments are carried at fair value on the balance 44 sheet (as other investments) with unrealized and realized gains reported as net gains on financial instruments on the income statement. INDEBTEDNESS. Fund American utilizes debt financing at all levels of its businesses, particularly at Source One. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of fixed rate indebtedness, respectively, particularly long-term debt. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. The table below summarizes the estimated effects of hypothetical increases and decreases in market interest rates on Fund American's fixed maturity portfolio, derivative securities and long-term fixed rate indebtedness outstanding. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available to the issuer or the holder which are not reflected herein. It is assumed that the changes occur immediately and uniformly to each category of instrument containing interest rate risk. 45 Estimated Fair Percentage Increase Fair Value at Assumed Change Value after Change (Decrease) to Dollars in Millions December 31, 1998 in Interest Rate in Interest Rate Shareholders' Equity - ------------------------------------------------------------------------------------------------------------- Fixed maturity investments $929.6 50 bp decrease $946.4 1.6% 50 bp increase $913.2 (1.5)% 100 bp increase $897.1 (3.0)% 200 bp increase $866.2 (5.9)% - ------------------------------------------------------------------------------------------------------------- Derivative securities $ 17.5 50 bp decrease $31.5 1.3% 50 bp increase $5.4 (1.1)% 100 bp increase $(4.7) (2.1)% 200 bp increase $(20.7) (3.5)% - ------------------------------------------------------------------------------------------------------------- Fixed rate indebtedness (a) $233.1 50 bp decrease $239.4 (.6)% 50 bp increase $227.0 .6% 100 bp increase $221.2 1.1% 200 bp increase $210.1 2.1% - ------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------- (a) Excludes short-term indebtedness, long-term indebtedness refinanced or callable by Fund American during 1999 and variable rate obligations. MORTGAGE-RELATED ASSETS. Source One's mortgage loan production and servicing activities are subject to interest rate risk and are generally counter cyclical in nature. In addition, Source One utilizes various financial instruments, including derivatives, to manage the interest rate risk related specifically to its mortgage loan pipeline, mortgage loans held for sale and gain or loss on sales of mortgage servicing rights. The overall objective of Source One's interest rate risk management policies is to offset changes in the values of these items resulting from changes in interest rates. As part of the interest rate risk management process, Source One performs various sensitivity analyses that quantify the net financial impact of changes in interest rate-sensitive assets and commitments. These analyses incorporate scenarios including assumed shifts in the yield curve. Various modeling techniques are employed to forecast the value of these assets and commitments. For pipeline commitments, an option-adjusted spread model is used which incorporates implied market volatilities and prepayment speeds. For mortgage servicing rights, a 46 discounted cash flow model is used which incorporates prepayment speeds, discount rates and credit losses. Utilizing the sensitivity analyses described above, the table below summarizes the estimated effects of hypothetical increases and decreases in market interest rates on Source One's mortgage servicing values: Estimated Fair Percentage Increase Carrying Value at Assumed Change Value after Change (Decrease) to Dollars in Millions December 31, 1998 in Interest Rate in Interest Rate Shareholders' Equity - -------------------------------------------------------------------------------------------------------------------------- Mortgage servicing rights (a) $171.3 50 bp decrease $156.0 (1.4)% 50 bp increase $183.9 1.2% Mortgage forward contracts $ - 50 bp decrease $ 11.6 1.1% 50 bp increase $(11.6) (1.1)% Mortgage loan pipeline $ - 50 bp decrease $(11.7) (1.1)% 50 bp increase $ 11.4 1.1% - -------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------- (a) Represents the carrying value of capitalized mortgage servicing excluding $1.6 million of capitalized subservicing. 47 As shown above, the projected increase or decrease in the value of the mortgage loan pipeline would be expected to be substantially offset by a decrease or increase in the related mortgage loan forward contracts. In addition, the projected increase or decrease in the value of the mortgage servicing rights would be expected to be substantially offset by a decrease or increase in the value of the related financial instruments as previously described herein. This analysis is limited by the fact that it was performed at a specific point in time and does not incorporate other factors that would impact Source One's financial performance. Actual results would likely vary. FOREIGN CURRENCY EXCHANGE RATES Folksamerica operates a branch office in Toronto, Canada to service its Canadian customers. Net unrealized foreign currency translation gains and losses, after tax, associated with Folksamerica's Canadian operations are reported as a net amount in a separate component of shareholders' equity. Changes in the values of these operations due to currency fluctuations, after tax, are reported on the income statement as a component of comprehensive net income. At December 31, 1998, Folksamerica's net assets denominated in Canadian dollars represented approximately one percent of Fund American's consolidated shareholders' equity, therefore, any significant change in foreign currency rates would not have a material impact on Fund American's financial position. EQUITY PRICE RISK The carrying values of Fund American's common equity securities, a significant portion of its other investments (primarily restricted common equity securities and partnership interests invested in common equity securities) and its investments in FSA Options and Preferred Stock are based on quoted market prices or management's estimates of fair value (which is based, in part, on quoted market prices) as of the balance sheet date. Market prices of common equity securities are subject to fluctuations which could cause the amount to be realized upon sale of the investment to differ significantly from the current reported value. The fluctuations may result from perceived changes in the underlying economic characteristics of the investee, the relative price of alternative investments, general market conditions and supply and demand imbalances for a particular security. The table below summarizes Fund American's equity price risks as of December 31, 1998 and shows the effects of a hypothetical 20% increase and a 20% decrease in market prices as of that date. 48 Estimated Fair Percentage Increase Fair Value at Assumed Value after Assumed (Decrease) to Dollars in Millions December 31, 1998 Price Change Price Change Shareholders' Equity - ------------------------------------------------------------------------------------------------------------------ Common equity securities $241.7 20% increase $290.0 4.5% 20% decrease $193.4 (4.5)% Other investments (a) $ 77.3 20% increase $ 92.8 1.4% 20% decrease $ 61.8 (1.4)% FSA Options and $114.4 20% increase $136.6 2.1% Preferred Stock 20% decrease $ 91.5 (2.1)% - ------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------ (a) Excludes $17.5 million of derivative securities (see "Interest Rate Risk") and $2.1 million of other investments which would not be directly affected by the assumed changes in equity prices. 49 OTHER MATTERS ACCOUNTING FOR FSA OPTIONS AND CONVERTIBLE PREFERRED STOCK Fund American currently owns 3,460,200 shares of the common stock of FSA ("FSA Shares") and various fixed price options and shares of convertible preferred stock of FSA (the "FSA Options and FSA Preferred Stock") which, in total, give Fund American the right to acquire up to 4,560,607 additional FSA Shares. Fund American's investment in FSA Shares is accounted for using the equity method of accounting pursuant to which the investment is reported at FSA's book value ($35.87 per FSA Share at December 31, 1998). Fund American's investments in FSA Options and FSA Preferred Stock are currently accounted for under the provisions of SFAS No. 115 pursuant to which the investments are reported at fair value ($52.62 per underlying FSA Share at December 31, 1998). Fund American currently expects to exercise the FSA Options during 1999 and convert the FSA Preferred Stock during 2004. Assuming that equity accounting continues to be the proper accounting method for valuing Fund American's investment in FSA Shares, upon exercise of the FSA Options and conversion of the FSA Preferred Stock, Fund American expects that it would be required to restate its historic balance sheets to account for its investments in FSA Options and FSA Preferred Stock from fair value to their original cost. Upon exercise, Fund American's original cost basis in the FSA Shares acquired will be increased by the exercise price paid. Because the new cost basis of Fund American's investment in FSA Shares is expected to be considerably less than its portion of the fair value of FSA's net identifiable assets at the date of exercise, Fund American would be required to record a deferred credit that would be amortized to income over an anticipated five year period. Assuming the FSA Options were exercised and the FSA Preferred Stock converted as of December 31, 1998, Fund American would be required to reduce its book value by $72.9 million ($10.67 per share) and would record a deferred credit of $35.7 million ($5.23 per share). This net difference in carrying value of $37.2 million (which represents the effective write-down of the FSA Options and FSA Preferred Stock from fair value to FSA's book value) would continue to exist until such time as equity accounting is no longer appropriate for Fund American's investment in FSA Shares. This analysis is based solely on Fund American's current circumstances concerning its investments in FSA Options and FSA Preferred Stock. Fund American's actual accounting valuation will be determined at the point of exercise for the FSA Options and upon the conversion of the FSA Preferred Stock and will be based on the circumstances concerning such investments existing at that time. YEAR 2000 STATUS. Since 1996 Fund American has been identifying, modifying and testing its internal systems and controls to ensure that these systems can accurately process transactions involving the Year 2000 and beyond with no material adverse effects to its customers or disruption to its business operations. As of December 31, 1998, the Company has substantially completed its testing phase (the final phase of its Year 2000 remediation plan). Fund American estimates that its total pretax cost of Year 2000 remediation, excluding its unconsolidated insurance 50 affiliates, is approximately $3.0 million of which the majority of this amount has been expensed as of December 31, 1998. This estimate does not include the cost of hardware and software replacements and upgrades made in the normal course of business and represents less than 20% of Fund American's total Information Technology budget. Fund American has also been closely monitoring the year 2000 issues of its third party constituents that it voluntarily interacts with (e.g. customers, suppliers, reinsurers, creditors, borrowers...). Fund American's third party constituents have been requested to provide Fund American with information concerning their Year 2000 remediation plans and the status of such plans. For those constituents who either fail to respond to this inquiry or are deemed to be unlikely to remedy their own Year 2000 issues in a timely manner, Fund American is in the process of either replacing that constituent or establishing similar relationships with new parties that are currently Year 2000 compliant. As of December 31, 1998, FSA and MSA had also substantially completed the testing phase of their Year remediation plans and are in the process of determining their third party exposures in a similar manner to that of Fund American. Fund American's nominees to the Boards of Directors of FSA and MSA have received detailed briefings concerning their respective Year 2000 plans and have determined that these plans appear to be on schedule for a timely completion and should reduce the risk of Year 2000 issues. Fund American's portion of the total estimated costs of the Year 2000 issue for its unconsolidated insurance affiliates are not material and the majority of such expenses have already been incurred. RISKS. The failure to identify or correct significant Year 2000 issues could result in an interruption in, or a failure of, certain normal business activities or operations concerning the Company, its consolidated insurance and mortgage banking subsidiaries and its unconsolidated insurance affiliates. Such failures could adversely affect Fund American's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of potential business interruptions caused by third party constituents in which Fund American must interact (including but not limited to suppliers of electrical power, various private and public markets for equity and debt securities, certain agencies of the Federal government and the states in which Fund American conducts business), Fund American is unable to determine at this time whether the consequences of any Year 2000 failures will have a material impact on its results of operation, liquidity or financial condition. However, Fund American currently believes that, with the implementation of its Year 2000 plan (which is in the final stages of completion), the possibility of significant interruptions of normal business activities due to the Year 2000 issue should be reduced. Folksamerica's approach towards underwriting against potential Year 2000 exposures is to seek coverages which contain Year 2000 event exclusions. In instances where exclusions are not provided, Folksamerica attempts to determine whether the risk is acceptable based on a variety of factors (a description of such factors is not provided herein as each situation is unique). Folksamerica has estimated that less that 9% of its property reinsurance coverage in force could be subject to Year 2000 exposures. However, these risks generally lie 51 with large corporations who have been aware of the issue for some time and have invested significant time and resources towards Year 2000 remediation. Additionally, Folksamerica does not anticipate significant Year 2000 exposures from its casualty reinsurance coverage in force due to the nature of such exposures. Further, Folksamerica generally writes such exposures on an excess of loss basis which provides Folksamerica with additional protections against potential losses of this nature. The Company is currently in the process of developing a Year 2000 contingency plan (the "Y2K Plan") which is designed to mitigate, to the extent possible, any adverse affects the Company may suffer due to any potential business interruptions caused by third party constituents in which Fund American must interact (as further explained above). It is expected that the Y2K Plan will be finalized during the third quarter of 1999. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See "Market Risk Disclosures" contained in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Financial Statements and Financial Statement Schedule appearing on page 38 of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On March 10, 1999, the Audit Committee of the Board appointed PricewaterhouseCoopers LLP ("PWC") as its independent auditors for the fiscal year ending December 31, 1999, to succeed KPMG LLP ("KPMG") effective upon the date of their reports on such consolidated financial statements for the year ended December 31, 1998. PWC has served as Folksamerica's independent auditors since 1981 and has served as FSA's independent auditors since 1989. The Audit Committee has recommended that PWC succeed KPMG as the Company's independent auditors for 1999 due to the growing significance of Folksamerica and FSA to the Company's 1999 financial position and results of operations and the pending disposition of VGI. In connection with the audits of the years ended December 31, 1998 and 1997, there were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosure, or auditing scope and procedures which, if not resolved to their satisfaction, would have caused them to make reference in connection with their opinion to the subject matter of the disagreement. The Company has requested KPMG furnish a letter addressed to the Commission stating whether it agrees with the above statements. A copy of this letter, dated March 25, 1999, is contained herein as Exhibit 16(a). 52 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS A. DIRECTORS (AS OF MARCH 22, 1999) Reported under the caption "Election of Directors" on pages 3 through 6 of the Company's 1999 Proxy Statement, herein incorporated by reference. B. EXECUTIVE OFFICERS (AS OF MARCH 22, 1999) Executive officer Name Position Age since - --------------------------------------------------------------------------------------- Raymond Barrette Executive Vice President and 48 1997 Chief Financial Officer Terry L. Baxter President of White Mountains 53 1994 Reid T. Campbell Vice President and Director 31 1996 of Finance Morgan W. Davis Executive Vice President of 48 1994 White Mountains K. Thomas Kemp President and CEO 58 1991 Michael S. Paquette Senior Vice President and 35 1993 Controller David G. Staples Vice President and Director 38 1997 of Taxation - --------------------------------------------------------------------------------------- All executive officers are elected by the Board for a term of one year or until their successors have been elected and have duly qualified. MR. BARRETTE joined Fund American in 1997 as the Company's Executive Vice President and Chief Financial Officer. Mr. Barrette is also Executive Vice President and Chief Financial Officer of White Mountains. He was formerly a consultant with Tillinghast-Towers Perrin from 1994 to 1996 and was President of the Personal Insurance Division of Fireman's Fund from 1991 to 1993. Mr. Barrette is a director of FAE, MSA, Source One, Folksamerica, White Mountains, Valley, Charter and WMIC. MR. BAXTER was elected President of White Mountains in 1997. Mr. Baxter previously served as Chairman of Source One from 1996 to 1997 and as President and Secretary of FAE from 1994 to 1997. Prior to joining Fund American in 1994, Mr. Baxter was Managing Director of the National Transportation Safety Board from 1990. Prior to that, he was the Assistant Director of OMB during the Reagan Administration. Mr. Baxter is a director of FAE, MSA, Source One, Folksamerica, White Mountains, Valley, Charter, WMIC and Sextant Underwriting Plc. MR. CAMPBELL was elected Vice President and Director of Finance in February 1998 and previously served as Assistant Controller from 1996 to 1998 and Director of Accounting from 1995 to 1996. Mr. Campbell has been with Fund American since 1994. Mr. Campbell is also 53 Vice President and Director of Finance of White Mountains. Prior to joining Fund American, Mr. Campbell was with KPMG Peat Marwick from 1990 to 1994. MR. DAVIS has served as White Mountains' Executive Vice President since 1997 and served as Senior Vice President since 1994. Mr. Davis is also President and Chief Executive Officer of WMIC and Chairman and President of VGI. Prior to joining Fund American in 1994, Mr. Davis was an independent consultant. Mr. Davis is a director of MSA, White Mountains, Valley, Charter, WMIC, ABRA, Inc. and CCC Information Services Group Inc. and is a trustee of Azusa Pacific University. MR. KEMP was appointed President and Chief Executive Officer in 1997. Mr. Kemp previously served as Executive Vice President since 1993 and as Vice President, Treasurer and Secretary from 1991 to 1993. Mr. Kemp also serves as a director of the Company, Chairman and Chief Executive Officer of White Mountains and Chairman of WMIC. He is also a director of Folksamerica, FSA, FAE, MSA and AMLIN Plc. MR. PAQUETTE was appointed Senior Vice President and Controller in 1997. Mr. Paquette previously served as Vice President and Controller since 1995 and as Vice President and Chief Accounting Officer from 1993 to 1995. Mr. Paquette is also Senior Vice President and Controller of White Mountains and WMIC. Mr. Paquette has been a member of the Fund American organization since 1989. MR. STAPLES was elected Vice President and Director of Taxation in 1997 and has been with Fund American since 1996. Prior to joining Fund American, Mr. Staples served as Vice President and Director of Taxation for Crum & Forster Holdings, Inc. from 1993 to 1996, and was with KPMG Peat Marwick from 1983 to 1993. ITEM 11. EXECUTIVE COMPENSATION Reported under the captions "Compensation of Executive Officers" on pages 9 through 11, "Reports of the Compensation Committees on Executive Compensation" on pages 11 though 13, "Shareholder Return Graph" on page 14, and "Compensation Plans" on page 15 of the Company's 1999 Proxy Statement, herein incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reported under the caption "Voting Securities and Principal Holders Thereof" on pages 7 through 8 of the Company's 1999 Proxy Statement, herein incorporated by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reported under the captions "Certain Relationships and Related Transactions" on page 11 and "Compensation Committee Interlocks and Insider Participation in Compensation Decisions" on page 16 of the Company's 1999 Proxy Statement, herein incorporated by reference. 54 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. DOCUMENTS FILED AS PART OF THE REPORT The financial statements and financial statement schedules and reports of independent auditors have been filed as part of this Annual Report on Form 10-K as indicated in the Index to Financial Statements and Financial Statement Schedules appearing on page 38 of this report. A listing of exhibits filed as part of the report appear on pages 56 through 58 of this report. B. REPORTS ON FORM 8-K During the fourth quarter of 1998 the Company filed two amendments to its Current Report on Form 8-K dated August 18, 1998 which was filed in connection with its acquisition of Folksamerica on that date. The amendments served to provide the requisite pro forma financial information concerning the Folksamerica transaction and were filed on October 16, 1998 and November 13, 1998. 55 C. EXHIBITS EXHIBIT NUMBER NAME - -------------------------------------------------------------------------------- 3(i) -- Amended and Restated Certificate of Incorporation of the Company (incorporated by reference herein to Exhibit 3(a) of the Company's 1993 Annual Report on Form 10-K) (ii) -- Amended and Restated By-Laws of the Company (incorporated by reference herein to Exhibit 3(b) of the Company's 1993 Annual Report on Form 10-K) 4 -- Indenture dated January 1, 1993, with The First National Bank of Chicago, as trustee, pursuant to the Company's offering of $150 million of medium-term notes (incorporated by reference herein to Exhibit (4) of the Company's Report on Form 8-K dated January 15, 1993) 9 -- Voting Trust Agreement dated September 2, 1994 between the Company, U S WEST Capital Corporation and First Chicago Trust Company of New York (incorporated by reference herein to Exhibit 10(a) of the Company's Report on Form 8-K dated April 10, 1994) 10(a) -- Second Amended and Restated Credit Agreement dated August 14, 1998 among the Company, the Lenders (as named therein) and The First National Bank of Chicago (*) (b) -- Second Amended and Restated Credit Agreement dated August 14, 1998 among White Mountains, the Lenders (as named therein) and The First National Bank of Chicago (*) (c) -- Second Amended and Restated Credit Agreement dated August 14, 1998 among VGI, the Lenders (as named therein) and The First National Bank of Chicago (*) (d) -- Amendment No. 1 dated November 20, 1998 to the Second Amended and Restated Credit Agreement dated August 14, 1998 among the Company, the Lenders (as named therein) and The First National Bank of Chicago (*) (e) -- Amendment No. 1 dated November 20, 1998 to the Second Amended and Restated Credit Agreement dated August 14, 1998 among White Mountains, the Lenders (as named therein) and The First National Bank of Chicago (*) (f) -- Amendment No. 1 dated November 20, 1998 to the Second Amended and Restated Credit Agreement dated August 14, 1998 among VGI, the Lenders (as named therein) and The First National Bank of Chicago (*) (g) -- Securities Purchase Agreement dated April 10, 1994 between the Company, U S WEST, Inc., U S WEST Capital Corporation and FSA (incorporated by reference herein to Exhibit 10(a) of the Company's Report on Form 8-K dated April 10, 1994) (h) -- Folksamerica Stock Purchase Agreement dated as of July 1, 1998 by and among the Company, White Mountains, Folksam Mutual General Insurance Company, Folksam International Insurance Co. Ltd, Weiner Staedtische Allgemeine Versicherung AG, P&V Assurances S.C. and Samvirke Skadeforsikring AS (incorporated by reference herein to Exhibit 10(a) of the Company's Report on Form 8-K dated August 18, 1998) 56 (i) -- Assignment and Assumption Agreement dated as of August 18, 1998 by and among Folksam Omsesidig Sakforsakring, Samvirke Skadeforsikring AS and the Company (incorporated by reference herein to Exhibit 10(b) of the Company's Report on Form 8-K dated August 18, 1998) (j) -- Subscription Agreement dated November 6, 1997 between Folksamerica, the Company, White Mountains, Folksam Mutual General Insurance Company, Folksam International Insurance Co. Ltd, Weiner Staedtische Allgemeine Versicherung AG, P&V Assurances S.C. and Samvirke Skadeforsikring AS (incorporated by reference herein to Exhibit 10(l) of the Company's 1997 Annual Report on Form 10-K) (k) -- Securities Purchase Agreement dated March 6, 1996 between the Company and Folksamerica (incorporated by reference herein to Exhibit 10(a) of the Company's Report on Form 8-K dated June 19, 1996) (l) -- Folksamerica Stock Purchase Agreement dated August 8, 1995 between the Company, Skandia U.S. Holding Corporation, and Skandia America Corporation (incorporated by reference herein to Exhibit 10(e) of the Company's 1995 Annual Report on Form 10-K) (m) -- Guaranty, dated February 28, 1997, by the Company to and for the benefit of Chemical Mortgage Company (incorporated by reference herein to Exhibit 10(y) of the Company's 1996 Annual Report on Form 10-K) (n) -- VGI Stock Acquisition Agreement dated February 10, 1999 between Unitrin, Inc. and the Company (*) (o) -- Transition Services Agreement dated March 25, 1999 between the Company and Citicorp Mortgage, Inc. (*) (p) -- Source One Asset Purchase Agreement dated March 25, 1999 between the Company, Source One and Citicorp Mortgage Inc.(*) (q) -- Common Stock Warrant Agreement with respect to shares of the Company's Common stock between the Company and John J. Byrne (incorporated by reference herein to Exhibit 10(v) of the Company's Registration Statement on Form S-1 (No. 33-0199)) (**) (r) -- The Company's Retirement Plan for Non-Employee Directors (incorporated by reference herein to Exhibit 10(aa) of the Company's 1992 Annual Report on Form 10-K) (**) (s) -- The Company's Voluntary Deferred Compensation Plan, as amended on November 15, 1996 (incorporated by reference herein to Exhibit 10(o) of the Company's 1996 Annual Report on Form 10-K) (**) (t) -- The Company's Deferred Benefit Plan, as amended on November 15, 1996 (incorporated by reference herein to Exhibit 10(p) of the Company's 1996 Annual Report on Form 10-K) (**) (u) -- The Company's Long-Term Incentive Plan, as amended February 15, 1995 (incorporated by reference to Appendix I of the Company's Notice of 1995 Annual Meeting of Shareholders and Proxy Statement) (**) (v) -- Valley Group Employees' 401(k) Savings Plan (incorporated by reference herein to Exhibit 4(c) of the Company's Registration Statement on Form S-8 (No. 333-30233) (**) 11 -- Statement Re Computation of Per Share Earnings (***) 16 -- Letter of KPMG LLP dated March 25, 1999 (*) 21 -- Subsidiaries of the Registrant (*) 57 23(a) -- Consent of KPMG LLP dated March 25, 1999 (*) (b) -- Consent of Ernst & Young LLP dated March 25, 1999 (*) (c) -- Consent of PricewaterhouseCoopers LLP dated March 25, 1999 relating to Valley, Folksamerica and FSA (*) 24 -- Powers of Attorney (*) 27 -- 1998 Financial Data Schedule (*) 99(a) -- Report of PricewaterhouseCoopers LLP dated February 2, 1999 relating to Folksamerica(*) (b) -- The Consolidated Financial Statements of FSA and the related Report of Independent Accountants as of December 31, 1998 and 1997 and for each of the three years in the period ended December 31, 1998 (*) (c) -- Report of Coopers & Lybrand L.L.P. dated February 14, 1997 relating to VGI (*) (*) Included herein. (**) Management contracts or compensation plans/arrangements required to be filed as an exhibit pursuant to Item 14(a)3 of Form 10-K. (***) Not included herein as the information is contained elsewhere within report. See Note 1 of the Notes to Consolidated Financial Statements. D. FINANCIAL STATEMENT SCHEDULE The financial statement schedule and report of independent auditors have been filed as part of this Annual Report on Form 10-K as indicated in the Index to Financial Statements and Financial Statement Schedule appearing on page 61 of this report. 58 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FUND AMERICAN ENTERPRISES HOLDINGS, INC. Date: March 26, 1999 By: /s/ MICHAEL S. PAQUETTE -------------------------------- Senior Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date RAYMOND BARRETTE* Executive Vice President and March 26, 1999 - -------------------------- Chief Financial Officer Raymond Barrette JOHN J. BYRNE* Chairman March 26, 1999 - -------------------------- John J. Byrne PATRICK M. BYRNE* Director March 26, 1999 - -------------------------- Patrick M. Byrne HOWARD L. CLARK, JR.* Director March 26, 1999 - -------------------------- Howard L. Clark, Jr. ROBERT P. COCHRAN* Director March 26, 1999 - -------------------------- Robert P. Cochran GEORGE J. GILLESPIE, III* Director March 26, 1999 - -------------------------- George J. Gillespie, III /s/ K. THOMAS KEMP President, Chief Executive March 26, 1999 - -------------------------- Officer and Director K. Thomas Kemp GORDON S. MACKLIN* Director March 26, 1999 - -------------------------- Gordon S. Macklin 59 FRANK A. OLSON* Director March 26, 1999 - -------------------------- Frank A. Olson MICHAEL S. PAQUETTE* Senior Vice President March 26, 1999 - -------------------------- and Controller Michael S. Paquette *By: /s/ K. THOMAS KEMP -------------------------------- K. Thomas Kemp, Attorney-in-Fact 60 FUND AMERICAN ENTERPRISES HOLDINGS, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Form 10-K page(s) - ----------------------------------------------------------------------------------------------- FINANCIAL STATEMENTS: Consolidated balance sheets as of December 31, 1998 and 1997.................... F-1 Consolidated income statements for each of the years ended December 31, 1998, 1997 and 1996........................................... F-2 Consolidated statements of shareholders' equity for each of the years ended December 31, 1998, 1997 and 1996........................................... F-3 Consolidated statements of cash flows for each of the years ended December 31, 1998, 1997 and 1996........................................... F-4 Notes to consolidated financial statements...................................... F-5 OTHER FINANCIAL INFORMATION: Report on management's responsibilities......................................... F-48 Independent auditors' reports................................................... F-49 Selected quarterly financial data (unaudited)................................... F-52 FINANCIAL STATEMENT SCHEDULES: I. Summary of investments other than investments in related parties......... FS-1 II. Condensed financial information of the Registrant........................ FS-2 III. Reinsurance.............................................................. FS-4 IV. Valuation and qualifying accounts......................................... FS-5 VI. Supplementary insurance information....................................... FS-6 - ----------------------------------------------------------------------------------------------- All other schedules are omitted as they are not applicable or the information required is included in the financial statements or notes thereto. 61 CONSOLIDATED BALANCE SHEETS - ------------------------------------------------------------------------------------------------------------------- December 31, --------------------------- Dollars in millions 1998 1997 - ------------------------------------------------------------------------------------------------------------------- ASSETS Fixed maturity investments, at fair value (cost $916.1 and $165.4) $ 929.6 $ 168.3 Common equity securities, at fair value (cost $195.4 and $64.7) 241.7 104.2 Other investments (cost $88.5 and $103.1) 96.9 167.9 Short-term investments, at amortized cost (which approximated fair value) 79.0 62.8 --------------------------- Total investments 1,347.2 503.2 Cash 22.4 7.0 Mortgage loans held for sale 676.3 519.3 Capitalized mortgage servicing, net of accumulated amortization 169.7 181.0 Pool loan purchases 165.0 149.8 Mortgage claims receivable and real estate acquired 33.1 41.2 Receivable from sale of mortgage servicing 73.8 27.3 Investments in unconsolidated insurance affiliates 354.3 360.1 Insurance and reinsurance balances receivable 124.7 56.1 Reinsurance recoverable on paid and unpaid losses 137.3 9.6 Other assets 176.9 155.7 --------------------------- Total assets $ 3,280.7 $ 2,010.3 LIABILITIES Short-term debt $ 748.5 $ 571.4 Long-term debt 359.7 304.3 Loss and loss adjustment expense reserves 811.7 71.9 Unearned insurance and reinsurance premiums 153.1 78.0 Deferred credit 37.1 - Accounts payable and other liabilities 424.1 281.8 --------------------------- Total liabilities 2,534.2 1,307.4 - ------------------------------------------------------------------------------------------------------------------- MINORITY INTEREST - PREFERRED STOCK OF SUBSIDIARY 44.0 44.0 - ------------------------------------------------------------------------------------------------------------------- SHAREHOLDERS' EQUITY Common stock - authorized 125,000,000 shares, issued 30,863,547 and 31,015,463 shares 30.9 31.0 Paid-in surplus 354.2 355.9 Retained earnings 1,063.2 1,008.9 Common stock in treasury, at cost: 25,034,939 shares (871.0) (871.0) Accumulated other comprehensive net income, after tax 125.2 134.1 --------------------------- Total shareholders' equity 702.5 658.9 - ------------------------------------------------------------------------------------------------------------------- Total liabilities, minority interest and shareholders' equity $ 3,280.7 $ 2,010.3 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. F-1 CONSOLIDATED INCOME STATEMENTS - -------------------------------------------------------------------------------------------------------------------------------- Year Ended December 31, --------------------------------------- Millions, except per share amounts 1998 1997 1996 - -------------------------------------------------------------------------------------------------------------------------------- REVENUES: Earned property and casualty insurance premiums $246.0 $145.3 $ 109.7 Earnings from unconsolidated insurance affiliates 24.3 21.3 12.0 Other insurance operations revenue 12.2 7.8 9.4 Net investment income 118.4 65.1 57.3 Gross mortgage servicing revenue 78.1 94.9 139.6 Amortization and impairment of capitalized mortgage servicing (55.2) (68.0) (79.2) Net gain on financial instruments 20.4 11.3 9.9 --------------------------------------- Net mortgage servicing revenue 43.3 38.2 70.3 Net gain on sales of mortgages 86.8 21.5 38.3 Gain (loss) on sales of mortgage servicing rights and assumption of subservicing 15.2 (8.0) 10.1 Other mortgage operations revenue 31.9 19.1 18.1 --------------------------------------- Total revenues 578.1 310.3 325.2 - -------------------------------------------------------------------------------------------------------------------------------- EXPENSES: Insurance losses and loss adjustment expenses 174.8 97.1 85.9 Compensation and benefits 130.2 101.8 91.3 Interest expense 83.9 46.0 46.3 General expenses 75.4 60.5 64.9 Insurance and reinsurance acquisition expenses 54.8 23.2 15.2 Write-off of goodwill and other intangible assets - - 32.6 --------------------------------------- Total expenses 519.1 328.6 336.2 - -------------------------------------------------------------------------------------------------------------------------------- Pretax operating earnings (loss) 59.0 (18.3) (11.0) Net realized investment gains 71.0 96.7 38.5 --------------------------------------- Pretax earnings 130.0 78.4 27.5 Income tax provision 47.8 29.4 18.9 --------------------------------------- AFTER TAX EARNINGS 82.2 49.0 8.6 Loss on early extinguishment of debt, after tax - (6.0) - --------------------------------------- NET INCOME 82.2 43.0 8.6 Net unrealized investment holdings gains and other, after tax 37.2 104.6 79.6 Reclasses of realized gains included in net income, after tax (46.1) (62.9) (25.0) --------------------------------------- COMPREHENSIVE NET INCOME 73.3 84.7 63.2 Preferred stock dividends of subsidiary (3.7) (3.7) (3.7) --------------------------------------- Comprehensive net income applicable to common stock $ 69.6 $ 81.0 $ 59.5 --------------------------------------- - -------------------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER COMMON SHARE: After tax earnings $13.38 $ 6.89 $ .66 Loss on early extinguishment of debt, after tax - (.91) - --------------------------------------- Net income $13.38 $ 5.98 $ .66 --------------------------------------- --------------------------------------- Comprehensive net income $11.87 $12.33 $ 8.01 --------------------------------------- --------------------------------------- DILUTED EARNINGS PER COMMON SHARE: After tax earnings $11.94 $ 6.22 $ .60 Loss on early extinguishment of debt, after tax - (.82) - --------------------------------------- Net income $11.94 $ 5.40 $ .60 --------------------------------------- --------------------------------------- Comprehensive net income $10.58 $11.15 $ 7.33 - -------------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. F-2 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Common Net Foreign stock and Common unrealized currency paid-in Retained stock in investment translation Millions Total surplus earnings treasury gains adjustment - ------------------------------------------------------------------------------------------------------------------- Balances at January 1, 1996 $699.7 $408.2 $1,124.6 $(871.0) $ 37.9 $ - - ------------------------------------------------------------------------------------------------------------------- Net income 8.6 - 8.6 - - - Dividends to shareholders (9.6) - (9.6) - - - Purchases of common stock retired (66.3) (9.8) (56.5) - - - Change in net unrealized investment gains and losses, after tax 54.6 - - - 54.6 - - ------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1996 687.0 398.4 1,067.1 (871.0) 92.5 - - ------------------------------------------------------------------------------------------------------------------- Net income 43.0 - 43.0 - - - Dividends to shareholders (9.0) - (9.0) - - - Purchases of common stock retired (103.7) (11.5) (92.2) - - - Change in net unrealized investment gains and losses, after tax 41.6 - - - 41.6 - - ------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1997 658.9 386.9 1,008.9 (871.0) 134.1 - - ------------------------------------------------------------------------------------------------------------------- Net income 82.2 - 82.2 - - - Dividends to shareholders (13.1) - (13.1) - - - Purchases of common stock retired (19.8) (1.8) (18.0) - - - Change in net unrealized investment gains and losses and other, after tax (8.9) - - - (8.0) (.9) Other 3.2 - 3.2 - - - - ------------------------------------------------------------------------------------------------------------------- BALANCES AT DECEMBER 31, 1998 $702.5 $385.1 $1,063.2 $(871.0) $126.1 $(.9) - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. F-3 CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, --------------------------------------- Millions 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------- Net income $ 82.2 $ 43.0 $ 8.6 Reconciliation of net income to cash flows from operating activities: Undistributed earnings from unconsolidated insurance affiliates (19.1) (14.7) (8.2) Net realized investment gains (71.0) (96.7) (38.5) Net unrealized gains on financial instruments (12.1) (11.1) (1.7) Depreciation and amortization of servicing assets, goodwill and other 63.1 71.0 92.8 Amortization of deferred credit (2.7) - - Write-off of goodwill and other intangible assets - - 32.6 Mortgage loan production (10,866.3) (4,403.3) (3,831.6) Mortgage loan sales and amortization 10,709.2 4,198.9 3,897.7 (Gain) loss on sales of mortgage servicing rights (15.2) 8.0 (10.1) (Decrease) increase in unearned insurance premiums (7.0) 5.4 37.6 Increase in insurance premiums receivable (2.4) (3.9) (6.9) Decrease (increase) in deferred insurance policy acquisition costs 2.5 (1.1) (6.5) Increase in insurance loss reserves 13.7 6.5 21.2 Net change in current and deferred income taxes receivable and payable 12.0 4.5 11.8 Change in other assets 26.4 55.9 (29.3) Change in accounts payable and other liabilities 120.5 11.1 33.7 Other, net (5.0) 17.4 (1.4) --------------------------------------- Net cash provided from (used for) operating activities 28.8 (109.1) 201.8 - ------------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Net decrease in short-term investments 47.0 4.7 36.1 Sales of common stocks and other investments 168.5 207.9 231.6 Sales of fixed maturity investments 132.8 92.5 131.7 Purchases of common stocks and other investments (61.1) (54.8) (85.0) Purchases of fixed maturity investments (122.7) (102.6) (180.8) Acquisitions of consolidated insurance affiliates, net of cash balances acq(167.5) - (13.2) Investments in unconsolidated insurance affiliates (70.3) (44.4) (107.6) Collections on other mortgage origination and servicing assets 278.4 274.2 175.3 Additions to capitalized mortgage servicing rights (249.1) (139.5) (88.6) Proceeds from sales of mortgage servicing rights 182.8 242.6 11.7 Additions to other mortgage origination and servicing assets (296.9) (285.1) (205.7) Collections on notes receivable 7.0 - - Net purchases of fixed assets (5.4) (2.9) (7.3) --------------------------------------- Net cash (used for) provided from investing activities (156.5) 192.6 (101.8) - ------------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Net issuances (repayments) of short-term debt 176.8 162.4 (36.2) Issuances of long-term debt - - 15.0 Repayments of long-term debt (1.1) (131.0) - Purchases of common stock retired (19.5) (103.7) (66.3) Cash dividends paid to common and preferred shareholders (13.1) (9.0) (9.6) Other - - (.8) --------------------------------------- Net cash provided from (used for) financing activities 143.1 (81.3) (97.9) - ------------------------------------------------------------------------------------------------------------------- Net increase in cash during year 15.4 2.2 2.1 Cash balance at beginning of year 7.0 4.8 2.7 --------------------------------------- Cash balance at end of year $ 22.4 $ 7.0 $ 4.8 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. F-4 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries and have been prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). All significant intercompany transactions have been eliminated in consolidation. The financial statements include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of Fund American. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in the prior year financial statements have been restated to conform with the current year presentation. INVESTMENT SECURITIES Fund American's portfolio of fixed maturity investments, common equity securities and other investments are mainly classified as available for sale and are reported at fair value as of the balance sheet date. Net unrealized investment gains and losses, after tax, associated with such investments are reported as a net amount in a separate component of shareholders' equity. Changes in net unrealized investment gains and losses, after tax, are reported on the income statement as a component of comprehensive net income. Premiums and discounts on fixed maturity investments are accreted to income over the anticipated life of the investment. Other investments include: (i) equity securities having no established public market value which are recorded at an internally appraised fair value; (ii) securities which, due to restrictions regarding resale, are recorded at a discount to the quoted market value for similar unrestricted securities; (iii) investment limited partnership interests which are recorded using the equity method of accounting; (iv) mortgage loans held for investment which are recorded at the lower of cost or fair value, determined on an individual loan basis; and (v) financial instruments which are classified as trading securities and are recorded at fair value with realized and unrealized gains and losses reported on the income statement as gains or losses on financial instruments. Realized gains and losses resulting from sales of investment securities or from other than temporary impairments of value are accounted for using the specific identification method. Short-term investments are carried at amortized cost, which approximated fair value as of December 31, 1998 and 1997, and comprise securities which mature or become available for use within one year. Fund American's consolidated insurance operations are required to maintain deposits with insurance regulators of certain states in order to maintain their insurance licenses. The total fair value of such F-5 deposits totalled $12.0 million and $11.3 million as of December 31, 1998 and 1997, respectively. INSURANCE AND REINSURANCE OPERATIONS Premiums written are recognized as revenues as earned ratably over the terms of the related policies or reinsurance treaties. Unearned premiums represent the portion of premiums applicable to future insurance or reinsurance coverage provided by policies or treaties in force. Deferred policy acquisition costs represent commissions, premium taxes, brokerage expenses and other costs which are directly attributable to and vary with the production of new business and are deferred and amortized over the applicable premium recognition period. Deferred acquisition costs are limited to the amount expected to be recovered from future earned premiums and anticipated investment income. F-6 Losses and loss adjustment expenses are charged against income as incurred. Unpaid insurance losses and loss adjustment expenses are based on estimates by claims adjusters, legal counsel and actuarial staff of the ultimate costs of settling claims, including the effects of inflation and other societal and economic factors. Unpaid reinsurance losses and loss adjustment expenses are based on reports received from ceding companies. Unpaid loss and loss adjustment expense reserves represent management's best estimate of ultimate losses and loss adjustment expenses net of estimated salvage and subrogation recoveries, if applicable. Such estimates are regularly reviewed and updated and any adjustments resulting therefrom are reflected in current operations. The process of estimating loss and loss adjustment expenses involves a considerable degree of judgement by management and the ultimate amount of expense to be incurred could be considerably greater than or less than the amounts currently reflected in the financial statements. In the normal course of business, Fund American's insurance subsidiaries seek to limit losses that may arise from catastrophes or other events that may cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Fund American remains contingently liable for risks reinsured with third parties to the extent that the reinsurer is unable to honor its obligations under reinsurance contracts at the time of loss. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance premiums, commissions, expense reimbursements and reserves related to reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other companies have been reported as a reduction of premiums written. Amounts applicable to reinsurance ceded for unearned premium reserves and loss and loss adjustment expense reserves (e.g., prepaid reinsurance premiums and reinsurance recoverable on unpaid losses, respectively) are not material and have been included as a component of other assets. Expense allowances received in connection with reinsurance ceded have been accounted for as a reduction of the related policy acquisition costs and are deferred and amortized accordingly. MORTGAGE BANKING OPERATIONS Fund American acquired Source One in 1986. The purchase price paid for Source One in 1986 was in excess of the estimated fair value of the net assets acquired on that date and was allocated to goodwill. Prior to December 1996 Source One's goodwill was being amortized over 20 years. During 1996 Fund American re-assessed the recoverability of goodwill and certain other intangible assets related to Source One and determined that it should write-off all such assets related to Source One. This resulted in a $32.6 million pretax write-off of goodwill and other intangible assets. Factors considered in the determination to write-off all Source One's goodwill and other assets were (i) increased competition and industry consolidation during 1996 which had adversely impacted the value of both the mortgage loan production and servicing operations of Source One and (ii) the attainment of a definitive agreement in the fourth quarter of 1996 to sell the majority of Source One's mortgage servicing portfolio at essentially book value. F-7 Mortgage loans held for sale are stated at the lower of aggregate cost or fair value, including the fair value of commitments to originate and sell mortgage loans. Conventional mortgage loans are placed on a non-accrual basis when delinquent 90 days or more as to interest or principal. Interest on delinquent FHA insured loans is accrued at the insured rate beginning on the sixty-first day of delinquency. Interest on delinquent VA guaranteed loans is accrued at the loan rate during the period of delinquency. Gains and losses from sales of mortgage loans are recognized when the proceeds are received. Loan origination fees, net of certain direct costs, are deferred and recognized as income when the related mortgage loans are sold. Discounts from the origination of mortgage loans held for sale are deferred and recognized as adjustments to gains or losses on sales. F-8 Capitalized mortgage servicing includes certain costs incurred in the origination and acquisition of mortgage servicing rights which are deferred and amortized over the expected life of the loan. The total cost of acquiring mortgage loans, either through origination activities or purchase transactions, is allocated between the mortgage servicing rights and the loans based on their relative fair values. The fair values of mortgage servicing rights are estimated by calculating the present value of the expected future net cash flows associated with such rights, incorporating assumptions that market participants would use in their estimates of future servicing income and expense. A current market rate is used to discount estimated future cash flows. Impairment of capitalized mortgage servicing rights is measured on a disaggregated basis by stratifying the mortgage servicing rights based on one or more predominant risk characteristics of the underlying loans. Impairment is recognized through a valuation allowance for each individual stratum. The valuation allowance for Source One's principal recourse portfolio includes a reserve for estimated losses on the corresponding loans. Pool loan purchases, which are carried at cost, represent FHA insured, VA guaranteed and conventional loans which were either delinquent or in the process of foreclosure at the time they were purchased from GNMA, FNMA or FHLMC mortgage-backed security pools which Source One services. Interest is accrued on these purchased loans at a rate based on expected recoveries. Mortgage claims receivable represent claims filed primarily with FHA and VA. These receivables are carried at cost less an estimated allowance for amounts that are not fully recoverable from the claims filed with the underlying mortgage insuring agencies. Real estate acquired is stated at the lower of fair value less estimated selling costs or the recorded balance satisfied at the date of acquisition, as determined on an individual property basis. Costs related to maintaining the properties are charged to expense as incurred. Mortgage servicing revenue represents fees earned for servicing real estate mortgage loans owned by investors and late charge income. The servicing fees are calculated based on the outstanding principal balances of the loans serviced and are recognized together with late charge income when received. FOREIGN CURRENCY TRANSLATION Folksamerica operates a branch office in Toronto, Canada to service its Canadian customers. Net unrealized foreign currency translation gains and losses, after tax, associated with Folksamerica's Canadian operation are reported as a net amount in a separate component of shareholders' equity. Changes in the values of these operations due to currency fluctuations, after tax, are reported on the income statement as a component of comprehensive net income. EARNINGS PER SHARE Basic earnings per share amounts are based on the weighted average number of Shares outstanding. In the basic earnings per share calculation, net income is reduced by preferred stock dividends to arrive at earnings applicable to common stock. Diluted earnings per share amounts are based on the weighted average number of Shares and potential dilutive Shares outstanding. Potential F-9 dilutive Shares include stock options, warrants and preferred stock redeemable for Shares. In the diluted earnings per share calculation, net income is reduced by preferred stock dividends to arrive at earnings applicable to common stock. F-10 The following table outlines the Company's computation of earnings per share for the years ended December 31, 1998, 1997 and 1996: - ------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ----------------------------------- 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE NUMERATORS (IN MILLIONS): After tax earnings $ 82.2 $ 49.0 $ 8.6 Preferred stock dividends of subsidiary (3.7) (3.7) (3.7) ----------------------------------- After tax earnings applicable to common stock 78.5 45.3 4.9 Loss on early extinguishment of debt, after tax - (6.0) - ----------------------------------- Net income available applicable to common stock $ 78.5 $ 39.3 $ 4.9 ----------------------------------- ----------------------------------- Comprehensive net income applicable to common stock $ 69.6 $ 81.0 $ 59.5 - ------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE NUMERATORS (IN MILLION): After tax earnings applicable to common stock $ 78.5 $ 45.3 $ 4.9 After tax dilution to earnings from unconsolidated insurance affiliates (.4) (.2) - ----------------------------------- Diluted after tax earnings available applicable to common stock 78.1 45.1 4.9 Loss on early extinguishment of debt, after tax - (6.0) - ----------------------------------- Diluted net income available applicable to common stock $ 78.1 $ 39.1 $ 4.9 ----------------------------------- ----------------------------------- Diluted comprehensive net income applicable to common stock $ 69.2 $ 80.8 $ 59.5 ----------------------------------- - ------------------------------------------------------------------------------------------------------------------- EARNINGS PER SHARE DENOMINATORS (IN THOUSANDS): Basic earnings per share numerator (average common shares outstanding) 5,866 6,570 7,429 Dilutive stock options and warrants to acquire common stock (a) 669 674 681 ----------------------------------- Diluted earnings per share denominator 6,535 7,244 8,110 ----------------------------------- - ------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE (IN DOLLARS): After tax earnings $13.38 $ 6.89 $ .66 Loss on early extinguishment of debt, after tax - (.91) - ----------------------------------- Net income applicable to common stock $13.38 $ 5.98 $ .66 ----------------------------------- ----------------------------------- Comprehensive net income $11.87 $12.33 $ 8.01 ----------------------------------- - ------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE (IN DOLLARS): After tax earnings $11.94 $ 6.22 $ .60 Loss on early extinguishment of debt, after tax - (.82) - ----------------------------------- Net income applicable to common stock and assumed conversions $11.94 $ 5.40 $ .60 ----------------------------------- ----------------------------------- Comprehensive net income $10.58 $11.15 $ 7.33 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- (a) See Note 11 for detailed information concerning the Company's outstanding dilutive stock options and warrants to acquire common stock. F-11 ACCOUNTING STANDARDS RECENTLY ADOPTED AND ISSUED In December 1996 the Financial Accounting Standards Board (the "FASB") issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125" which deferred the adoption of certain transfer and collateral provisions of SFAS No. 125 to periods beginning after December 31, 1997. The adoption of SFAS No. 127, did not have a material effect on Fund American's current financial position or results of operations. In June 1997 the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprises and Related Information" which establishes new standards for reporting information about operating segments. The required information under SFAS No. 131 is contained in Note 14. In March 1998, the American Institute of Certified Public Accountants (the "AICPA") issued Statement of Position ("SOP") 98-1 entitled "Accounting For the Cost of Computer Software Developed or Obtained for Internal Use" which requires the capitalization of certain prospective costs in connection with developing or obtaining software for current use. The adoption of SOP 98-1 is not expected to have a material impact on Fund American's financial position or results of operations. In June 1998 the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at fair value. The manner in which companies are to record gains and losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. SFAS No. 133 is effective beginning in 2000 with earlier adoption permitted. The adoption of SFAS No. 133, is not expected to have a material effect on Fund American's financial position or results of operations. In October 1998, the AICPA issued SOP 98-7 entitled "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Risk". SOP 98-7 provides guidance on how to account for all insurance and reinsurance contracts that do not transfer insurance risk, except for long-duration life and health insurance contracts. SOP 98-7 is effective for periods beginning January 1, 2000, with early adoption permitted. Fund American is currently evaluating the impact of the adoption of SOP 98-7 and the potential effects on its financial position and results of operations. NOTE 2. REINSURANCE OPERATIONS On August 18, 1998, Fund American acquired all of the remaining outstanding shares of Folksamerica Common Stock for $169.1 million thereby causing Folksamerica to become a consolidated subsidiary of the F-12 Company as of that date. Before the August 18th transaction, Fund American owned a 50% non-consolidated interest in Folksamerica, primarily through the Folksamerica Preferred Stock with fixed price warrants to acquire common stock. As a result of the Folksamerica transaction, Fund American has restated its December 31, 1997 balance sheet and its income statement for the year ended December 31, 1997 to account for the portion of its investment in Folksamerica that was reported at fair value in accordance with SFAS No. 115 entitled "Accounting for Certain Investments in Debt and Equity Securities" to its original cost in accordance with the purchase accounting principles of Accounting Principles Board Opinion ("APB") No. 18 entitled "The Equity Method of Accounting for Investments in Common Stock". Because the cost of Fund American's investment in Folksamerica was less than the fair value of Folksamerica's net identifiable assets at August 18, 1998, Fund American recorded a $39.8 million deferred credit ($37.1 million as of December 31, 1998) that will be amortized to income over 5 years. Supplemental condensed pro forma financial information for the year ended December 31, 1998, which assumes that Fund American's acquisition of all the outstanding Folksamerica Common Stock had occurred as of January 1, 1998, follows: - --------------------------------------------------------------------------------------------------------------------- PRO FORMA YEAR ENDED Millions, except per share amounts DECEMBER 31, 1998 - --------------------------------------------------------------------------------------------------------------------- Total revenues $756.0 Net income $ 98.7 Comprehensive net income $ 99.5 BASIC EARNINGS PER SHARE: Net income $16.19 Comprehensive net income $16.33 DILUTED EARNINGS PER SHARE: Net income $14.46 Comprehensive net income $14.59 - --------------------------------------------------------------------------------------------------------------------- The pro forma information presented does not purport to represent what Fund American's results of operations actually would have been had Fund American acquired all the outstanding common stock of Folksamerica as of January 1, 1998, or to project Fund American's results of operations for any future date or period. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVE ACTIVITY The following table summarizes Fund American's loss and loss adjustment expense reserve activity relating to Folksamerica for the interim period from August 18, 1998 to December 31, 1998: F-13 - ------------------------------------------------------------------------------------------------------------------- Millions YEAR ENDED DECEMBER 31, 1998 - ------------------------------------------------------------------------------------------------------------------- Beginning balance $ - Gross loss and loss adjustment expenses acquired 726.1 Less beginning reinsurance recoverable (124.1) ----------------- Net loss and loss adjustment expenses acquired 602.0 Losses and loss adjustment expenses incurred relating to: Current year losses 58.6 Prior year losses 1.1 Loss and loss adjustment expenses paid relating to: Current year losses (13.0) Prior year losses (54.5) ----------------- Net ending balance 594.2 Plus ending reinsurance recoverable 129.0 ----------------- Gross ending balance $ 723.2 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- As of December 31, 1998, Folksamerica carried reported case reserves for environmental and asbestos exposures of $14.9 million ($10.9 million net of reinsurance) and $29.5 million ($17.9 million net of reinsurance), respectively. Folksamerica also holds IBNR for these exposures of $25.2 million ($19.2 million net of reinsurance). ADDITIONAL REINSURANCE OPERATIONS INFORMATION For the period from August 18, 1998 to December 31, 1998, Fund American recorded $73.7 million of premiums written, $85.4 million of premiums earned, $29.1 million of reinsurance acquisition costs and $59.7 million of loss and loss adjustment expenses relating to Folksamerica. These amounts are shown net of reinsurance ceded by Folksamerica of $9.4 million of premiums written, $8.7 million of premiums earned, $.9 million of reinsurance acquisition costs and $18.9 million of loss and loss adjustment expenses. Folksamerica's policyholders' surplus, as reported to various regulatory authorities as of December 31, 1998 was $328.5 million and its statutory net income for the period from August 18, 1998 to December 31, 1998 was $9.0 million. The principal differences between Folksamerica's statutory amounts and the amounts reported in accordance with GAAP (Folksamerica's stand-alone shareholders' equity was $302.0 million at December 31, 1998 and its net income was $5.5 million for the year then ended) include deferred taxes, deferred acquisition costs and market value adjustments for debt securities. Folksamerica's statutory policyholders' surplus at December 31, 1998 was in excess of the minimum requirements of relevant state insurance regulations. Under the insurance laws of the states under which Folksamerica is incorporated or licensed to write business, an insurer is restricted with respect to the amount of dividends it may pay without prior approval by state regulatory authorities. Accordingly, there is no assurance that dividends may be paid by Folksamerica in the future. At December 31, 1998, Folksamerica had the ability to pay dividends to its shareholders of $32.9 million without prior approval of regulatory authorities. F-14 NOTE 3. INSURANCE OPERATIONS CONSOLIDATED INSURANCE OPERATIONS In 1995 White Mountains created WMIC and commenced its operations. On December 1, 1995, White Mountains acquired Valley and Charter for $41.7 million in cash less $3.0 million of purchase price adjustments. The purchase price paid for Valley and Charter was $.9 million less than the aggregate book value and estimated fair value of the net assets of the companies on the date of acquisition. The resulting negative goodwill is being amortized to income on a straight-line basis over five years. On January 19, 1996, VIC purchased Valley National for $13.2 million, net of cash balances acquired. Assets acquired pursuant to the Valley National acquisition included an investment portfolio, consisting principally of fixed maturity investments, totalling $6.7 million. The excess purchase price of $6.4 million is being amortized over a five year period. In 1998, 1997 and 1996, Valley, Charter and WMIC had $167.8 million, $157.5 million and $154.3 million of gross written premiums, respectively, primarily in California, Oregon, Texas and Washington. In 1998, 1997 and 1996 Valley, Charter and WMIC had $160.6 million, $145.3 million and $109.7 million of earned premiums. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVE ACTIVITY The following table summarizes Valley, Charter and WMIC's loss and loss adjustment expense reserve activity for the years ended December 31, 1998, 1997 and 1996: - ------------------------------------------------------------------------------------------------------------------- Year Ended Millions December 31, --------------------------- 1998 1997 1996 --------------------------- Beginning balance $ 71.9 $ 65.4 $ 44.1 Less beginning reinsurance recoverable (8.7) (9.2) (7.3) --------------------------- Net loss and loss adjustment reserve 63.2 56.2 36.8 Losses and loss adjustment expenses incurred relating to: Current year losses 108.4 99.6 82.1 Prior year losses 6.7 (2.5) 3.5 Loss and loss adjustment expenses paid relating to: Current year losses (65.5) (59.7) (47.8) Prior year losses (33.2) (30.4) (18.4) --------------------------- Net ending balance 79.6 63.2 56.2 Plus ending reinsurance recoverable 8.9 8.7 9.2 --------------------------- Ending balance $ 88.5 $ 71.9 $ 65.4 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- F-15 ADDITIONAL INSURANCE OPERATIONS INFORMATION Total policyholders' surplus of Valley, Charter and WMIC, as reported to various regulatory authorities, as of December 31, 1998 and 1997, was $105.7 million and $97.7 million, respectively. Statutory net income for the years ended December 31, 1998 and 1997 for Valley, Charter and WMIC totalled $8.4 million and $11.0 million, respectively. For the year ended December 31, 1996, Valley had a statutory net loss of $6.4 million. The principal differences between Valley, Charter and WMIC's statutory amounts and the amounts reported in accordance with GAAP (VGI's stand-alone shareholders' equity was $109.4 million at December 31, 1998 and its net income was $4.8 million for the year then ended) include deferred taxes, surplus debentures and deferred acquisition costs. Valley, Charter and WMIC's statutory policyholders' surplus at December 31, 1998 and 1997, was in excess of the minimum requirements of relevant state insurance regulations. Under the insurance laws of the various states under which Valley, Charter and WMIC are incorporated or licensed to write business, an insurer is restricted with respect to the amount of dividends it may pay without prior approval by state regulatory authorities. Accordingly, there is no assurance that dividends may be paid by Valley, Charter and WMIC in the future. At December 31, 1998 and 1997, $1.1 million and $9.8 million, respectively, of Valley, Charter and WMIC's statutory surplus was available for the payment of dividends to its shareholders without prior approval of regulatory authorities. NOTE 4. INVESTMENT SECURITIES Fund American's net investment income is comprised primarily of interest income earned on mortgage loans held for sale (gross of related interest expense on short-term borrowings used to finance such loans), interest income from its fixed maturity investments, dividend income from its equity investments and interest income from its short-term investments. Net investment income consisted of the following: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Investment income: Mortgage loans held for sale $ 81.4 $ 43.1 $ 39.3 Fixed maturity investments 28.4 11.3 10.4 Common equity securities 3.6 7.3 4.3 Short-term investments 3.5 3.9 6.6 Other 2.3 - (2.3) ------------------------------------- Total investment income 119.2 65.6 58.3 Less investment expenses and other charges (.8) (.5) (1.0) ------------------------------------- Net investment income, before tax $118.4 $ 65.1 $ 57.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-16 Total net investment gains, before tax, associated with Fund American's investment portfolio consisted of the following: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Gross realized investment gains $ 74.0 $ 98.6 $ 43.3 Gross realized investment losses (3.0) (1.9) (4.8) ------------------------------------- Net realized investment gains 71.0 96.7 38.5 Change in net unrealized investment holding gains (a) (44.2) (10.1) 68.0 ------------------------------------- Total net investment gains, before tax $ 26.8 $ 86.6 $ 106.5 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Excludes net unrealized investment gains and losses recorded from Fund American's investments in unconsolidated insurance affiliates. The components of Fund American's ending net unrealized investment gains and losses on its investment portfolio and its investments in unconsolidated insurance affiliates were as follows: - --------------------------------------------------------------------------------------------------------------------- December 31, ------------------------ Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- Investment securities: Gross unrealized investment gains $ 68.4 $ 112.1 Gross unrealized investment losses (2.5) (2.0) ------------------------ Net unrealized gains from investment securities 65.9 110.1 Net unrealized gains from investments in unconsolidated insurance affiliates 128.1 96.2 ------------------------ Total net unrealized investment gains, before tax $ 194.0 $ 206.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-17 The cost or amortized cost, gross unrealized investment gains and losses, and carrying values of Fund American's fixed maturity investments as of December 31, 1998 and 1997, were as follows: - --------------------------------------------------------------------------------------------------------------------- December 31, 1998 --------------------------------------------------------- Cost or Gross Gross amortized unrealized unrealized Carrying Millions cost gains losses value - --------------------------------------------------------------------------------------------------------------------- Debt securities issued by industrial corporations $351.9 $ 7.0 $(1.0) $357.9 U. S. Government and agency obligations 217.6 4.7 (.3) 222.0 Municipal obligations 189.1 2.8 (.1) 191.8 GNMA Mortgage-backed securities 79.0 .9 (.7) 79.2 MediaOne redeemable preferred stock 49.8 - - 49.8 Foreign government obligations 26.7 .3 (.1) 26.9 Aggregate of holdings less than $10 million 2.0 - - 2.0 --------------------------------------------------------- Total fixed maturity investments $916.1 $15.7 $(2.2) $929.6 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- December 31, 1997 --------------------------------------------------------- Cost or Gross Gross amortized unrealized unrealized Carrying Millions cost gains losses value - --------------------------------------------------------------------------------------------------------------------- MediaOne redeemable preferred stock $ 49.4 $ - $ - $ 49.4 Municipal obligations 33.3 .6 - 33.9 Debt securities issued by industrial corporations 32.4 1.0 (.7) 32.7 U. S. Government and agency obligations 32.3 .9 - 33.2 GNMA Mortgage-backed securities 15.4 1.0 - 16.4 Aggregate of holdings less than $10 million 2.6 .1 - 2.7 --------------------------------------------------------- Total fixed maturity investments $165.4 $3.6 $(.7) $168.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- The cost or amortized cost and carrying value of Fund American's fixed maturity investments at December 31, 1998 and 1997, are presented below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. - --------------------------------------------------------------------------------------------------------------------- December 31, 1998 -------------------------- Cost or Amortized Carrying Millions Cost Value - --------------------------------------------------------------------------------------------------------------------- Due in one year or less $109.4 $108.1 Due after one year through five years 278.9 279.9 Due after five years through ten years 352.8 365.9 Due after ten years 98.0 99.1 GNMA Mortgage-backed securities 77.0 76.6 ---------------------------- Total $916.1 $929.6 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-18 Sales of investments, excluding short-term investments, totalled $301.3 million, $300.4 million and $363.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. A non-cash exchange of investment securities totalling $2.3 million is not reflected in the 1996 Consolidated Statement of Cash Flows. There were no non-cash exchanges of investment securities during 1998 or 1997. Fund American adopted the provisions of SFAS No. 130 during 1997 and now reports the change in net unrealized investment gains, after tax, on its income statement to arrive at comprehensive net income. All prior period income statements have been restated to reflect application of this statement. The components of the change in net unrealized investment gains, after tax, are as follows: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Net realized investment gains $ 71.0 $ 96.7 $ 38.5 Income tax expense applicable to net realized investment gains (24.9) (33.8) (13.5) -------------------------------------- Net realized investment gains, after tax $ 46.1 $ 62.9 $ 25.0 -------------------------------------- -------------------------------------- Net unrealized investment holding gains arising during the year $ 58.6 $ 160.9 $ 122.5 Income tax expense applicable to net unrealized investment holding gains (20.5) (56.3) (42.9) -------------------------------------- Net unrealized investment holding gains arising during the year, after tax 38.1 104.6 79.6 Net unrealized gains reclassed to realized gains for investments sold, after tax(46.1) (62.9) (25.0) -------------------------------------- Change in net unrealized investment gains, after tax $(8.0)(a) $ 41.7 $ 54.6 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Excludes a $.9 million after tax unrealized loss associated with foreign currency translation adjustments NOTE 5. CAPITALIZED MORTGAGE SERVICING Source One estimates the fair values of its mortgage servicing rights by calculating the present value of the expected future net cash flows associated with such rights. In making those estimates, Source One incorporates assumptions that market participants would use in their estimates of future servicing income and expense. To measure impairment of its owned mortgage servicing rights, Source One has determined that the predominant risk characteristics inherent in the portfolio are prepayment risk, risk of default and operational risk. As a result, Source One has stratified its owned mortgage loan servicing portfolio by interest rate, loan type (investor), original term to maturity and principal recourse. In estimating the fair value of its owned mortgage loan servicing portfolio, Source One uses market consensus prepayment rates and discounts future net cash flows using representative market interest rates which were 10.5% for conventional loans, 12.0% for insured loans, and 21.0% for recourse loans. The fair value of each stratum is computed and compared to its recorded book value to determine if an F-19 impairment valuation allowance, or recovery of a previously established valuation allowance, is required. As a result of the 1997 servicing sale, Source One's recourse portfolio has become a significant component of its total remaining owned servicing portfolio. Included in Source One's calculation for measuring impairment of its capitalized servicing asset is an $5.2 million and $8.2 million pretax reserve for estimated recourse losses on the corresponding loans in determining the fair value of its principal recourse portfolio as of December 31, 1998 and 1997, respectively. The discount rate and prepayment assumptions are significant factors used in estimating the fair value of Source One's mortgage servicing rights. Accordingly, the value of mortgage servicing rights can be significantly impacted by changes in interest rates. Source One adopted certain provisions of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" in the 1997 first quarter. SFAS No. 125 served to eliminate the distinction between "normal" servicing rights and excess servicing receivables. Source One estimated the fair value of its portfolio during 1997 in accordance with SFAS No. 125 which did not materially effect Source One's 1997 results. Prior to the adoption of SFAS No. 125, Source One estimated the fair value of its capitalized excess servicing asset by discounting the anticipated future cash flows over the estimated life of the related loans. Source One uses "interest only strip" interest rates to determine the appropriate discount rates and prepayment speed assumption rates that are based on interest rates, loan types (investor) and original term to maturity. The discount rate used to capitalize excess servicing for the year ended December 31, 1996, ranged from 12.0% to 12.6%. For the year ended December 31, 1996, the weighted average discount rate inherent in the carrying amount of the capitalized excess servicing asset was 10.4%. The following table summarizes the fair value of mortgage servicing rights and certain characteristics of Source One's servicing portfolio related to such mortgage servicing rights by loan type as of December 31, 1998: - --------------------------------------------------------------------------------------------------------------------- Fair value Principal Weighted Weighted Weighted of mortgage balance average average average servicing rights serviced(a) interest maturity service (millions) (millions) rate (months) fee - --------------------------------------------------------------------------------------------------------------------- Loan Type: Insured $117.4 $4,901 7.47% 334 .50% Conventional 33.0 1,573 7.78 271 .39 Recourse 25.9 1,787 8.43 202 .47 Adjustable 1.7 106 7.89 256 .41 -------------------------------- Total servicing portfolio $178.0 $8,367 7.74% 293 .47% - --------------------------------------------------------------------------------------------------------------------- F-20 (a) Excludes $635 million of principal balance of mortgage servicing rights not capitalized prior to the adoption of an accounting standard implemented by Source One in 1995 and $195 million of originations funded but not yet capitalized. The following table summarizes changes in Source One's capitalized servicing asset: - --------------------------------------------------------------------------------------------------------------------- Deferred gain on Total Mortgage Valuation sale of capitalized Millions servicing allowance Subservicing servicing servicing - --------------------------------------------------------------------------------------------------------------------- Balances at January 1, 1996 $438.1 $(28.0) $ - $(13.0) $397.1 Additions 125.5 - - - 125.5 Scheduled amortization (69.9) - - - (69.9) Impairment/unscheduled amortization (1.1) (8.2) - - (9.3) Amortization of deferred gain - - - 6.1 6.1 Recourse loan losses - 7.3 - - 7.3 Sales (45.9) - - - (45.9) - --------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1996 446.7 (28.9) - (6.9) 410.9 Additions 90.4 (1.2) - - 89.2 Scheduled amortization (37.5) - (8.9) - (46.4) Impairment/unscheduled amortization - (21.2) (.5) - (21.7) Amortization of deferred gain - - - 6.9 6.9 Recourse loan losses - 3.9 - - 3.9 Sales (273.7) 2.3 9.6 - (261.8) - --------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1997 225.9 (45.1) .2 - 181.0 Additions 240.8 - - - 240.8 Scheduled amortization (38.6) - (1.8) - (40.4) Impairment/unscheduled amortization - (14.7) - - (14.7) Recourse loan losses - 2.7 - - 2.7 Sales (221.2) 21.5 - - (199.7) - --------------------------------------------------------------------------------------------------------------------- BALANCES AT DECEMBER 31, 1998 $206.9 $(35.6) $(1.6) $ - $169.7 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-21 During 1998 Source One sold the rights to service $10.6 billion of nonrecourse mortgage loans for cash proceeds of $227.9 million resulting in a pretax gain on sale of $15.2 million. During 1997 Source One sold the rights to service $17.0 billion of nonrecourse mortgage loans for cash proceeds of $266.9 million resulting in a pretax loss on sale of $8.0 million including a related loss on the assumption of subservicing. During 1996 Source One sold the rights to service $3.3 billion of mortgage loans for net proceeds of $55.9 million, resulting in a pretax gain of $10.1 million. As part of the 1998 and 1997 servicing sales, Source One retained the right to subservice $4.1 billion and $17.0 billion of these loans, respectively, for a contracted fee through 2001. Subservicing assets are amortized on a straight-line basis over the subservicing period and are tested for impairment. During 1994 Source One sold the rights to service $3.9 billion of mortgage loans to a third party and retained the rights to subservice those loans pursuant to a subservicing agreement. In connection with the servicing sale, a pretax gain of $19.9 million was deferred in 1994 and was to be recognized as income over the five-year life of the subservicing agreement. In 1996, the third party sold the rights to service approximately $1.0 billion of these loans subserviced by Source One which resulted in Source One recognizing $2.4 million of the deferred gain on an accelerated basis. In 1997, the third party sold the remainder of the loans subserviced by Source One which resulted in Source One recognizing the remaining balance of the deferred gain during 1997. NOTE 6. MORTGAGE SERVICING Source One services loans throughout the United States. Source One's portfolio of mortgage loans serviced (including loans subserviced, interim servicing contracts and portfolios under contract to acquire but excluding loans sold but not transferred) totalled $25.1 billion and $26.5 billion as of December 31, 1998 and 1997, respectively. The following table summarizes the mortgage loan servicing portfolio as of December 31, 1998: - --------------------------------------------------------------------------------------------------------------------- Weighted average --------------------------------------------------------------- Principal Remaining balance Loan contractual serviced balance Interest Net servicing life Loan type (millions) (thousands) rate fee rate (months) - --------------------------------------------------------------------------------------------------------------------- Residential Conventional $ 3,929 $ 64 8.14% .396% 237 FHA 2,486 75 7.74 .398 334 VA 2,736 81 7.26 .400 331 Commercial 46 927 7.16 .189 173 ------------- Owned servicing portfolio $ 9,197 $ 72 7.76% .397% 291 Subservicing portfolio 15,915 ------------- - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- Total mortgage servicing portfolio $25,112 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- The servicing fee rates in the preceding table are shown after deducting applicable guarantee fees. Guarantee fees, when applicable, range from 6 basis points for governmental loans to approximately 30 basis points for certain conventional loans. Certain loans sold to private investors have no guarantee fees. F-22 The following tables summarize Source One's owned mortgage loan servicing portfolio by interest rate range and by location of property: - --------------------------------------------------------------------------------------------------------------------- December 31, 1998 December 31, 1997 ------------------------------------------- -------------------------------------------- Aggregate Weighted Aggregate Weighted Number principal average Number principal average Interest rate of balance interest of balance interest range loans (millions) rate loans (millions) rate - --------------------- ------------------------------------------- -------------------------------------------- 5.99% and lower 438 35 5.17% 843 $ 66 5.41% 6.00% - 6.49% 1,193 127 6.22 1,823 159 6.13 6.50% - 6.99% 10,870 1,111 6.64 4,166 319 6.66 7.00% - 7.49% 28,036 2,337 7.08 12,968 729 7.17 7.50% - 7.99% 30,928 2,550 7.58 29,240 2,455 7.63 8.00% - 8.49% 15,778 1,155 8.12 27,989 2,280 8.13 8.50% - 8.99% 17,999 809 8.62 32,178 1,867 8.59 9.00% - 9.49% 5,934 275 9.12 13,452 722 9.07 9.50% - 9.99% 7,580 339 9.64 29,142 1,420 9.55 10% and above 9,574 459 10.73 32,488 1,610 10.49 ------------------------------------------- -------------------------------------------- Total 128,330 $9,197 7.76% 184,289 $11,627 8.52% - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- December 31, 1998 December 31, 1997 ------------------------------------------- --------------------------------------------- Aggregate Aggregate Number principal Percentage Number principal Percentage of balance of servicing of balance of servicing State loans (millions) portfolio loans (millions) portfolio - --------------------- ------------------------------------------- --------------------------------------------- California 17,617 $1,795 19.5% 20,459 $ 1,889 16.3% New York 17,572 935 10.2 22,118 1,162 10.0 Texas 11,448 676 7.4 15,655 736 6.3 Washington 5,033 486 5.3 7,889 690 5.9 Florida 7,849 471 5.1 12,894 663 5.7 Michigan 7,810 393 4.3 10,773 520 4.5 Maryland 4,159 377 4.1 5,020 362 3.1 New Jersey 5,145 364 4.0 7,088 503 4.3 Ohio 4,461 298 3.2 6,658 357 3.1 Illinois 3,441 260 2.8 6,335 420 3.6 Other 43,795 3,142 34.1 69,400 4,325 37.2 ------------------------------------------- --------------------------------------------- Total 128,330 $9,197 100.0% 184,289 $11,627 100.0% - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- Escrow funds of approximately $207.9 million and $196.8 million as of December 31, 1998 and 1997, respectively, relating to mortgages serviced and subserviced, were held in non-interest bearing accounts at non-affiliated banks and are not included in the consolidated financial statements. F-23 NOTE 7. MORTGAGE LOANS HELD FOR SALE AND POOL LOAN PURCHASES The following tables summarize Source One's mortgage loans held for sale and pool loan purchases: - --------------------------------------------------------------------------------------------------------------------- December 31, --------------------------- Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- Adjustable rate mortgage loans, weighted average interest rates of 6.39% and 6.36% $ 15.1 $ 51.6 Fixed rate 5 year through 25 year mortgage loans, weighted average interest rates of 7.10 and 7.68% 240.0 60.4 Fixed rate 30 year mortgage loans, weighted average interest rates of 7.33% and 7.76% 420.3 405.0 --------------------------- Total principal amount 675.4 517.0 Net premiums .9 2.3 --------------------------- Total mortgage loans held for sale $676.3 $ 519.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- December 31, ---------------------------------------------------- Principal balance Number of loans ---------------------- --------------------- Dollars in Millions 1998 1997 1998 1997 - --------------------------------------------------------------------------------------- --------------------- Loan type: FHA $119.6 $103.1 1,640 1,781 VA 45.3 43.3 550 669 Conventional .1 3.4 4 45 ---------------------- --------------------- Total pool loan purchases $165.0 $149.8 2,194 2,495 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-24 NOTE 8. DEBT SHORT-TERM DEBT Short-term debt outstanding consisted of the following: - --------------------------------------------------------------------------------------------------------------------- December 31, ---------------------------- Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- White Mountains: Credit facility $ 50.0 $ - Charter: Notes payable and lease obligations 1.5 2.0 Source One: Credit agreement borrowings 697.3 569.5 Less net discounts (.3) (.1) ---------------------------- Total Source One 697.0 569.4 ---------------------------- Total short-term debt $748.5 $ 571.4 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- The weighted average interest rates of short-term debt outstanding during the year ended December 31, 1998 and 1997 were as follows: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ------------------------- 1998 1997 - --------------------------------------------------------------------------------------------------------------------- White Mountains: Credit facility 6.20% 6.04% Charter: Notes payable 6.50% 6.50% Source One: Credit agreement borrowings 5.79% 6.34% Commercial paper and short-term borrowings - % 5.81% - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- In August 1998 the Company entered into a $35.0 million revolving credit agreement with a syndicate of banks which served to replace an expiring arrangement in the same amount. Under the agreement, through August 12, 1999 the Company may borrow up to $35.0 million at short-term market interest rates. The credit agreement contains certain customary covenants and conditions. At December 31, 1998 the Company was in compliance with all covenants under the facility and had no borrowings outstanding under the agreement. At December 31, 1997 the Company had no outstanding borrowings under the former facility. In November 1996 White Mountains entered into a five year revolving credit facility under which it may borrow up to $50.0 million at market interest rates. At December 31, 1998 White Mountains had $50.0 million of borrowings outstanding under the facility which was used to partially fund White Mountains additional investment in MSA and its acquisition of Folksamerica during 1998. White Mountains had no borrowings outstanding at December 31, 1997 under the facility. During 1996 Charter extended $3.2 million of notes payable to be repaid in three equal installments in 1997, 1998 and 1999. As of December 31, 1998 $1.1 million of the notes remained outstanding. The notes are collateralized by certain assets of Charter. F-25 In July 1998 Source One amended and restated its $600.0 million secured revolving credit agreement to increase its borrowing capacity and flexibility. The provisions of the amended agreement increased Source One's borrowing capacity to $800.0 million. The facility expires on July 9, 1999. At December 31, 1998, Source One was in compliance with all covenants under the agreement and had $650.5 million of borrowings outstanding under this agreement. During the second quarter of 1998 Source One entered into two additional secured credit agreements whereby it may borrow up to $35.0 million and $175.0 million through July 1999 and April 1999, respectively. At December 31, 1998, Source One had a total of $21.6 million in borrowings outstanding under these agreements. In April 1998 Source One replaced its existing $15.0 million unsecured revolving credit agreement under which it can borrow up to $40.0 million through April 15, 1999. As of December 31, 1998, there was $25.2 million outstanding under the revolving credit agreement. In July 1997 Source One amended and restated its secured revolving credit agreement to reflect a reduction in its borrowing requirements resulting from the 1997 servicing sale. The provisions of the amended agreement decreased Source One's revolving credit facility from $750.0 million to $600.0 million and reduced Source One's borrowing costs by lowering the facility fee. At December 31, 1997, Source One was in compliance with all covenants and had $559.0 million of borrowing outstanding under this facility. In May 1997 Source One entered a unsecured revolving credit agreement under which it can borrow up to $15.0 million through June 1, 1998. As of December 31, 1997, there was $10.5 million outstanding under the revolving credit agreement. Source One must comply with certain financial covenants provided in its secured and unsecured revolving credit facilities, including restrictions relating to tangible net worth and leverage. In addition, the secured facility contains certain covenants which limit Source One's ability to pay dividends or make distributions of its capital in excess of preferred stock dividends and subordinated debt interest requirements each year. Source One is currently in compliance with all such covenants. F-26 LONG-TERM DEBT Long-term debt outstanding consisted of the following: - --------------------------------------------------------------------------------------------------------------------- December 31, ---------------------------- Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- Parent Company: Medium-term notes $116.3 $116.3 Less net discounts (.6) (.7) ---------------------------- Total Parent Company 115.7 115.6 ---------------------------- Folksamerica: Medium-term notes 55.6 - Valley: Medium-term notes 15.0 15.0 Charter: Notes payable in 1999 - 1.1 Source One: Medium-term notes, 8.875% due in 2001 18.7 18.7 Debentures, 9.0% due in 2012 100.0 100.0 Subordinate debentures, 9.375% due in 2025 56.0 56.0 Less net discounts (1.3) (2.1) ---------------------------- Total Source One 173.4 172.6 ---------------------------- Total long-term debt $359.7 $304.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- At December 31, 1998, the Parent Company had $116.3 million of outstanding medium-term notes with an average maturity of 4.4 years and a yield to maturity of 7.82%. Folksamerica has $55.6 million of medium-term notes outstanding which are guaranteed by one of the European Mutuals. As part of the August 18, 1998 Folksamerica acquisition, Fund American guaranteed Folksamerica's debt to the former owner and agreed to repay or refinance the obligation during the 1999 first quarter. The Folksamerica medium-term notes had scheduled maturities from 2001 to 2005 and had a weighted average interest rate of approximately 5.65% from August 18, 1998 to December 31, 1998. Valley has a five year credit facility under which it may borrow up to $15.0 million at market interest rates. During 1998 and 1997 Valley had $15.0 million of borrowings outstanding under the facility with a weighted average interest rate of 6.14% and 6.09%, respectively. In 1991 Source One issued $160.0 million of 8.875% medium-term notes due in 2001 of which $138.4 million remained outstanding at December 31, 1996. During 1997 Source One repurchased and retired in principal amount $119.7 million of these notes leaving $18.7 million outstanding at December 31, 1997 and 1998. In 1992 Source One issued $100.0 million of 9% debentures due in 2012 pursuant to a $250.0 million shelf registration statement. The debentures may not be redeemed by Source One prior to maturity. The proceeds from issuance were used for general corporate purposes. In December 1995, Source One exchanged and retired 2,239,061 shares Source One Preferred Stock for $56.0 million in principal amount of 9.375% subordinated debentures. The subordinated debentures are due in F-27 2025 but are redeemable at the option of Source One, in whole or part, at any time on or after May 1, 1999. In connection with Source One's February 28, 1997 sale of approximately $17.0 billion of mortgage servicing rights to a third party, the Company has made certain collection, payment and performance guarantees to the buyer for a period of no more than ten years. The aggregate amount of the Company's guaranty is initially limited to $20.0 million and amortizes down to $15.0 million as mortgage loans serviced under agreement are repaid. During 1998, the Company permitted the third party to include an additional $2.9 billion of mortgage servicing rights that it purchased from Source One during 1998 to be included in the guaranty, however, the inclusion of the 1998 servicing rights sold did not serve to change the maximum amount of the guarantee or the original term of the agreement. Total interest paid by Fund American for both short-term and long-term debt was $83.5 million, $51.9 million and $51.5 million in 1998, 1997 and 1996, respectively. Fund American's long-term debt maturities, including the current portion of long-term debt, for 1999, 2000, 2001, 2002, 2003 and beyond are $57.7 million, $6.0 million, $20.7 million, $10.0 million, $102.3 million and $166.0 million, respectively. NOTE 9. INCOME TAXES The Company and its subsidiaries file a consolidated Federal income tax return. The Federal income tax provision is computed on the consolidated taxable income of the Company and those subsidiaries. The total income tax provision consisted of the following: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Tax on pretax earnings: Federal $ 45.2 $26.7 $ 18.1 State and local 2.6 2.7 .8 --------------------------------------------- Income tax provision on pretax earnings 47.8 29.4 18.9 Tax benefit from loss on early extinguishment of debt - 3.2 - --------------------------------------------- Total income tax provision $ 47.8 $32.6 $ 18.9 --------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- Net income tax payments $ 35.7 $24.9 $ 7.0 --------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- Tax provision recorded directly to shareholders' equity related to: Changes in net unrealized investment gains and losses $(4.3) $22.5 $ 29.4 Changes in net foreign currency translation gains and losses $ (.5) $ - $ - - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-28 The components of the income tax provision (benefit) on pretax earnings follow: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, --------------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Current provision $ 49.0 $33.5 $ 22.5 Deferred benefit (1.2) (4.1) (3.6) --------------------------------------------- Total income tax provision on pretax earnings $ 47.8 $29.4 $ 18.9 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax return purposes. Fund American recorded a net deferred Federal income tax asset of $7.8 million as of December 31, 1998 and a net deferred Federal income tax liability of $19.6 million as of December 31, 1997. Significant components of Fund American's net deferred Federal income tax asset and liability follow: - --------------------------------------------------------------------------------------------------------------------- December 31, Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- Deferred tax assets related to: Employee compensation and benefit accruals $ 51.1 $ 39.1 Discounting of loss reserves 40.1 2.9 Capitalized mortgage servicing 21.1 26.2 Unearned insurance premiums 10.5 5.3 Allowance for mortgage loan losses 4.3 4.8 Other items 15.8 10.1 -------------------------- Total deferred tax assets $ 142.9 $ 88.4 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- F-29 - --------------------------------------------------------------------------------------------------------------------- December 31, -------------------------- Millions 1998 1997 - --------------------------------------------------------------------------------------------------------------------- Deferred tax liabilities related to: Net unrealized investment holding gains $ 83.0 $ 71.4 Earnings from insurance affiliates 17.5 11.8 Deferred acquisition costs 12.4 5.0 Purchase accounting adjustments 4.8 5.5 Unrealized gains on financial instruments 4.3 4.6 Other items 13.1 9.7 -------------------------- Total deferred tax liabilities $135.1 $108.0 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- A reconciliation of taxes calculated using the 35% Federal statutory rate to the income tax provision on pretax earnings follows: - --------------------------------------------------------------------------------------------------------------------- Year Ended December 31, --------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- Tax provision at Federal statutory rate $45.4 $27.4 $ 9.6 Differences in taxes resulting from: Dividends received deduction (2.6) (3.1) (2.3) Nonconventional fuel source tax credits (1.1) (2.4) - Tax reserve adjustments 5.4 5.1 4.2 State income taxes 1.7 1.8 .5 Write-off of goodwill and other intangible assets - - 8.1 Other, net (1.0) .6 (1.2) --------------------------------------- Total income tax provision on pretax earnings $47.8 $29.4 $18.9 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- The Company believes that it is more likely than not that results of future operations will generate sufficient taxable income to realize the deferred tax asset balances carried as of December 31, 1998 and 1997. NOTE 10. RETIREMENT AND POST-RETIREMENT PLANS The Company has an unfunded, nonqualified defined contribution plan for a select group of management employees for the purpose of providing retirement benefits (the "Deferred Benefit Plan"). The amount of annual contribution to the Deferred Benefit Plan is determined using actuarial assumptions. At December 31, 1998 and 1997, Fund American's liability to participants pursuant to the Deferred Benefit Plan was $4.8 million and $3.9 million, respectively. The Company also has an unfunded, nonqualified plan for a select group of management employees for the purpose of deferring current compensation for retirement savings (the "Deferred Compensation Plan"). Pursuant to the Deferred Compensation Plan, participants may voluntarily defer all or a portion of qualifying remuneration payable by Fund American. At December 31, 1998 and 1997, Fund American's liability to participants pursuant to the Deferred Compensation Plan was $65.1 million and $37.6 million, respectively. Source One, Folksamerica and Valley have defined contribution employee savings plans for the benefit of substantially all their employees. The costs of these plans are not material to Fund American's financial statements. F-30 Fund American also has various defined benefit pension plans for the benefit of the majority of its employees. Benefits under these plans are based on years of service and each employee's highest average eligible compensation over five consecutive years in his or her last ten years of employment. Cash contributions made by Fund American totalled less than $1.0 million for the years ended December 31, 1998 and 1997 and the projected benefit obligation of such plans totalled $11.0 million and $11.3 million, respectively, as of those dates. Fund American's postretirement benefit costs, included in accounts payable and other liabilities, were $3.8 million and $3.7 million at December 31, 1998 and 1997, respectively. NOTE 11. EMPLOYEE STOCK PLANS Fund American's Long-Term Incentive Plan (the "Incentive Plan") provides for granting to executive officers and other key employees of the Company (and certain of its subsidiaries) various types of stock-based incentive awards including stock options and performance shares. At December 31, 1998, 329,200 Shares remained available for grants under the Incentive Plan. Performance shares are conditional grants of a specified maximum number of Shares or an equivalent amount of cash. The grants are generally payable, subject to the attainment of a specified after tax return on equity at the end of a three year period or as otherwise determined by the Compensation Committee of the Board. The Compensation Committee consists solely of disinterested, non-management directors. Pursuant to the Incentive Plan 47,800, 50,000 and 73,000 performance shares were granted in 1998, 1997 and 1996, respectively, of which 5,150, 4,300 and 14,000 of the performance shares granted, respectively, remain unallocated to participants as of December 31, 1998 and are not deemed to be outstanding. During 1998, 1997 and 1996, 47,129, 22,944 and 0 performance shares were paid in cash, respectively. At December 31, 1998, 147,350 performance shares were outstanding. The financial goal for full payment of the performance shares is the achievement of a 13% annual after tax return on equity as measured over the applicable performance periods. As of December 31, 1998, 1997 and 1996 there were 2,000, 2,000 and 3,000 stock options outstanding, respectively, which had exercise prices ranging from $24.82 to $32.60 per Share. All Fund American stock options outstanding during the three year period ended December 31, 1998, were fully vested and exercisable. No new stock options have been issued to Fund American employees since 1990. In 1985 the Company's Chairman purchased warrants (the "Warrants") from American Express Company ("American Express") entitling him to buy 1,700,000 Shares for $25.75 per Share. Warrants to purchase 420,000 Shares, 130,000 Shares and 150,000 Shares were exercised by the Chairman during 1992, 1994 and 1995, respectively, leaving Warrants to purchase 1,000,000 Shares outstanding at December 31, 1995. Pursuant to a proposal approved by shareholders at the Company's 1995 Annual Meeting, the expiration date with respect to the Warrants was extended from January 2, 1996, to January 2, 2002. In accordance with APB No. 25, the F-31 extension of the Warrants resulted in a $46.2 million pretax charge to compensation expense which was recorded in the second quarter of 1995. No Warrants were exercised by the Chairman during 1998 and 1997. Pursuant to certain anti-dilution adjustments related to the distribution of White River Shares to the Company's shareholders, the exercise price for the Warrants to purchase Fund American Shares was reduced to $21.66 per Share. All employees (other than employees of Source One, FAE and Folksamerica are eligible to participate in an employee savings plan qualified under Section 401(k) of the Internal Revenue Code ("IRC") (the "Valley 401(k) Plan"). Contributions to the Valley 401(k) Plan can be invested in various investment options including Shares. There is an employer match provision to the Valley 401(k) Plan which is equal to 50% of the first 6% of employee compensation contributed to the plan, subject to IRC limits. Fund American added Shares to the investment options offered under the Valley 401(k) Plan as of July 1, 1997. As of December 31, 1998 participants of the Valley 401(k) Plan owned a total of 3,949 Shares. All employees of Folksamerica are eligible to participate in an employee savings plan qualified under Section 401(k) of the Internal Revenue Code ("IRC") (the "Folksamerica 401(k) Plan"). Contributions to the Folksamerica 401(k) Plan can be invested in various investment options. The Folksamerica 401(k) Plan does not currently provide for investments in Shares. There is an employer match provision to the Folksamerica 401(k) Plan which is equal to 100% of the first 6% of employee compensation contributed to the plan, subject to IRC limits. Source One also has a qualified employee savings plan (the "Source One 401(k) Plan"). Contributions to the Source One 401(k) Plan can be invested in various investments including Shares. In 1997, Source One added a matching contribution feature to the Source One 401(k) Plan which is equal to a certain percentage of employee contributions, up to a maximum of 5%, dependent upon Source One's return on equity. As of December 31, 1998, participants of the Source One 401(k) Plan owned a total of 38,046 Shares. SFAS No. 123, "Accounting for Stock Based Compensation," requires disclosure regarding all employee stock options and encourages companies to recognize compensation expense for stock-based awards based on the fair value of such awards on the date of grant. Alternatively, companies may continue following existing accounting standards provided that disclosures are made regarding the net income and earnings per share impact as if the value recognition and measurement criteria of SFAS No. 123 had been adopted. Fund American has not adopted the recognition and measurement criteria of SFAS No. 123 and alternatively has chosen to disclose the pro forma effects of SFAS No. 123 as it relates to outstanding Warrants and performance shares granted in 1998, 1997 and 1996, as follows: F-32 - ------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ------------------------------------- Millions, except per share amounts 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------- Net income: As reported $ 82.2 $43.0 $ 8.6 Pro forma 77.4 39.4 - - ------------------------------------------------------------------------------------------------------------------- Basic net income per share: As reported $13.38 $5.98 $ .66 Pro forma 12.56 5.99 - - ------------------------------------------------------------------------------------------------------------------- Diluted net income per share: As reported $11.94 $5.40 $ .60 Pro forma 11.20 5.41 - - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- SFAS No. 123 provides for the expense of Warrants, stock options and performance shares over the life of the award using the Black Scholes option pricing model. Significant assumptions used include a 5.0% risk-free interest rate, an expected Share volatility of .167 and an expected life of five years for Warrants and three years for performance shares. In determining the pro forma effects of SFAS No. 123, the Company recognizes the pro forma expense of the Warrants over time. The pro forma net income figures disclosed above may not be representative of the effects on reported net income to be reported in future years. NOTE 12. MINORITY INTEREST - PREFERRED STOCK OF SUBSIDIARY In 1994 Source One issued 4,000,000 shares of 8.42% Source One Preferred Stock, having a liquidation preference of $25.00 per share, for net cash proceeds of $96.8 million. On December 8, 1995, Source One exchanged and retired 2,239,061 shares of Source One Preferred Stock for $56.0 million in principal amount of subordinated debentures. The Source One Preferred Stock is not redeemable prior to May 1, 1999. NOTE 13. SHAREHOLDERS' EQUITY COMMON SHARE REPURCHASES During 1998, 1997 and 1996 the Company repurchased 151,916 Shares, 924,739 Shares and 779,077 Shares, respectively, for $19.8 million, $103.7 million and $66.3 million, respectively. All Shares repurchased during 1998, 1997 and 1996 have been retired. At December 31, 1998, the Company had outstanding authorization to purchase an additional 41,501 Shares. CAPITAL STOCK DIVIDENDS During 1998 and 1997 the Company declared and paid quarterly cash dividends of $.40 per Share and $.20 per Share, respectively. During 1998 and 1997 Source One declared and paid quarterly cash dividends of $2.105 per share of Source One Preferred Stock. F-33 NOTE 14. SEGMENT INFORMATION Fund American has determined that its reportable segments include Mortgage Banking (Source One), Property and Casualty Insurance (Valley, Charter and WMIC), Reinsurance (Folksamerica), Investments in Unconsolidated Insurance Affiliates and other (primarily the Company, FAE and White Mountains, all on a stand-alone basis). This determination was based on the provisions of SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information" which was adopted by Fund American in December 1998. Prior year segment information has been restated to conform to the current presentation under SFAS No. 131. Investment results are included within the segment to which the investments relate. The Company has made this determination based on consideration of the following criteria: (i) the nature of the business activities of each of the Company's subsidiaries and affiliates; (ii) the manner in which the Company's subsidiaries and affiliates are organized; (iii) the existence of primary managers responsible for specific subsidiaries and affiliates; and (iv) the organization of information provided to the Board. There are no significant intercompany transactions among Fund American's segments. Revenues, pretax earnings and ending assets for Fund American's segments are shown below: - ------------------------------------------------------------------------------------------------------------------- Property and Investments in Casualty Unconsolidated Mortgage Insurance Affiliates Millions Banking Reinsurance Other Total - ------------------------------------------------------------------------------------------------------------------- 1998 - ------------------------------------------------------------------------------------------------------------------- Revenues for external customers $212.0 $170.0 $ 85.4 $ - $ - $467.4 Net investment income 81.6 8.2 18.1 3.8 6.7 118.4 Equity in earnings of unconsolidated affiliates - - - 24.3 - 24.3 Amortization of deferred credit - - 2.7 - - 2.7 Other (34.8)(a) - - - .1 (34.7) ---------------------------------------------------------------------- Total revenues 258.8 178.2 106.2 28.1(b) 6.8578.1 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- 1997 - ------------------------------------------------------------------------------------------------------------------- Revenues for external customers 127.5 153.1 - - - 280.6 Net investment income 43.5 8.9 - 3.8 8.9 65.1 Equity in earnings of unconsolidated affiliates - - - 21.3 - 21.3 Other (56.7)(a) - - - - (56.7) ---------------------------------------------------------------------- Total revenues 114.3 162.0 - 25.1(b) 8.9310.3 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- 1996 - ------------------------------------------------------------------------------------------------------------------- Revenues for external customers 206.2 119.1 - - - 325.3 Net investment income 40.8 7.5 - 3.7(a) 5.2 57.2 Equity in earnings of unconsolidated affiliates - - - 12.0 - 12.0 Other (69.3)(a) - - - - (69.3) ---------------------------------------------------------------------- Total revenues $177.7 $126.6 $ - $15.7(b) $5.2$325.2 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- (a) Represents amortization and impairment of capitalized mortgage servicing of $55.2 million, $68.0 million and $79.2 million for 1998, 1997 and 1996, respectively, partially offset of net gains on financial instruments of $20.4 million, $11.3 million and $9.9 million, respectively. (b) Includes interest income on Fund American's investment in MediaOne preferred stock (considered to be related to Fund American's investment in FSA) of $3.8 million for 1998, 1997 and 1996. F-34 - ------------------------------------------------------------------------------------------------------------------- Property and Investments in Casualty Unconsolidated Mortgage Insurance Affiliates Millions Banking Reinsurance Other Total - ------------------------------------------------------------------------------------------------------------------- 1998 - ------------------------------------------------------------------------------------------------------------------- Income (loss) before realized gains, taxes and $123.7 $ 5.3 $ 8.9 $28.1 $(16.6) $149.4 certain other expenses Net realized investment gains (losses) 2.2 5.4 (.8) - 64.2 71.0 Interest expense (70.2) (1.1) (1.4) - (11.2) (83.9) Depreciation and amortization (3.1) (3.0) - - (.4) (6.5) ---------------------------------------------------------------------- Pretax earnings 52.6 6.6 6.7 28.1 36.0 130.0 ---------------------------------------------------------------------- ---------------------------------------------------------------------- Income tax expense (19.3) (1.8) (1.2) (7.6) (17.9)(47.8) - ------------------------------------------------------------------------------------------------------------------- 1997 - ------------------------------------------------------------------------------------------------------------------- Income (loss) before realized gains, taxes and 18.2 11.5 - 25.1 (18.7) 36.1 certain other expenses Net realized investment gains (losses) (.7) 4.1 - - 93.3 96.7 Interest expense (35.4) (1.2) - - (9.4) (46.0) Depreciation and amortization (5.0) (3.0) - - (.4) (8.4) ---------------------------------------------------------------------- Pretax earnings (loss) (22.9) 11.4 - 25.1 64.8 78.4 ---------------------------------------------------------------------- ---------------------------------------------------------------------- Income tax (expense) benefit 7.0 (4.3) - (6.1) (26.0) (29.4) ---------------------------------------------------------------------- Loss on early extinguishment of debt (6.0) - - - - (6.0) - ------------------------------------------------------------------------------------------------------------------- 1996 - ------------------------------------------------------------------------------------------------------------------- Income (loss) before realized gains, taxes and 44.1 (2.7) - 15.7 (9.3) 47.8 certain other expenses Net realized investment gains (losses) (.2) (.3) - - 39.0 38.5 Interest expense (36.0) (.7) - - (9.6) (46.3) Depreciation and amortization (6.5) (3.2) - - (2.8) (12.5) ---------------------------------------------------------------------- Pretax earnings (loss) 1.4 (6.9) - 15.7 17.3 27.5 ---------------------------------------------------------------------- ---------------------------------------------------------------------- Income tax (expense) benefit $ (9.5) $ 3.4 $ - $(3.5) $ (9.3) $ (18.9) - ------------------------------------------------------------------------------------------------------------------- F-35 - ------------------------------------------------------------------------------------------------------------------- Millions Property and Investments in Casualty Unconsolidated Mortgage Insurance Affiliates Ending assets: Banking Reinsurance Other Total - ------------------------------------------------------------------------------------------------------------------- December 31, 1998 $1,234.1 $311.5 $1,220.5 $404.1 $110.5 $3,280.7 December 31, 1997 1,063.1 288.8 - 409.6 248.8 2,010.3 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- NOTE 15. INVESTMENTS IN UNCONSOLIDATED AFFILIATES INVESTMENT IN FSA Fund American owned 3,460,200 shares of FSA Common Stock at December 31, 1998, 1997 and 1996. This represented approximately 11.6%, 12.1% and 11.5%, respectively, of the total shares of FSA Common Stock outstanding at those times. Fund American had voting rights to an additional 3,893,940 shares of FSA Common Stock at December 31, 1998, 1997 and 1996, raising Fund American's voting control of FSA to approximately 23.1%, 24.0% and 23.0%, respectively. At December 31, 1998, 1997 and 1996, Fund American also owned FSA Options and Preferred Stock which, in total, give Fund American the right to acquire up to 4,560,607 additional shares of FSA Common Stock for aggregate consideration of $125.7 million. As of December 31, 1998, 1997 and 1996, Fund American's economic interest in FSA was 25.1%, 26.2% and 25.1%, respectively. Fund American's investment in FSA Common Stock is accounted for using the equity method. FSA Common Stock is publicly traded on the NYSE. The market value of the FSA Common Stock as of December 31, 1998 and 1997, as quoted on the NYSE, exceeded Fund American's carrying value of F-36 the FSA Common Stock on the equity method. Fund American's investments in FSA Options and Preferred Stock are accounted for under the provisions of SFAS No. 115 whereby the investments are reported at fair value as of the balance sheet date, with related unrealized investment gains and losses, after tax, reported as a net amount in a separate component of shareholders' equity and reported on the income statement as a component of comprehensive net income. The following table summarizes financial information for FSA: - --------------------------------------------------------------------------------------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- FSA BALANCE SHEET DATA: Total investments $ 1,874.8 $ 1,431.6 $1,154.4 Total assets 2,405.5 1,900.6 1,537.7 Deferred premium revenue 721.7 595.2 511.2 Loss and loss adjustment expense reserve 63.9 75.4 72.1 Preferred shareholder's equity .7 .7 .7 Common shareholders' equity 1,072.7 881.7 800.6 FSA INCOME STATEMENT DATA: Gross premiums written $ 319.3 $ 236.4 $ 177.0 Net premiums written 219.9 172.9 121.0 Net premiums earned 137.9 109.5 90.4 Net investment income 78.8 72.1 65.1 Net income 117.0 100.5 80.8 - --------------------------------------------------------------------------------------------------------------------- AMOUNTS RECORDED BY FUND AMERICAN: Investment in FSA Common Stock $ 119.7 $ 104.3 $ 92.3 Investment in FSA Options and Preferred Stock 114.4 87.8 19.8 ------------------------------------ Total Investment in FSA $ 234.1 $ 192.1 $ 112.1 ------------------------------------ ------------------------------------ Equity in earnings from FSA Common Stock (a) $ 13.8 $ 11.4 $ 7.8 Equity in net unrealized investment gains (losses) from FSA's investment portfolio, before tax (b) 3.1 2.1 (1.0) Unrealized investment gains on FSA Options and Preferred Stock, before tax (b) 26.6 68.0 17.3 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Recorded net of related amortization of goodwill. (b) Recorded directly to shareholders' equity (after tax) with related changes in net unrealized investment gains and losses (after tax) reported on the income statement as a component of comprehensive net income. At December 31, 1998 and 1997, Fund American's consolidated retained earnings included $35.9 million and $23.6 million, respectively, of F-37 accumulated undistributed earnings of FSA (net of related amortization of goodwill). INVESTMENT IN MSA At December 31, 1998, 1997 and 1996, Fund American owned 222,093, 90,606 and 90,606 shares of MSA Common Stock. This represented approximately 50.0%, 33.1% and 33.1% of the total shares of MSA Common Stock outstanding at those times. Fund American's investment in MSA is accounted for using the equity method. The following tables summarize financial information for MSA: - --------------------------------------------------------------------------------------------------------------------- Millions 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------- MSA BALANCE SHEET DATA: Total investments $ 465.9 $280.1 $ 249.4 Total assets 588.6 337.2 316.2 Unearned premium reserve 113.0 71.8 64.0 Loss and loss adjustment expense reserves 212.2 123.7 120.1 Shareholders' equity 232.5 120.6 101.4 MSA INCOME STATEMENT DATA: Net premiums written $ 258.5 $156.6 $ 147.2 Net premiums earned 226.3 148.7 141.6 Net investment income 22.1 15.4 14.9 Net income 13.4 11.9 9.7 - --------------------------------------------------------------------------------------------------------------------- AMOUNTS RECORDED BY FUND AMERICAN: Investment in MSA Common Stock $ 120.2 $ 40.9 $ 34.7 Equity in earnings from MSA Common Stock (a) 4.9 3.8 1.5 Equity in net unrealized investment gains (losses) from MSA's investment portfolio, before tax (b) 4.1 2.4 (.5) - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Recorded net of related amortization of goodwill. (b) Recorded directly to shareholders' equity (after tax) with related changes in net unrealized investment gains and losses (after tax) reported on the income statement as a component of comprehensive net income. At December 31, 1998 and 1997, Fund American's consolidated retained earnings included $14.2 million and $9.3 million, respectively, of F-38 accumulated undistributed earnings of MSA (net of related amortization of goodwill). INVESTMENT IN FOLKSAMERICA On August 18, 1998, Fund American acquired all of the remaining outstanding shares of the common stock of Folksamerica for $169.1 million which resulted in Folksamerica becoming a consolidated subsidiary of the Company as of that date. As of December 31, 1997 and 1996, Folksamerica was an unconsolidated subsidiary of Fund American. Prior to the consolidation of Folksamerica in 1998, White Mountains owned 6,920,000 shares of Folksamerica Preferred Stock at December 31, 1997 and 1996 and owned 1,563,907 shares of Folksamerica Common Stock at December 31, 1997. White Mountains ownership percentage of Folksamerica at December 31, 1997 and 1996 represented 50.0% of the total Folksamerica voting shares outstanding at those times. At December 31, 1997 and 1996, White Mountains also owned ten year Folksamerica Warrants to purchase up to 6,920,000 shares of Folksamerica Common Stock for aggregate consideration of $79.4 million. Fund American acquired its investment in Folksamerica Preferred Stock and Folksamerica Warrants on June 19, 1996. White Mountains acquired its investment in Folksamerica Common Stock on November 20, 1997. Prior to the consolidation of Folksamerica in 1998, White Mountains' investment in Folksamerica Common Stock was accounted for using the equity method and Fund American's investment in Folksamerica Preferred Stock and Folksamerica Warrants were accounted for under the provisions of SFAS No. 115 whereby the investments were reported at fair value as of the balance sheet date, with related unrealized investment gains and losses, after tax, reported as a net amount in a separate component of shareholders' equity and reported on the income statement as a component of comprehensive net income. Dividends earned on Folksamerica Preferred Stock were recorded as earnings from unconsolidated insurance affiliates on the income statement. F-39 The following table summarizes financial information for Folksamerica: - --------------------------------------------------------------------------------------------------------------------- Millions 1997 1996 - --------------------------------------------------------------------------------------------------------------------- FOLKSAMERICA BALANCE SHEET DATA: Total investments $ 926.2 $ 711.4 Total assets 1,213.6 994.8 Unearned premium reserve 96.5 61.5 Loss and loss adjustment expense reserve 739.1 628.9 Preferred shareholder's equity 79.4 79.4 Common shareholders' equity 175.6 88.2 FOLKSAMERICA INCOME STATEMENT DATA: Gross premiums written $ 251.0 $ 187.2 Net premiums written 232.4 171.9 Net premiums earned 238.0 181.4 Net investment income 46.7 32.4 Net income 35.9 17.1 - --------------------------------------------------------------------------------------------------------------------- AMOUNTS RECORDED BY FUND AMERICAN: Investment in Folksamerica Common Stock $ 23.5 $ - Investment in Folksamerica Preferred Stock and Warrants 80.0 80.0 ------------------------- Total Investment in Folksamerica $ 103.5 $ 80.0 ------------------------- Equity in earnings from Folksamerica Common Stock (a) $ .9 $ - Dividends from Folksamerica Preferred Stock (a) 5.2 2.7 Equity in net unrealized investment gains from Folksamerica's investment portfolio, before tax (b)1.8 .2 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Recorded net of related amortization of goodwill and accretion of discount. (b) Recorded directly to shareholders' equity (after tax) with related changes in net unrealized investment gains and losses (after tax) reported on the income statement as a component of comprehensive net income. At December 31, 1997, Fund American's consolidated retained earnings included $1.0 million of accumulated undistributed earnings of Folksamerica. INVESTMENT IN AMLIN (FORMERLY MURRAY LAWRENCE) F-40 At December 31, 1997 White Mountains owned 38,651,270 shares of the common stock of Murray Lawrence which it had acquired on December 8, 1997 for $23.6 million. This represented approximately 15.8% of the total shares of Murray Lawrence common stock outstanding at that time. At December 31, 1997 White Mountains carried its investment in Murray Lawrence as an "investment in unconsolidated insurance affiliate" and valued the investment at its original cost of $23.6 million which approximated its fair value at that date.. During 1998 Murray Lawrence merged with Angerstein Underwriting which resulted in the creation of Amlin. White Mountains owns 13,980,861 shares of the common stock of Amlin, which represents an approximate 6.5% ownership stake as of December 31, 1998 . As a result of White Mountains' decreased ownership percentage of this investment resulting from the merger, White Mountains recharacterized its investment in Amlin as an "other investment" and carried the investment at its fair value of $25.1 million at December 31, 1998. NOTE 16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK Source One utilizes derivative financial instruments in the management of interest rate risk. Source One's use of derivative financial instruments is primarily limited to (i) commitments to extend credit, (ii) mandatory forward commitments and (iii) interest rate floor contracts, interest rate swap agreements and principal-only swap agreements. Although SFAS No. 115 requires that these financial instruments be classified as held for trading purposes, Fund American does not consider these investments to be speculative holdings. Source One is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its exposure to fluctuations in interest rates. These financial instruments primarily include commitments to extend credit and mandatory forward commitments. Those instruments involve, to varying degrees, elements of credit and market interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of risk Source One has related to the instruments. Source One's exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit is represented by the contractual notional amount of those commitments. Source One's locked mortgage loan commitments expected to close totalled $608.3 million and $284.5 million at December 31, 1998 and 1997, respectively. Fixed rate commitments result in Source One having market interest rate risk as well as credit risk. Variable rate commitments result primarily in credit risk. The amount of collateral required upon extension of credit is based on management's credit evaluation of the mortgagor and consists of the mortgagor's residential property. F-41 Source One obtains mandatory forward commitments of up to 120 days to sell mortgage-backed securities to hedge the market interest rate risk associated with a substantial portion of the Pipeline that is expected to close and all mortgage loans receivable. At December 31, 1998 and 1997, Source One had $1,805.3 million and $776.8 million, respectively, of mandatory forward commitments outstanding. If secondary market interest rates decline after Source One commits to an interest rate for a loan, the loan may not close and Source One may incur a loss from the cost of covering its obligations under a related mandatory forward commitment. If secondary market interest rates increase after Source One commits to an interest rate for a loan and Source One has not obtained a forward commitment, Source One may incur a loss when the loan is subsequently sold. Source One's risk management function closely monitors the Pipeline to determine appropriate forward commitment coverage on a daily basis in order to manage the risk inherent in these off-balance-sheet financial instruments. In addition, the risk management area seeks to reduce counterparty risk by committing to sell mortgage loans only to approved dealers with no dealer having in excess of 20% of current commitments. Source One sells loans through mortgage-backed securities issued pursuant to programs of GNMA, FNMA and FHLMC, or through institutional investors. Most loans are aggregated in pools of $1.0 million or more which are purchased by institutional investors after having been guaranteed by GNMA, FNMA or FHLMC. Substantially all GNMA securities are sold by Source One without recourse for loss of principal in the event of a subsequent default by the mortgagor due to the FHA and VA insurance underlying such securities. Prior to December 1992, substantially all conventional securities were sold with recourse to Source One, to the extent of insufficient proceeds from private mortgage insurance, foreclosure and other recoveries. Since December 1992 all conventional loans have been sold without recourse to Source One. Servicing agreements relating to mortgage-backed securities issued pursuant to programs of GNMA, FNMA or FHLMC require Source One to advance funds to make the required payments to investors in the event of a delinquency by the borrower. Source One expects that it would recover most funds advanced upon cure of default by the borrower or foreclosure. However, funds advanced in connection with VA partially guaranteed loans and certain conventional loans (which are at most partially insured by private mortgage insurers) may not be fully recovered due to potential declines in collateral value. Source One is subject to limited amounts of risk with respect to these loans since the insurer has the option to reimburse the servicer for the lower of fair value of the property or the mortgage loan outstanding, in addition to the VA guarantee on the loan. In addition, most of Source One's servicing agreements for mortgage-backed securities typically require the payment to investors of a full month's interest on each loan although the loan may be paid off (by optional prepayment or foreclosure) other than on a month-end basis. In this instance, Source One is obligated to pay the investor interest at the pass-thru rate from the date of loan payoff through the end of the calendar month without reimbursement. F-42 At December 31, 1998 and 1997, Source One serviced approximately $4.0 billion and $5.4 billion of GNMA loans (without substantial recourse), respectively, and $1.7 billion and $2.5 billion of conventional loans (with recourse), respectively. To cover loan losses that may result from these servicing arrangements and other losses, Source One has provided an allowance for loan losses of $11.5 million and $12.8 million at December 31, 1998 and 1997, respectively. In addition, the valuation allowance for Source One's capitalized servicing asset related to its principal recourse portfolio includes a $5.3 million and $8.2 million reserve for estimated losses at December 31, 1998 and 1997, respectively. Source One's management believes the allowance for loan losses is adequate to cover unreimbursed foreclosure advances and principal losses, including losses on loans with recourse. In order to offset changes in the value of Source One's capitalized servicing asset and to mitigate the effect on earnings of higher amortization and impairment of such rights which results from increased prepayment activity, Source One invests in various financial instruments. As interest rates decline, prepayment activity increases, thereby reducing the value of the capitalized servicing asset, while the value of the financial instrument increases. Conversely, as interest rates increase, the value of the capitalized servicing asset increases while the value of the financial instrument decreases. The financial instruments utilized by Source One include interest rate floor contracts, interest rate swap agreements and principal-only swap agreements. Source One's interest rate floor contracts derive their value from differences between the floor strike rate specified in the contract and prevailing market interest rates and are not subject to total losses in excess of their original cost. As of December 31, 1998, Source One's open interest rate contracts had a fair value of $9.9 million, an original cost of $5.3 million and a total notional value of $1.1 billion. The interest rate contracts have remaining terms ranging from 5 to 10 years with floor rates ranging from 3.54% to 5.05%. Source One's interest rate swap agreements, which were entered into in the 1998 third quarter, entitle Source One to receive interest at fixed rates and pay interest at variable rates based on a contracted notional amount. As of December 31, 1998, Source One's open interest rate swap agreements had a fair value of $4.8 million and had remaining terms ranging from 5 to 10 years. Source One's exposure to losses on the interest rate swap agreements is related to the differences between the contracted fixed interest rates assumed and the contracted variable interest rates ceded over the life of the contract. Source One's principal-only swap agreements derive their value from changes in the value of referenced principal-only securities. As of December 31, 1998, Source One's open principal-only swap agreements had a fair value of $2.7 million, a notional value of $50.0 million and had a remaining term of 5 years. Source One's exposure to losses on the principal-only swap agreements is related to changes in the market value of the underlying principal-only securities over the life of the contract. Contingent liabilities exist with respect to reinsurance ceded, which would become an ultimate liability of Folksamerica in the event that the F-43 assuming companies were unable to meet their obligations under reinsurance agreements in force. Folksamerica evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. At December 31, 1998, reinsurance recoverables with a carrying value of $41.7 million were associated with a single reinsurer. Folksamerica holds collateral from this reinsurer in the form of a letter of credit totalling $21.4 million and funds withheld totalling $23.4 million that can be drawn on for amounts that remain unpaid. White Mountains' insurance subsidiaries extend credit to their policyholders in the normal course of business, perform credit evaluations and maintain allowances for potential credit losses. Concentration of credit risk with respect to receivables is limited due to the large number of policyholders and their dispersion across a multi-state area. NOTE 17. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of Fund American's financial instruments have been determined by using appropriate market information and valuation methodologies. Considerable judgement is required to develop the estimates of fair value. Therefore, the estimates provided herein are not necessarily indicative of the amounts that could be realized in a current market exchange. Carrying value equals or approximates fair value for FIXED MATURITY INVESTMENTS, COMMON EQUITY SECURITIES, FINANCIAL INSTRUMENTS (DERIVATIVES), SHORT-TERM INVESTMENTS, CASH, OTHER FINANCIAL ASSETS AND OTHER FINANCIAL LIABILITIES. For each other class of financial instrument for which it is practicable to estimate fair value, the following methods and assumptions were used to estimate such value: OTHER INVESTMENTS. Mortgage loans held for investment are carried at fair value. Financial instruments are carried at fair value which is estimated based on quoted market prices for those or similar investments. For all other securities classified as other investments, fair values have been determined using quoted market values or internal appraisal techniques. MORTGAGE LOANS HELD FOR SALE. Fair values are estimated using quoted market prices for securities backed by similar loans. POOL LOAN PURCHASES. Fair values are estimated based on discounted cash flow analyses using Source One's short-term incremental borrowing rate, quoted market prices for securities backed by similar loans or actual prices at which the loans were subsequently sold. MORTGAGE CLAIMS RECEIVABLE. Fair values are estimated by discounting anticipated future cash flows using Source One's short-term incremental borrowing rate. F-44 DEBT. Fair value is estimated by discounting future cash flows using incremental borrowing rates for similar types of borrowing arrangements or quoted market prices. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS. Fair value for commitments to sell mortgage loans is based on current settlement values for those commitments, net of the face amounts of the commitments. Fair value for commitments to extend credit is based on current quoted market prices for securities backed by similar loans, net of the principal amounts of the commitments. The carrying amounts and estimated fair values of Fund American's financial instruments were as follows: - --------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1998 December 31, 1997 -------------------------- ------------------------- CARRYING FAIR Carrying Fair Millions AMOUNT VALUE amount value - --------------------------------------------------------------------------------------------------------------------- FINANCIAL ASSETS: Fixed maturity investments $929.6 $929.6 $168.3 $168.3 Common equity securities 241.7 241.7 104.2 104.2 Other investments (excluding derivative instruments) 79.4 85.9 147.2 156.7 Derivative instruments: Interest rate floor contracts 9.9 9.9 8.2 8.2 Interest rate swaps 4.9 4.9 - - Principal-only swaps 2.7 2.7 12.5 12.5 Short-term investments 79.0 79.0 62.8 62.8 Cash 22.4 22.4 7.0 7.0 Mortgage loans held for sale 676.3 680.0 519.3 529.3 Pool loan purchases 165.0 165.1 149.8 150.2 Mortgage claims receivable, net (a) 27.2 26.5 35.6 34.9 Receivables from sales of servicing 73.8 73.8 27.3 27.3 Other financial assets 39.6 39.6 43.4 43.4 FINANCIAL LIABILITIES: Short-term debt 748.5 748.5 571.4 571.4 Long-term debt 359.7 370.0 304.3 326.5 Other financial liabilities 5.9 5.9 22.3 22.3 OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS: Mandatory forward commitments - .6 - 1.6 Commitments to extend credit expected to close - 11.1 - 6.5 - --------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- (a) Excludes $5.9 million and $5.6 million of real estate owned in 1998 and 1997, respectively. OTHER FINANCIAL ASSETS includes investment income receivable, accounts receivable from securities sales, notes receivable and, for 1997, White River Shares held for delivery upon exercise of existing employee stock options. OTHER FINANCIAL LIABILITIES includes accrued interest payable, accounts payable on securities purchases, dividends payable to F-45 shareholders and, for 1997, liability for existing employee stock options to purchase White River Shares. Fund American's investments in FSA Options and Preferred Stock, Folksamerica Preferred Stock and Folksamerica Warrants are not presented in the table above. These financial instruments are accounted for under the provisions of SFAS No. 115 and are carried on the balance sheet at fair value. See Note 15. The estimated fair value amounts for Fund American's financial instruments have been determined using available market information and valuation methodologies. Such estimates provided herein are not necessarily indicative of the amounts that would be potentially realized in a current market exchange. NOTE 18. RELATED PARTY TRANSACTIONS For corporate travel purposes Fund American jointly owns two short-range aircraft with Haverford Utah, LLC ("Haverford"). Messrs. Jack Byrne, Patrick M. Byrne, a director of the Company and White Mountains, and Kemp are principals of Haverford. Both aircraft were acquired from unaffiliated third parties during 1996. In exchange for Haverford's 20% ownership interest in the aircraft, Haverford contributed capital equal to 20% of the total initial cost of the aircraft and Haverford bears the full costs of its usage and maintenance of the aircraft pursuant to a Joint Ownership Agreement dated September 16, 1996. Prior to the Joint Ownership Agreement, Fund American was a party to a "dry lease" agreement dated January 2, 1995, for the use of aircraft owned by Haverford Transportation Inc. ("HTI") for corporate travel purposes. Messrs. Jack Byrne and Kemp are the sole shareholders of HTI. During 1996 Fund American paid HTI a total of $279,739 pursuant to the dry lease arrangement. The terms of the agreement provided for the use of HTI's aircraft (excluding pilot and fuel) for a fixed hourly charge of $200 for a single engine piston aircraft and $800 to $1,000 for a twin engine turbine aircraft. Based on the Company's experience in operating comparable aircraft, the hourly operating charges incurred pursuant to the HTI dry lease are considered to be representative of the actual hourly costs of operating HTI's aircraft. In September 1998 Fund American sold its 25% joint ownership interest in a private jet operated by a third party to Haverford for cash proceeds of $500,000. The purchase price received from Haverford represented a payment of $437,500 for Fund American's joint ownership interest (which resulted in Fund American recognizing a pretax gain on sale of approximately $75,000) and $62,500 for reimbursement of prepaid aircraft expenses which were required to be paid to the operator prior to the sale to Haverford. Mr. Howard Clark, Jr., a director of the Company, is Vice Chairman of Lehman Brothers Inc. Lehman Brothers Inc. has, from time to time, F-46 provided various services to Fund American including investment banking services, brokerage services, underwriting of debt and equity securities and financial consulting services. Mr. George J. Gillespie, III, a director of the Company, is a Partner in the firm Cravath, Swaine & Moore, which has been retained by Fund American from time to time to perform legal services. Fund American believes that all the above transactions were on terms that were reasonable and competitive. Additional transactions of this nature may be expected to take place in the ordinary course of business in the future. NOTE 19. SUBSEQUENT EVENT - SALE OF VGI On February 11, 1999, White Mountains entered into a definitive agreement to sell VGI (which includes Valley, Charter and WMIC but excludes Valley National) to Unitrin, Inc. The transaction is expected to close during the 1999 second quarter and is subject to state regulatory approvals. NOTE 20. SUBSEQUENT EVENT - SALE OF MORTGAGE BANKING ASSETS On March 25, 1999 Fund American and Citicorp reached a definitive agreement under which Citicorp will acquire a substantial amount of Fund American's mortgage-banking related assets and certain of its mortgage banking liabilities. Fund American will retain the Source One legal entity which will continue to own all of Fund American's investments in FSA and certain other mortgage-related and other assets and liabilities. The transaction is expected to close during the 1999 second quarter and is subject to various Federal, state and other regulatory approvals. F-47 REPORT ON MANAGEMENT'S RESPONSIBILITIES The financial information included in this annual report, including the audited consolidated financial statements, has been prepared by the management of Fund American. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and, where necessary, include amounts based on informed estimates and judgments. In those instances where there is no single specified accounting principle or standard, management makes a choice from reasonable, accepted alternatives which are believed to be most appropriate under the circumstances. Financial information presented elsewhere in this report is consistent with that shown in the financial statements. Fund American maintains internal financial and accounting controls designed to provide reasonable and cost effective assurance that assets are safeguarded from loss or unauthorized use, that transactions are recorded in accordance with management's policies and that financial records are reliable for preparing financial statements. The internal controls structure is documented by written policies and procedures which are communicated to all appropriate personnel and is updated as necessary. Fund American's business ethics policies require adherence to the highest ethical standards in the conduct of its business. Compliance with these controls, policies and procedures is continuously maintained and monitored by management. KPMG LLP have audited the consolidated financial statements of Fund American as of December 31, 1998 and 1997 and for each of the two years in the period ended December 31, 1998, and issued their unqualified report thereon dated February 12, 1999, which appears on page F-49. Ernst & Young LLP served as Fund American's independent auditors as of December 31, 1996 and for the year then ended, and issued their unqualified report thereon dated March 21, 1997, which appears on page F-51. PricewaterhouseCoopers LLP served as the independent auditors of Folksamerica during 1998 and Valley during 1996. The unqualified reports issued with respect to 1998 audit of Folksamerica and the 1996 audit of Valley have been included as exhibits to this report. In connection with their audits, the independent auditors provide an objective, independent review and evaluation of the structure of internal controls to the extent they consider necessary. Management reviews all recommendations of the independent auditors concerning the structure of internal controls and responds to such recommendations with corrective actions, as appropriate. The Audit Committee of the Board, which is comprised solely of non-management directors, has general responsibility for the oversight and surveillance of the accounting, reporting and financial control practices of Fund American. The Audit Committee, which reports to the full Board, annually reviews the effectiveness of the independent auditors, Fund American's internal auditors and management with respect to the financial reporting process and the adequacy of internal F-48 controls. Both the internal auditors and the independent auditors have, at all times, free access to the Audit Committee, without members of management present, to discuss the results of their audits, the adequacy of internal controls and any other matter that they believe should be brought to the attention of the Audit Committee. K. Thomas Kemp Raymond Barrette Michael S. Paquette Director, President Executive Vice President Senior Vice President and Chief Executive Officer and Chief Financial Officer and Controller INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Fund American Enterprises Holdings, Inc. We have audited the accompanying consolidated balance sheets of Fund American Enterprises Holdings, Inc. and Subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated income statements, statements of shareholders' equity , and cash flows for the years then ended (collectively, the "consolidated financial statements"). In connection with our audits of the consolidated financial statements, we also have audited the 1998 and 1997 financial information in Schedule I Summary of investments other than investments in related parties, Schedule II Condensed financial information of the registrant, Schedule III Reinsurance, Schedule IV Valuation and qualifying accounts, and Schedule VI Supplementary insurance information (collectively, the "financial statement schedules"). These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We did not audit the consolidated financial statements of Folksamerica Holding Company, Inc. ("Folksamerica"), a wholly-owned subsidiary and Financial Security Assurance Holdings, Ltd. ("FSA"), an 11.6 percent owned equity investee company. The financial statements of Folksamerica reflect total assets constituting 37.2 percent and total revenues of 18.4 percent in 1998 of the related consolidated totals. The Company's equity investment in FSA at December 31, 1998 and 1997 was $119.7 million and $104.3 million, respectively, and its equity in earnings of FSA were $13.8 million and $11.4 million for the years 1998 and 1997 respectively. The financial statements of Folksamerica and FSA were audited by other auditors, PricewaterhouseCoopers LLP, whose reports were furnished to us, and our opinion, insofar as it relates to the amounts included for Folksamerica F-49 and FSA, is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Fund American Enterprises Holdings, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also in our opinion, based on our audits and the reports of other auditors, the 1998 and 1997 information in the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP February 12, 1999 Providence, Rhode Island except for Note 20 which is as of March 25, 1999 F-50 INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Fund American Enterprises Holdings, Inc. We have audited the accompanying consolidated income statement of Fund American Enterprises Holdings, Inc. and the related statements of shareholders' equity and cash flows for the year ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our audit also included the financial statement schedules listed at Item 14(d). Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the consolidated financial statements of Valley Group, Inc., a wholly-owned subsidiary, representing substantially all of the Company's consolidated insurance operations, which statements reflected total revenues of $126.9 million for the year ended December 31, 1996, and the consolidated financial statements of Financial Security Assurance Holdings Ltd. ("FSA"), an equity method investee. The Company's equity in FSA's earnings represents $7.8 million of total revenues for the year ended December 31, 1996. Those statements were audited by other auditors, PricewaterhouseCoopers LLP, whose reports have been furnished to us, and our opinion, insofar as it relates to data included for Valley Group, Inc. and FSA, with respect to the amounts in the two preceding sentences, is based solely on the reports of the other auditors. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audit and the reports of other auditors, the financial statements referred to above present fairly, in all material respects, Fund American Enterprises Holdings, Inc.'s consolidated results of operations and its cash flows for the year ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules when considered in relation to the basic financial statements taken as a whole presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP New York, New York March 21, 1997 F-51 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 1998 and 1997 is shown in the following table. The quarterly financial data includes, in the opinion of management, all recurring adjustments necessary for a fair presentation of the results of operations for the interim periods. Certain 1998 and 1997 items have been restated as a result of the Folksamerica transaction, see Note 2. - -------------------------------------------------------------------------------------------------------------------- 1998 Three Months Ended (a) 1997 Three Months Ended (b) ---------------------------------- ----------------------------------- Millions, except per share amounts Dec. 31Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31 - -------------------------------------------------------------------------------------------------------------------- Revenues $197.2 $ 153.6 $ 117.6 $109.7 $ 81.9 $78.0 $ 69.5 $ 80.9 Expenses 187.2 130.0 106.7 95.2 91.0 76.4 80.9 80.3 ------------------------------------------------------------------------ Pretax operating earnings (loss) 10.0 23.6 10.9 14.5 (9.1) 1.6 (11.4) .6 Net realized investment gains 5.2 61.6 1.7 2.5 49.1 21.8 16.2 9.6 ------------------------------------------------------------------------ Pretax earnings 15.2 85.2 12.6 17.0 40.0 23.4 4.8 10.2 Income tax provision 5.5 30.1 5.0 7.2 14.7 7.1 3.2 4.4 ------------------------------------------------------------------------ AFTER TAX EARNINGS 9.7 55.1 7.6 9.8 25.3 16.3 1.6 5.8 Loss on early extinguishment of debt, after tax - - - - - - (6.0) - ------------------------------------------------------------------------ NET INCOME (LOSS) 9.7 55.1 7.6 9.8 25.3 16.3 (4.4) 5.8 Other comprehensive net income, after tax 26.7 (73.1) 11.2 26.3 (20.1) 30.1 39.6 (7.9) ------------------------------------------------------------------------ COMPREHENSIVE NET INCOME (LOSS) $ 36.4 $(18.0) $ 18.8 $ 36.1 $ 5.2 $46.4 $ 35.2 $(2.1) ------------------------------------------------------------------------ ------------------------------------------------------------------------ BASIC EARNINGS PER COMMON SHARE: After tax earnings $ 1.51 $ 9.28 $ 1.13 $ 1.50 $ 3.89 $2.41 $ .09 $ .71 Net income (loss) 1.51 9.28 1.13 1.50 3.89 2.41 (.80) .71 Comprehensive net income (loss) 6.08 (3.22) 3.02 5.94 .68 7.12 5.10 (.43) DILUTED EARNINGS PER COMMON SHARE: After tax earnings 1.33 8.31 1.00 1.33 3.50 2.18 .08 .65 Net income (loss) 1.33 8.31 1.00 1.33 3.50 2.18 (.73) .65 Comprehensive net income (loss) 5.44 (2.90) 2.70 5.32 .61 6.44 4.63 (.40) - -------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------- (a) The quarterly amounts for the three month periods ended September 30, 1998 and December 31, 1998 reflect the consolidation of Folksamerica which became a wholly-owned subsidiary on August 18, 1998. The quarterly amounts for the three month period ended September 30, 1998 include $61.6 million of pretax realized investment gains which served to increase third quarter 1998 net income by $40.0 million. (b) The quarterly amounts for the three month period ended June 30, 1997 include a $9.2 million pretax loss on early extinguishment of Source One's debt which served to decrease second quarter 1997 net income by $6.0 million. The quarterly amounts for the three month period ended December 31, 1997 include $49.1 million of pretax realized investment gains which served to increase fourth quarter 1997 net income by $31.9 million. F-52 SCHEDULE I FUND AMERICAN ENTERPRISES HOLDINGS, INC. SUMMARY OF INVESTMENTS -- OTHER THAN INVESTMENTS IN RELATED PARTIES AT DECEMBER 31, 1998 - ------------------------------------------------------------------------------------------------- Fair Millions Cost Value - ------------------------------------------------------------------------------------------------- Fixed maturities: Bonds: United States Government and government agencies and authorities $ 217.6 $ 222.0 States, municipalities and political subdivisions 189.1 191.8 Foreign governments 26.7 26.9 All other (primarily corporate bonds) 430.8 437.1 Redeemable preferred stock 51.8 51.8 ---------------------- Total fixed maturities 916.1 929.6 ---------------------- Common equity securities: Banks, trust and insurance companies 28.3 35.5 All other 167.1 206.2 ---------------------- Total common equity securities 195.4 241.7 Other investments 88.5 96.9 Short-term investments 79.0 79.0 - ------------------------------------------------------------------------------------------------- Total investments $ 1,279.0 $ 1,347.2 - ------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------- NOTE - fair value was equal to carrying value at December 31, 1998. FS-1 SCHEDULE II FUND AMERICAN ENTERPRISES HOLDINGS, INC. (PARENT COMPANY ONLY) CONDENSED BALANCE SHEETS - --------------------------------------------------------------------------- December 31, -------------------- Millions 1998 1997 - --------------------------------------------------------------------------- Assets: Common equity securities and other investments $ - $ 49.2 Short-term investments, at amortized cost 10.8 2.3 Other assets 37.8 40.4 Investments in consolidated affiliates 972.2 843.1 -------------------- Total assets $ 1,020.8 $ 935.0 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Liabilities: Long-term debt with third parties $ 115.7 $ 115.6 Intercompany borrowings 53.0 30.0 Accounts payable and other liabilities 149.6 130.5 -------------------- Total liabilities 318.3 276.1 Shareholders' equity 702.5 658.9 -------------------- Total liabilities and shareholders' equity $ 1,020.8 $ 935.0 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- CONDENSED INCOME STATEMENTS - -------------------------------------------------------------------------------------- Year Ended December 31, ------------------------------- Millions 1998 1997 1996 - -------------------------------------------------------------------------------------- Revenues $ 2.2 $ 8.5 $ 11.7 Expenses 23.2 21.2 15.5 ------------------------------- Pretax operating loss (21.0) (12.7) (3.8) Net realized investment gains (losses) 26.7 44.2 (3.1) ------------------------------- Pretax earnings (loss) 5.7 31.5 (6.9) Income tax provision (benefit) 8.3 16.3 .5 ------------------------------- Parent company only operating income (loss) (2.6) 15.2 (7.4) Earnings from consolidated affiliates 84.8 27.8 16.0 ------------------------------- Consolidated net income 82.2 43.0 8.6 ------------------------------- Consolidated change in net unrealized investment gains, after tax (8.9) 41.7 54.6 ------------------------------- Consolidated comprehensive net income $ 73.3 $ 84.7 $ 63.2 ------------------------------- ------------------------------- FS-2 SCHEDULE II (CONTINUED) FUND AMERICAN ENTERPRISES HOLDINGS, INC. (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF CASH FLOWS Year Ended December 31, 1998 --------------------------------- Millions 1998 1997 1996 - ------------------------------------------------------------------------------------------------- Net income $ 82.2 $ 43.0 $ 8.6 Reconciliation of net income to net cash from operating activities: Net realized investment (gains) losses (26.7) (44.2) 3.1 Undistributed earnings from consolidated subsidiaries (78.0) (24.1) (12.3) Undistributed earnings from unconsolidated insurance - (.4) (1.1) affiliates Changes in current income taxes receivable and 8.5 5.1 28.4 payable Deferred income tax provision (benefit) .1 (3.7) .1 Dividends and return of capital distributions received - - 65.0 from subsidiaries Other, net 1.7 (1.3) (19.6) --------------------------------- Net cash (used for) provided from operating activities (12.2) (25.6) 72.2 - ------------------------------------------------------------------------------------------------- Cash flows from investing activities: Net (increase) decrease in short-term investments (8.5) (2.0) 28.2 Sales of investment securities - 119.4 134.4 Purchases of investment securities - - (108.9) Investments in consolidated affiliates - (12.7) (25.2) Investments in unconsolidated affiliates - - (27.7) Sale of securities carried in other assets 26.8 - - Purchases of fixed assets - - (.8) --------------------------------- Net cash (used for) provided from investing activities 18.3 104.7 - - ------------------------------------------------------------------------------------------------- Cash flows from financing activities: Purchases of common stock retired (19.5) (103.8) (66.3) Intercompany borrowings from subsidiaries 23.0 30.0 - Cash dividends paid to common shareholders (9.4) (5.3) (5.9) --------------------------------- Net cash used for financing activities (5.9) (79.1) (72.2) - ------------------------------------------------------------------------------------------------- Net increase in cash during year .2 - - Cash balance at beginning of year - - - - ------------------------------------------------------------------------------------------------- Cash balance at end of year $ .2 $ - $ - - ------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------- FS-3 SCHEDULE III FUND AMERICAN ENTERPRISES HOLDINGS, INC. REINSURANCE - ---------------------------------------------------------------------------------------------- Column A Column B Column C Column D Column E Column F - ---------------------------------------------------------------------------------------------- Percentage Ceded to Assumed of amount Premiums earned Gross other from other Net assumed to (Dollars in millions) amount companies companies amount net - ---------------------------------------------------------------------------------------------- Years ended: December 31, 1998: Property and casualty insurance $ 153.9 $ (6.7) $ -- $ 160.6 -- % Reinsurance (a) 2.4 (8.7) 91.7 85.4 107.4% December 31,1997: Property and casualty insurance 152.1 (6.8) -- 145.3 -- % December 31,1996: Property and casualty insurance 116.7 (7.0) -- 109.7 -- % - ---------------------------------------------------------------------------------------------- (a) Amounts shown in columns B through F represent activity for Folksamerica from August 18, 1998 through December 31,1998. FS-4 SCHEDULE IV FUND AMERICAN ENTERPRISES HOLDINGS, INC. VALUATION AND QUALIFYING ACCOUNTS - -------------------------------------------------------------------------------------------------------------- Column A Column B Column C Column D Column E - -------------------------------------------------------------------------------------------------------------- Additions -------------------- Balance at Charged to Charged Balance beginning costs and to other Deductions at end Millions of period expenses accounts described of period - -------------------------------------------------------------------------------------------------------------- Years ended: December 31,1998: Reinsurance recoverable: Allowance for reinsurance balances (a) $ 1.2 $ -- $ -- $ -- (b) $ 1.2 Property and casualty insurance: Allowance for uncollectible accounts .3 1.9 -- (1.8)(b) .4 Mortgage banking: Allowance for mortgage loan losses 12.8 3.8 .1 (5.2)(b) 11.5 Impairment allowance for mortgage servicing 45.1 14.8 -- (24.3)(c) 35.6 December 31,1997: Property and casualty insurance: Allowance for uncollectible accounts .4 1.1 -- (1.2)(b) .3 Mortgage banking: Allowance for mortgage loan losses 15.4 4.7 -- (7.3)(b) 12.8 Impairment allowance for mortgage servicing 28.9 22.4 -- (6.2)(c) 45.1 December 31,1996: Property and casualty insurance: Allowance for uncollectible accounts .8 .7 -- (1.1)(b) .4 Mortgage banking: Allowance for mortgage loan losses 13.5 3.0 1.7 (2.8)(b) 15.4 Impairment allowance for mortgage servicing 28.0 8.2 -- (7.3)(c) 28.9 - -------------------------------------------------------------------------------------------------------------- (a) Represents allowances acquired from Folksamerica on August 18, 1998. (b) Represents charge-offs of balances receivable. (c) Represents charge-offs of balances receivable relating to recourse mortgage loans and allowance reductions for mortgage servicing sales. FS-5 SCHEDULE V FUND AMERICAN ENTERPRISES HOLDINGS, INC. SUPPLEMENTARY INSURANCE INFORMATION MILLIONS Column A Column B Column C Column D Column E Column F - ----------------------------------------------------------------------------------------- Future policy Other Deferred benefits, policy policy losses, claims acquisition and loss Unearned benefits Premiums Segment cost expenses premiums payable earned - ----------------------------------------------------------------------------------------- Years ended: December 31, 1998: Reinsurance (a) $20.7 $723.2 $71.2 $ -- $ 85.4 Property casualty insurance 14.7 88.5 81.9 -- 160.6 December 31, 1997: Property and casualty insurance 14.3 71.9 78.0 -- 145.3 December 31, 1996: Property and casualty insurance 13.2 65.4 72.6 -- 109.7 - ----------------------------------------------------------------------------------------- Column A Column G Column H Column I Column J Column K - ----------------------------------------------------------------------------------------- Benefits, claims, losses, Amortization Net and of deferred Other investment settlement acquisition operating Premiums Segment income (b) expenses costs expenses written - --------------------------------------------------------------------------------------------- Years ended: December 31, 1998: Reinsurance (a) $18.1 $ 59.7 29.1 $36.0 $ 73.7 Property casualty insurance 8.3 115.1 30.0 62.3 164.9 December 31, 1997: Property and casualty insurance 9.0 97.1 27.5 58.9 150.8 December 31, 1996: Property and casualty insurance 7.8 85.9 19.9 53.9 147.0 - --------------------------------------------------------------------------------------------- (a) The amounts shown for Reinsurance in columns F through K represent activity for Folksamerica from August 18, 1998 through December 31, 1998. (b) The amounts shown exclude net investment income relating to non-insurance operations of $92.0 million, $56.1 million and $49.5 million for the twelve months ended December 31,1 998, 1997 and 1996,respectively. FS-6