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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 25049
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
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 0-23181
PAULA Financial
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(Exact Name of Registrant as Specified in Its Charter)
Delaware 95-4640368
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(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification Number)
300 North Lake Ave., Ste. 300 Pasadena CA 91101
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (626) 304-0401
Securities Registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
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None
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Securities Registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
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(Title of Class)
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(Title of Class)
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
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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 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. /X/
[COVER PAGE 1 OF 2 PAGES.]
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The aggregate market value of the voting stock held by nonaffiliates of
the registrant was $100,938,570 as of February 28, 1998.
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
As of February 28, 1998, the registrant had outstanding 6,321,177 shares
of Common Stock, $.01 par value.
DOCUMENTS INCORPORATED BY REFERENCE
1. The information called for by Part III, Items 10, 11, 12 and 13 of this
report are incorporated herein from the Company's Proxy Statement for its 1998
Annual Meeting of Stockholders.
2. A number of the exhibits to this Report called for by Part IV, Item 14
are incorporated herein from the Company's Registration Statement of Form S-1
(Reg. No. 333-33159) filed on August 8, 1997 and from Amendment No. 1 thereto.
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PART I
ITEM 1. BUSINESS
THE COMPANY
The Company is a California-based specialty underwriter and distributor
of commercial insurance products which, through its subsidiary PAULA Insurance
Company ("PICO"), is one of the largest underwriters specializing in workers'
compensation insurance products and services for the agribusiness industry. The
Company began operations in 1946 as an insurance agency providing workers'
compensation and group medical employee benefits to agribusiness employers in
underserved rural markets. In 1974, PICO was formed to underwrite the workers'
compensation portion of the business distributed by Pan American Underwriters,
Inc. ("Pan Am"), the Company's insurance agency. The Company's primary insurance
subsidiary, PICO, is currently rated "A- (Excellent)" by A.M. Best. The
Company's other principal subsidiaries include Pan Am, PAULA Assurance Company
("PACO"), a life and health carrier, and Pan Pacific Benefit Administrators,
Inc. ("Pan Pacific"), a third party administrator.
WORKERS' COMPENSATION SYSTEM
Workers' compensation is a statutory system under which an employer is
required to reimburse its employees for the costs of medical care and other
specified benefits for work-related injuries or illnesses. Most employers comply
with this requirement by purchasing workers' compensation insurance. The
principal concept underlying workers' compensation laws is that an employee
injured in the course of his employment has only the legal remedies for that
injury available under workers' compensation law and does not have any other
claims against his or her employer. Generally, workers are covered for injuries
which occur in the course and scope of their employment. The obligation to pay
such compensation does not depend on any negligence or wrong on the part of the
employer and exists even for injuries that result from the negligence or wrongs
of another person, including the employee.
Workers' compensation insurance policies obligate the carrier to pay
all benefits which the insured employer may become obligated to pay under
applicable workers' compensation laws. Each individual state has its own
workers' compensation regulatory system that determines the level of wage
replacement to be paid, the level of medical care required to be provided and
the cost of permanent impairment. For instance, there are four types of benefits
payable under California workers' compensation policies: (i) temporary or
permanent disability benefits (either in the form of short-term to life-term
payments or lump sum payments); (ii) vocational rehabilitation benefits; (iii)
medical benefits; and (iv) death benefits. The amount of benefits payable for
various types of claims is determined by regulation and varies with the severity
and nature of the injury or illness and the wage, occupation and age of the
employee.
BUSINESS STRATEGY
The Company believes that its differentiated approach as a provider of
insurance services to the agribusiness industry and its expertise with immigrant
employee groups, partial year workforces and businesses in rural communities
have been critical to its success. The Company views its key strengths as: (i)
its integrated distribution and underwriting activities; (ii) the distinctive
labor relations and cost containment services it provides; and (iii) its
underwriting and risk management expertise with respect to agribusiness risks.
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The Company's target agribusiness market includes those employers who
farm, harvest, transport, pack and process tree fruit, vegetables, fiber,
flowers, vine fruit and dairy products. Labor intensive agribusiness employers
rely on their workforces performing to maximum productivity in order to deliver
their fresh product to market at the best price. Agribusiness insurance risks
are generally characterized by: (i) monolingual Spanish speaking workforces;
(ii) moving work sites and a relative lack of machinery and equipment, making
loss control engineering more difficult; (iii) large seasonal fluctuations and
high turnover in the employee pool, making timely and frequent safety training
more critical and increasing the opportunity for filing fraudulent claims; (iv)
fewer opportunities for discounts from health providers in rural locations; and
(v) a relatively young workforce performing physically demanding labor for low
hourly or piece-work wages. The Company's knowledge of these risk
characteristics has enabled the Company to help its clients satisfy the benefits
needs of their workforces and assisted it to achieve underwriting profitability.
INTEGRATED DISTRIBUTION
The Company has developed an expertise in the agribusiness industry
through its long history of both distributing and underwriting insurance and
through a focus on the agent-customer relationship. PICO was formed by the
owners of Pan Am in 1974 to underwrite the workers' compensation portion of the
business distributed by Pan Am. The Company believes that Pan Am's direct
interest in the Company's success results in a cooperative relationship among
the agent, the underwriter, loss control consultants, claims management
personnel and the customer and its employees. Pan Am, which has 17 locations in
California, Oregon and Arizona, is the largest distributor for PICO.
To enhance the Company's presence in rural areas not served by Pan Am,
the Company affiliates with insurance agencies of similar size and operating
histories to Pan Am. In late 1996 and early 1997, the Company made minority
equity investments in two regional commercial insurance agencies, James G.
Parker Insurance Associates ("Parker"), headquartered in Fresno, California, and
CAPAX Management & Insurance Services ("CAPAX"), headquartered in Modesto,
California. In 1996, the Company, Parker and CAPAX formed the PAULA Trading
Company ("PTC") to affiliate with other independent agencies. Typically, PTC
member agencies have extensive operating histories, a significant commercial
insurance presence in rural communities and historically high client persistency
rates. The Company believes that its close relationships with PTC member
agencies assist it in lowering its loss ratio, raising persistency rates and
lowering acquisition costs.
The Company believes it gains significant marketing benefits from the
endorsements Pan Am has developed for the Company. These endorsements by more
than 20 prominent agribusiness trade associations have allowed the Company to be
identified with brand names significant to agribusiness customers. Trade
associations which have endorsed the Company have recommended the Company's
products and services to their members. Endorsements provide the Company with
access to large groups of potential customers without the usual sales process of
prospecting individual clients. The Company believes that solicitation of
association members results in a higher percentage of sales than do individual
unaffiliated solicitations.
DISTINCTIVE SERVICES TO AGRIBUSINESS EMPLOYERS
Throughout its history, the Company has tailored its labor relations
and cost containment services to the unique needs of the agribusiness employer.
From the initial reporting of a claim to the careful explanation of benefits to
the medical treatment delivery to the return of an employee to work, the
Company's capabilities are field-based, bilingual, cross-cultural and sensitive
to the unique fraud-prevention and cost-containment issues present in
agribusiness. The Company's safety training, early return to work efforts, case
management and case settlement operations are tailored specifically to the labor
relations and cost containment needs of agribusiness employers and to the needs
of Hispanic and other immigrant laborers.
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LOSS PREVENTION. Since employee turnover is high among agribusiness
employers and labor intensive agribusiness requires little fixed equipment, the
Company's field representatives hold employee safety training, forklift training
and tail-gate sessions for the Company's clients and their employees. In
addition, the Company's field representatives train crew foremen and field
supervisors on safety practices, visit the workplace to help prevent fraudulent
claims and report safety concerns to the Company's loss control consultants and
underwriters. The Company's field representatives are a team of 16
community-based bilingual employees with agribusiness employment backgrounds.
CLAIMS REPORTING AND FRAUD DETECTION. The Company's Special Investigation
Unit reviews each claim for potential fraud as it is reported to the Company
rather than only those claims referred to the unit by claims adjusters after
they suspect fraud, as the Company believes is more typical in the industry. By
reviewing every claim at an early stage, the Company is able to take advantage
of its experience in identifying the principal indicators of fraud and thereby
mitigate its exposure to fraudulent claims. The Company has also implemented a
toll-free injury reporting telephone number which allows employers and injured
workers to report claims more quickly.
CLAIMS MANAGEMENT EXPERTISE. The Company commits significant resources to
its claims operations. The Company's claims staff is bilingual, has an average
of 14 years of claims experience and typically manages 125 open claims per
examiner, which the Company believes is lower than the industry average.
BENEFIT DELIVERY AND EXPLANATION OF BENEFITS TO FARM WORKERS. It has been a
long-standing and distinctive practice of the Company's field representatives to
hand deliver first-time benefit checks as often as possible and explain benefits
in the language of preference of the claimant. The Company believes this helps
to reduce the cost of claims, particularly by reducing the number of litigated
claims, and reduces the incidence of fraud. The Company's field representatives
also assist in returning employees to modified duty as part of the Company's
early return to work program.
RURAL MEDICAL CARE DELIVERY. The ability of an insurer to influence medical
costs is substantially different in rural areas than in metropolitan areas where
insurers can negotiate for meaningful discounts to physicians' fee schedules.
The Company believes that its longstanding relationships with rural medical
providers and its claims management approach, which emphasizes proper medical
protocol and utilization rather than significant fee discounting, allows it to
operate at a lower cost and return workers to the job more quickly.
MEDICAL DELIVERY IN MEXICO. The Company offers occupational medical
treatment options in Mexico in three approved clinics in Tijuana, Mexicali and
San Luis. The Company believes it is the only carrier to provide this service,
which allows covered employees to obtain culturally-compatible care in
sought-after private medical facilities in Mexico. The Company realizes
significant average cost savings from Mexico-based medical care compared with
comparable care in the United States.
AGRIBUSINESS UNDERWRITING EXPERTISE
The Company underwrites and prices its products with the objective of
earning an underwriting profit. The Company believes that its expertise and long
history serving agribusiness employers assist it in achieving this objective.
Though agribusiness is widely considered to be a "substandard" class of
insurance, the Company has consistently reported underwriting profitability
above both the California and national workers' compensation insurance industry
averages for all classes of business. For the five years ended December 31,
1997, PICO's combined ratios (based on statutory accounting practices, "SAP")
have averaged 97.9%. The
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Company's in-depth understanding of the risks in its target market and its
ability to price its product appropriately are the keys to these results.
KNOWLEDGE OF AGRIBUSINESS RISKS. The Company's proprietary loss experience
database, its trade association endorsements and its understanding of the risk
management needs of agribusiness employers are the key elements of its
underwriting capabilities. The Company's rate making process benefits
significantly from more than 50 years of claim experience in the agribusiness
industry and a proprietary database built over 24 years. This database includes
experience by class of business and by subclass within those business classes in
which the Company specializes. The information in the database has been
developed since PICO's inception and is relevant today in that the Company
continues to specialize in the same classes of business in which it has
historically focused. This experience has enabled the Company to differentiate
risks by creating more than 35 farm classes and subclasses, reflecting the
unique characteristics of job classifications and differences in farming
operations. In comparison, the California Workers' Compensation Insurance Rating
Bureau ("WCIRB") publishes only 15 payroll classifications in its schedule of
farm rating reports.
TRADE ASSOCIATION ENDORSEMENTS AND SAFETY GROUPS. The Company enjoys the
endorsement of more than 20 agribusiness trade associations and has promoted the
formation and operation of more than 40 other safety groups that purchase
workers' compensation insurance from the Company. Each employer participating in
these groups is individually underwritten and then pooled with other homogeneous
employers for the purpose of rating experience. These groups help the Company to
achieve the actuarial benefit of writing larger pools, to provide safety
training and services to small accounts more efficiently and to promote the
selection of good risks and safety practices by linking the self interest of
each group member. The Company believes that the loss ratios of its trade
association and safety group customers have been lower than that of its
customers as a whole. The trade association endorsements, in particular, are
also a good source of marketing and provide penetration opportunities through
access to association mailing lists. Approximately two-thirds of the Company's
policies are in trade associations and safety groups.
RISK MANAGEMENT. Risk management is the process of identifying and analyzing
loss exposures and taking steps to minimize the financial impact of those
exposures. The Company's loss control consultants, all of whom are bilingual and
are trained and certified in various farm safety practices, assist the
underwriters in reviewing new accounts and in initiating safety programs based
on industry best practices for each type of customer. The Company runs a
customized software system which networks the underwriters to field
representatives, loss control consultants, premium auditors, credit and
collections personnel and claims supervisors to provide renewal data and
schedule service visits. A record of all customer interaction is maintained for
review by the applicable underwriter, agent and customer.
GROWTH STRATEGY
The Company plans to grow its workers' compensation insurance business
further by: (i) expanding the Company's agribusiness franchise outside of
California, Arizona and Oregon; (ii) increasing the Company's penetration of
rural communities within California, Arizona and Oregon; and (iii) expanding
into other industries whose risk characteristics and service requirements are
similar to those of agribusiness. The Company intends to support its growth
strategy by continuing to affiliate with well-regarded, rural-focused insurance
agencies and by developing additional relationships with trade associations and
safety groups.
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EXPANSION INTO NEW STATES
The Company continues to grow outside of its historic California and
Arizona markets. In 1994, the Company began its expansion by entering the Oregon
market. Since then, it has entered five additional states: Idaho, Texas,
Florida, Alaska and New Mexico. In new states, the Company targets the same
types of small- to medium-sized agribusiness operations that it has historically
served. With the addition of New Mexico and Texas, the Company is now licensed
in all states that share a border with Mexico. Migrant labor pools, however,
stretch into Oregon, Idaho and any other locations where fresh food is hand
harvested in the United States.
INCREASED PENETRATION WITHIN CALIFORNIA AND ARIZONA
AGRIBUSINESS MARKETS
The Company believes that there are opportunities to grow within its
historic markets. According to data compiled by the California Farm Bureau in
1996, California farming enterprises, which are a portion of the Company's
target market, generated 9.5% of the state's total annual income and supported
1.4 million jobs, or nearly 10% of the state total. The California Farm Bureau
estimates that California has over 80,000 farms, widely distributed in rural
areas throughout the state. The Company believes that these agribusiness
employers prefer to build long-term relationships with agents and to trade
locally. Accordingly, the Company has focused on building market share within
well-defined rural communities rather than broadly throughout the state. The
Company has offices in 12 communities in California and has identified over 75
additional communities in California that it believes represent significant
growth opportunities for the Company.
EXPANSION INTO RELATED INDUSTRIES
The Company has capitalized on its experience working in the
agribusiness industry by expanding into other industries with immigrant
workforces, including grocery stores, restaurants and garment manufacturers.
Like agribusiness employers, these businesses typically hire low-wage immigrant
labor forces to perform semi-skilled labor and have risk characteristics and
service requirements similar to those of the Company's agribusiness client base.
PTC member agencies with expertise in these industries have been the key factor
behind the Company's growth in non-agribusiness industries.
CUSTOMERS
AGRIBUSINESS
The Company has served the insurance needs of western agribusiness
employers and other employers of immigrant workers for over 50 years. The
Company defines "agribusiness" to include those employers who farm, harvest,
transport, pack and process tree fruit, vegetables, fiber, flowers, vine fruit,
and dairy products. Because the Company focuses on clients in a limited number
of industries, it believes it has developed expertise in assessing the risks
associated with those industries.
The Company believes that the experience level required to be
successful in serving the agribusiness industry makes it difficult for
competitors to enter this market. In each state in which it operates, the
Company's single largest competitor for agribusiness is that state's workers'
compensation insurance fund. Due in part to the limited number of
non-governmental carriers, state funds have built substantial market share in
the states where they exist.
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TRADE ASSOCIATIONS AND SAFETY GROUPS
Two significant factors in the Company's recent growth and
profitability have been the success of Pan Am in obtaining endorsements from
agricultural trade associations and in promoting the formation and operation of
successful safety groups. The Company believes that it gains significant
marketing and underwriting benefits from these relationships. Trade association
endorsements are made and renewed on an annual basis. As of December 31, 1997,
no single trade association accounted for more than 5% of the Company's
estimated annual premium ("EAP"). The Company individually underwrites each
policy and is not obligated to offer insurance to any other trade association
member. The Company works with significant independent employers or groups of
employers in selected crops or industries to form safety groups for group
insurance purchasing and safety training purposes. Safety groups are chartered
business entities which are registered with the applicable Department of
Insurance and formed primarily to encourage workplace safety among employer
members of the group and to purchase workers' compensation insurance as a group.
OTHER EMPLOYERS OF HISPANIC AND IMMIGRANT LABORERS
In recent years, the Company has leveraged its experience working with
non-English speaking immigrant workers into serving the needs of other
businesses employing low-wage, Hispanic workers and other immigrant populations.
Examples include Company programs focused on grocery stores, restaurants and
garment manufacturers. The Company has hired completely bi-cultural (of Hispanic
or Asian descent) loss control personnel and works closely with ethnic insurance
agency forces in these programs.
DISTRIBUTION
DIRECT
The Company, operating through its wholly-owned subsidiary Pan Am,
distributes its workers' compensation products to employers in California,
Arizona and Oregon. Management believes Pan Am is one of the largest agency
operations specializing in offering employee benefit products to
agribusiness-related employers in California and Arizona. Pan Am primarily has
developed internally, to a current full-time sales force of approximately 35,
with commission revenues (before intercompany eliminations) of $10.0 million in
1996 and $8.9 million in 1997. Pan Am, as agent and broker, offers its customers
a wide range of insurance products tailored to agribusiness employers' specific
needs.
Pan Am's revenues are derived from commissions from the placement of
insurance with insurance carriers, including PICO and PACO. In 1997, Pan Am
placed 52.8% of its total insurance premiums with PICO and PACO. The Company's
integration of the sales and underwriting elements of the workers' compensation
insurance business sold through Pan Am enhances the Company's ability to retain
this business. PICO's insurance business sold through Pan Am is not subject to
being moved at the sole discretion of the agent, although PICO's insurance sold
through Pan Am is still subject to competition from other insurance carriers.
For 1997, 39.0% of PICO's premiums written was sold through Pan Am.
Pan Am has approximately 70 full-time equivalent employees operating
from 17 offices in California, Arizona and Oregon. Many of these locations also
house PICO personnel and operations. This provides Pan Am sales personnel with
direct access to insurance company underwriting and claims personnel which, the
Company believes, improves the effectiveness of Pan Am's sales and servicing
efforts.
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PAULA TRADING COMPANY
To enhance the Company's presence in rural areas not served by Pan Am,
the Company affiliates with insurance agencies of similar size and operating
histories to Pan Am. In late 1996 and early 1997, the Company made minority
equity investments in Parker and CAPAX, two regional commercial insurance
agencies. In 1996, the Company, Parker and CAPAX formed the PTC to affiliate
with other independent agencies. Typically, PTC member agencies have extensive
operating histories, a significant commercial insurance presence in rural
communities and historically high client persistency rates.
The insurance agencies that have been selected to join the PTC are
expected to submit applications on risks where there is a high likelihood of
PICO successfully writing the business. PICO also typically expects the first
and last chance to quote agribusiness or Hispanic-focused workers' compensation
business written by a PTC member. The agencies also pay an annual fee to the
PTC. PTC members have access to PAULA's innovative product features such as the
employment practices liability insurance products described below and have the
potential to join an insurance agency marketing arrangement established by the
founders of the PTC. The Company believes the PTC allows the Company to receive
better quality insurance submissions, face less price competition and maintain
relatively low insurance business acquisition costs.
INDEPENDENT INSURANCE AGENTS
The Company has appointed a limited number of independent insurance
agents to sell its workers' compensation insurance, primarily in jurisdictions
not well covered by PTC members. The Company favors appointing independent
agents who will primarily represent the Company in its desired agribusiness
focused markets rather than presenting the Company as one of many competing
quotes together in a pricing comparison.
OTHER AGENCY OPERATIONS
Other products and services offered by Pan Am include group health
insurance, third party administration, managed care programs, property and
casualty insurance, crop insurance, life and disability insurance and other
financial services.
SCOPE OF OPERATIONS
The Company has operated successfully in California for more than 50
years and in Arizona for more than 40 years. In 1994, the Company commenced
operations in Oregon to test whether its business formula would prove successful
in other jurisdictions. The Company wrote its first policy in Oregon on January
1, 1995. The Company next commenced operations in Idaho, where it wrote its
first policy on July 1, 1996, just prior to the legislative requirement that
workers' compensation insurance become mandatory for agricultural employers for
the first time in January 1997. Most recently, based on the success of the
Company's Oregon and Idaho expansion, the Company has expanded into Alaska,
Florida, New Mexico and Texas. The Company has focused its expansion in states
with significant labor-intensive agribusiness insurance opportunities.
The Company wrote its first policy in Texas in early 1997. The
Company was admitted to write workers' compensation insurance in New Mexico and
Florida in early 1997, wrote its first policy in Florida in July 1997 and in New
Mexico in December 1997. The Company commenced writing policies in Alaska in
1996.
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PRODUCTS AND SERVICES
The Company's principal product consists of workers' compensation
insurance policies sold primarily to agribusiness employers. For the year ended
December 31, 1997, workers' compensation premiums earned accounted for 89.2% of
the Company's revenues.
In order to differentiate its product from its competitors and provide
the members of the PTC with points of difference to aid them with the sale and
retention of business, the Company has developed a number of innovative product
features, including: (i) automatic coverage in California for discrimination
claims based on an employee's intent to file a workers' compensation claim; (ii)
available employment practices liability insurance in California ("EPL"), which
provides coverage for sexual harassment, wrongful termination and
discrimination; (iii) automatic benefits for the provision of occupational
medicine to workers' compensation claimants in Mexico; and (iv) additional
premium credit to the insured employer in California when the agent provides
both the workers' compensation and health insurance to the employer client and
its employees. The Company has entered into a quota-share reinsurance agreement
with Lloyds of London with respect to the underwriting risk of its EPL product.
The Company's EPL product was introduced in April 1997 and generated gross
premiums written of $65,000 for the year ended December 31, 1997.
The Company sells "AmeriMex", a product underwritten by PACO, which is
typically sold alongside PICO's workers' compensation product in California, and
which provides group medical benefits for services rendered at three provider
hospitals in Mexico. PACO also offers low limit group term life and accidental
death and dismemberment insurance to employer groups. The Company's third party
administrator ("TPA") services consist of the independent administration of
claims and related matters for self-insured employers' health benefit plans. For
the year ended December 31, 1997, TPA, group medical and group life products
accounted for an aggregate of less than 2% of the Company's revenues. These
products are typically sold to the same employers that purchase the Company's
workers' compensation products.
As a general commercial agent, Pan Am distributes group health
insurance, property and casualty insurance, life and disability insurance and
other products underwritten by unaffiliated insurance companies to the Company's
agribusiness clients. The Company believes that the ability of Pan Am to offer
these products and the ability of Pan Am and the PTC member agencies to offer
the Company's distinctive products strengthen the relationship between the agent
and the Company's policyholders.
UNDERWRITING
RISK SELECTION
The Company's focus allows it to concentrate on agribusiness in rural
areas where litigation, fraud and abuse, which tend to increase the frequency of
claims as well as the Company's loss adjustment expense ("LAE"), are less
pronounced. The Company believes the historically lower claim frequency and LAE
in these areas are due in large part to the stronger work ethic and lower wage
level in these areas coupled with a lower density of attorneys and other
workers' compensation claimants' intermediaries.
Most of PICO's business is produced through Pan Am and a group of
selected independent agents which have a local presence in the major
agricultural areas throughout the Company's operating markets. The Company
believes that this local involvement in rural communities allows its agents to
gain insight into the insureds' financial stability, ability to run their
business, attitudes toward safety and loss control and willingness to work as
partners with the Company in the management of their workers' compensation
program.
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The Company focuses on small- to medium-sized accounts which make up
the broadest segment of agribusiness employers. PICO's average annual workers'
compensation policy premium, as measured by EAP, was approximately $10,500 as of
December 31, 1997. The Company has found that smaller businesses tend to be
supervised by the owner rather than management staff. The Company believes that
an employer's claims experience directly depends on the owner's commitment to
workplace safety and its hiring practices. By underwriting small- to
medium-sized accounts, the Company has an opportunity to assess directly the
owners' commitment to workplace safety rather than trying to assess such
commitment through interaction with management staff.
UNDERWRITING PROCESS
PICO's relationship with Pan Am and other agents allows the
pre-screening by such agents of new workers' compensation accounts according to
criteria established by PICO, including the employers' prior loss experience,
hiring practices, safety record, credit history, geographic location and types
of job assignments within employment classifications. The Company's agents also
meet with the employer's management to assess the extent to which management is
committed to safety in the workplace. The Company believes that this initial
screening of potential clients improves risk selection.
Once an account passes this initial screening process and prior to
approving an application, the Company's underwriting department reviews each
employer applicant's prior loss experience, safety record, operations,
geographic location and payroll classifications and the types of job assignments
within employment classifications. If necessary, more often for accounts with
EAP of $250,000 or greater, a pre-inspection is conducted by the Company's loss
control department to evaluate safety in the workplace, hiring practices,
industrial health hazards and the potential insured's enthusiasm for loss
control and workplace safety. The Company's underwriters evaluate the potential
profitability of each insurance application by analyzing the various potential
loss exposures related to that particular risk compared to the standard
exposures in that classification. The Company's concentration in the
agribusiness industry permits this comparison to be done in a more thorough and
cost effective manner.
The Company runs a customized software system which networks the
underwriters to field representatives, loss control consultants, premium
auditors, credit and collections personnel and claims supervisors to provide
renewal data and schedule service visits. A record of all customer interaction
is maintained for the underwriters' review. On larger risks, the Company's
underwriters consult with the Company's senior claims management personnel
during the underwriting process. For new business submissions, this process
improves the Company's ability to estimate an employer's expected claims
experience. For renewing businesses, this process informs the underwriters of
the Company's experience handling claims for the particular employer and the
employer's attitude toward safety, cooperation in the claims settlement process,
return to work efforts and collection payment history. Any expected change in
reserves is also discussed in the renewal business claims review.
Once an account is written, a service plan is put into place utilizing
a team of bilingual field representatives, certified loss control specialists
and employer personnel to establish and periodically review formal and informal
safety programs, safety committees, conformity with OSHA standards, procedures
for reporting injuries, medical cost containment, anti-fraud information,
accident investigation, safety incentive/rewards programs and claims review
procedures. A service call by claims and field personnel is scheduled with each
account with EAP in excess of $75,000. The Company's field representatives
provide a number of valuable services for the Company's underwriting and claims
personnel as well as to the Company's insured employers. All of the field
representatives speak English and Spanish. The field representatives spend their
working hours making periodic visits to the Company's insured employers and
their workers. Among other
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things, the field representatives provide feedback to the Company's
underwriting personnel about particular accounts and their attitude toward,
and actions to implement, workplace safety. Input from the field
representatives influences rating and pricing decisions by the Company's
underwriters. The Company uses its bilingual, state-certified loss control
personnel to hold safety seminars to train insureds' employees.
The Company has established an underwriting referral policy designed to
allow the Company's senior underwriting officer to review all large and unusual
underwriting opportunities. All accounts with (i) high EAP, (ii) high experience
modifications (indicating poor prior claims experience), (iii) a projected
overall rate reduction at renewal, or (iv) large variations from the Company's
standard rates are reviewed by the senior underwriting officer, together with
the senior claims officer, senior loss control officer and the chief operating
officer.
UNDERWRITING PERSONNEL
The Company's underwriting department consists of ten senior
underwriters with an average of 23 years experience in property/casualty
underwriting and ten other underwriting staff members. Each of the senior
underwriters is given individually determined binding authority. All of the
Company's underwriters are expected to spend a significant portion of their time
out of the office visiting agents and policyholders.
PRICING
The amount of premium the Company charges for workers' compensation
insurance is dependent on the size of an employer's payroll, the job
classifications of its employees and the application of the Company's rating
plan to each individual employer. The Company's rating plan varies from state to
state due to differences in regulatory environments. In certain states, the
premium rate charged to a particular employer may be affected by a risk premium
modifier if the employer is a member of a safety group or meets certain safety
or other requirements. Each employer's indicated premium is then adjusted based
on the employer's experience modification, which is determined by a third party
rating bureau. Application of the experience modification factor results in an
increase or decrease to the indicated premium rate based on the employer's loss
experience and, therefore, provides an incentive to employers to reduce
work-related injuries and illnesses.
In certain states, at the time the Company issues a policy to an
employer, the Company is paid a deposit premium, which is a percentage of the
EAP of the policy at the time of issuance. The percentage ranges from 10% to
100% of the EAP depending, among other things, on the premium payment schedule,
the employer's credit history and employment classifications. The employer
remits its premiums either in installments based on a payment plan or in amounts
calculated from periodic reports of its payrolls. At the end of the policy term,
or when the policy is cancelled, a final audit of the employer's records is
conducted by the Company to determine the correct amount of premium due to the
Company.
For a description of regulation of workers' compensation insurance
premium rates, see "Business-Regulation-Regulation of PICO's Business in Each
State in Which it is Licensed".
CLAIMS
The Company's policy is to protect injured workers or their dependents
and policyholders by promptly investigating each loss occurrence, administering
benefits in a prompt, efficient and cost effective manner and maintaining an
appropriate reserve estimate on each claim through closure. The Company expends
significant efforts to improve its insureds' claim experience. Because the
Company charges insurance rates based in part on an insured's claims experience
over a three-year period, improvements in an insured's claims experience are not
10
<PAGE>
immediately reflected in lower rates, thereby providing an opportunity for the
Company's loss ratio to improve as each accounts' claims experience is reduced.
MANAGEMENT OF CLAIMS COSTS
The Company's Special Investigation Unit reviews each claim for
potential fraud as it is reported to the Company rather than only those claims
referred to the unit by claims adjusters after they suspect fraud, as the
Company believes is more typical in the industry. By reviewing every claim at an
early stage, the Company is able to take advantage of its experience in
identifying the principal indicators of fraud and thereby mitigate its exposure
to fraudulent claims. The Company believes its Special Investigation Unit's
review of every claim diminishes the number of fraudulent claims paid by the
Company and is responsible in part for lowering the Company's loss ratio. The
Company has also established a separate litigation management unit, utilizing
its own administrative hearing representatives, which makes extensive use of
alternative dispute resolution techniques to settle claims prior to these claims
going before local workers' compensation appeals boards. The Company holds
special one-day arbitration conferences with retired workers' compensation
judges at least quarterly and attempts to settle pending claims at these
conferences.
In addition, the Company has taken significant steps to reduce its
outside legal fee expenses when litigated claims cannot be resolved by the
Company's in-house litigation personnel. The Company has entered into capitation
arrangements with each of the members of its panel of outside law firms. These
arrangements limit the amount the Company will be charged by its attorneys for
given legal actions. The Company believes these capitation arrangements have
reduced its LAE.
As an integral part of its claims operations, PICO utilizes specially
trained personnel, both employees and independent contractors, to carry out cost
containment techniques in the areas of medical management, litigation
management, vocational rehabilitation management, subrogation management, fraud
investigation, bill review, utilization review and benefit delivery compliance.
The Company's medical management efforts are devoted to providing medical
utilization review and quality assurance with the objectives of controlling unit
cost, volume of services and lost work days due to work-related injury and
illness. In particular, due to its long experience in rural markets, the Company
understands how the delivery of occupational medical services varies in rural
areas from metropolitan areas, allowing the Company, it believes, to more
effectively utilize its rights to direct injured workers to medical providers
approved by the Company during the first weeks after an injury occurs.
Claims management is further enhanced by the Company's bilingual field
representatives who assist in the benefit-delivery process and the explanation
of benefits to injured workers in their language of preference. A substantial
majority of the Company's loss control and field representatives have prior work
experience in the businesses in which the Company's clients operate. The Company
believes that it can mitigate claim incidence and duration and prevent the
settlement of claims from becoming an adversarial process by maintaining open
communication with the farm worker communities. To that end, whenever possible
the Company's field representatives attempt to personally deliver the first
claims payment to each injured worker, which the Company believes leads to
greater cooperation in the ultimate settlement of claims and fulfills a fraud
prevention function by allowing Company personnel to meet and evaluate the
injured worker. In addition, the Company's claims department has operated for
many years with a bilingual and cross-cultural claims examination workforce,
which facilitates more rapid explanation of benefits and settlement of claims
with Spanish speaking claimants.
The Company has implemented a toll-free injury reporting telephone
number which allows employers and injured workers to report claims more quickly.
Callers receive assistance reporting their claim and the
11
<PAGE>
Company's claims personnel receive a "head start" on the management of the
costs of that claim. The head start allows the Company to investigate the
circumstances of the injury to determine the claim status, assist the injured
worker in the selection of medical providers approved by the Company and
assist the injured party through the claims process in a manner designed to
reduce the likelihood that the injured party will need to seek the assistance
of legal counsel with the claims process. The Company believes that there is
a direct relationship between the speed with which it learns of a claim and
its ability to reduce the cost of the claim to its lowest possible value.
The Company has created a panel of medical providers practicing in
three facilities in Mexico who are skilled in delivering occupational medicine
in a manner consistent with the requirements of the California workers'
compensation system at less cost than United States providers for those workers
more comfortable with Mexico clinics and hospitals. For instance, a common
inguinal hernia repair which may cost over $4,000 in the United States costs as
little as $1,600 in one of these Mexico-based medical provider facilities.
CLAIMS PERSONNEL
The Company's claims management is conducted under the direction of 15
claims management personnel with an average of 18 years of experience in the
industry. The Company's claims examiners are responsible for the management of
caseloads typically averaging 125 claims per examiner, which the Company
believes is lower than the industry average. Due to the combination of
experience and manageable caseloads, the Company's claims personnel can be
effective at managing claims through frequent contact with policyholders,
injured workers and medical providers. Moreover, the Company's claims personnel
are able to quickly and cost effectively respond to changes in mandated workers'
compensation benefits. The Company maintains claims processing offices with
Spanish-speaking bilingual staff in seven of its 21 offices.
LOSSES AND LOSS RESERVES
In many cases, significant periods of time may elapse between the
occurrence of an insured loss, the reporting of the loss to the insurer and the
insurer's payment of that loss. To recognize liabilities for unpaid losses,
insurers establish reserves, which are balance sheet liabilities representing
estimates of future amounts needed to pay claims with respect to insured events
that have occurred, including events that have occurred but have not yet been
reported to the insurer. Reserves are also established for LAE representing the
estimated expenses of settling claims, including legal and other fees, and
general expenses of administering the claims adjustment process.
Reserves for losses and LAE are based not only on historical experience
but also on management's judgment of the effects of factors such as future
economic and social forces likely to impact the insurer's experience relative to
the type of risk involved, benefit changes, circumstances surrounding individual
claims and trends that may affect the probable number and nature of claims
arising from losses not yet reported. Consequently, loss reserves are inherently
subject to a number of highly variable circumstances.
Reserves for losses and LAE are evaluated quarterly using a variety of
actuarial and statistical techniques for producing current estimates of expected
claim costs. Claim frequency and severity and other economic and social factors
are considered in the evaluation process. Since the Company relies on both
actual historical data, which reflect past inflation, and on other factors which
are judged to be appropriate modifiers of past experience, the Company uses an
implied, rather than explicit, provision for inflation in its calculation of
estimated future claim costs. Adjustments to reserves are reflected in operating
results for the periods in which they are made.
12
<PAGE>
The Company sets an initial case reserve upon being notified of an
insured injury. Since 1992, the Company has employed automated computer
technology utilizing a database comprised of data from participating
unaffiliated workers' compensation carriers to assist the Company in setting
such initial reserves. As more facts regarding the loss become known, the
Company reviews and, if appropriate, revises the initial case loss reserve.
In addition to case reserves, the Company also establishes bulk
reserves. Bulk reserves are established on an aggregate basis to provide for
losses incurred but not yet reported to the insurer and to supplement the
overall adequacy of individual case reserves established by claims adjusters and
estimated expenses of settling such claims, including legal and other fees and
general expenses of administering the claims adjustment process. The Company
establishes bulk reserves by estimating the ultimate net liability for losses
and LAE by using actuarial reserving techniques. Such techniques are used to
adjust, in the aggregate, the amount estimated for individually established case
reserves, as well as to establish estimates for reserves for unreported claims.
Adjustments are made for changes in the volume and mix of business, mix of claim
categories, claims processing and other items which affect the development
patterns over time.
On the basis of the Company's internal procedures which analyze, among
other things, the Company's experience with similar cases and historical trends
such as reserving patterns, loss payments and pending levels of unpaid claims,
as well as court decisions, economic conditions and public attitudes, management
has made its best estimate of the Company's liabilities for unpaid losses and
LAE and believes that adequate provision has been made for such items. However,
because the establishment of loss reserves is an inherently uncertain process,
there can be no assurance that ultimate losses and LAE will not exceed the
Company's reserves. There can be no assurance that future loss development will
not require reserves for prior periods to be increased, which would adversely
affect earnings in future periods.
13
<PAGE>
The following table sets forth a reconciliation of beginning and ending
reserves for losses and LAE after reinsurance deductions for the periods
indicated. There are no material differences between the Company's reserves for
losses and LAE shown below calculated in accordance with GAAP and those
calculated in accordance with SAP. The Company does not discount claim reserves
on either a GAAP basis or under SAP.
RECONCILIATION OF RESERVES FOR LOSSES AND LAE
(IN THOUSANDS)
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- --------
<S> <C> <C> <C>
Unpaid loss and loss adjustment expenses beginning of year.............. $60,473 $57,049 $55,720
Less: reinsurance recoverable on unpaid losses and LAE.................. 6,886 6,775 6,427
PACO reserves.................................................. 300 292 533
--------- --------- --------
Net PICO balance, beginning of year.................................. $53,287 $49,982 $48,760
--------- --------- --------
Incurred related to:
Current period....................................................... 33,048 35,938 66,330
Prior periods........................................................ (3,884) (2,646) 1,586
--------- --------- --------
$29,164 $33,292 $67,916
--------- --------- --------
Paid related to:
Current period....................................................... 10,727 12,833 20,495
Prior periods........................................................ 21,742 21,681 25,134
--------- --------- --------
$32,469 $34,514 $45,629
--------- --------- --------
Net PICO balance, end of year........................................ 49,982 48,760 71,047
Plus: reinsurance recoverable on unpaid losses and LAE.................. 6,775 6,427 6,394
PACO reserves.................................................. 292 533 343
--------- --------- --------
Unpaid loss and loss adjustment expenses, end of year................... $57,049 $55,720 $77,784
--------- --------- --------
--------- --------- --------
</TABLE>
The table below shows changes in historical workers' compensation net
loss and LAE reserves for PICO for each year since 1987. Reported reserve
development is derived from information included in PICO's statutory financial
statements. The first line of the upper portion of the table shows the net
reserves as of December 31 of each of the indicated years, representing the
estimated amounts of net outstanding losses and LAE for claims arising during
that year and in all prior years that are unpaid, including losses that have
been incurred but not yet reported to the Company. The upper portion of the
table shows the reestimated amount of the previously recorded net reserves for
each year based on experience as of the end of each succeeding year. The
estimate changes as more information becomes known about claims for individual
years. The lower portion of the table shows the cumulative net amounts paid as
of December 31 of successive years with respect to the net reserve liability for
each year.
In evaluating the information in the table below, it should be noted
that each amount includes the effects of all changes in amounts for prior
periods. For example, if a loss determined in 1990 to be $10,000 was first
reserved in 1987 at $8,000, the $2,000 deficiency would be included in the
cumulative redundancy (deficiency) for each of the years 1987 through 1990 shown
below. This table, unlike the table headed "Calendar Year Development by
Accident Year" that follows, does not present accident or policy year
development data. Conditions and trends that have affected the development of
liability in the past may not necessarily occur in the future. Accordingly, it
may not be appropriate to extrapolate future redundancies or deficiencies based
on this table.
14
<PAGE>
CHANGES IN HISTORICAL NET RESERVES FOR LOSSES AND LAE
<TABLE>
<CAPTION>
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
------- -------- ------- -------- ------- -------- -------- -------- -------- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Unpaid losses and loss
adjustment expenses at
end of year............ $49,221 $52,893 $49,994 $49,104 $57,909 $59,492 $56,792 $53,287 $49,982 $48,760 $71,047
Reserve re-estimated as of:
One year later......... 46,450 47,061 47,833 52,209 58,618 57,000 52,837 49,403 47,335 50,346
Two years later........ 44,777 46,462 50,060 53,491 60,095 57,115 50,480 48,189 45,041
Three years later...... 44,294 47,725 49,970 54,316 60,733 55,305 50,647 46,855
Four years later....... 44,507 47,473 50,321 55,269 59,806 56,725 50,056
Five years later....... 44,336 47,064 51,095 54,808 60,286 56,813
Six years later........ 43,948 47,444 51,025 55,184 60,794
Seven years later...... 44,092 47,346 51,348 55,738
Eight years later...... 44,077 47,847 51,714
Nine years later....... 44,468 48,216
Ten years later........ 44,684
Cumulative redundancy
(deficiency).............. 4,537 4,677 (1,720) (6,634) (2,885) 2,679 6,736 6,432 4,941 (1,586)
Cumulative paid as of:
One year later......... 14,289 16,761 19,757 21,736 25,543 23,464 21,711 21,742 21,680 25,133
Two years later........ 25,290 29,212 32,602 36,021 40,328 37,040 34,721 33,601 33,007
Three years later...... 33,298 36,832 40,456 43,482 48,429 45,529 41,855 39,372
Four years later....... 37,758 41,251 44,254 47,923 53,416 50,395 45,253
Five years later....... 40,320 43,271 46,682 50,713 56,250 52,941
Six years later........ 41,295 44,676 48,430 52,442 58,261
Seven years later...... 42,083 45,562 49,406 53,801
Eight years later...... 42,723 46,465 50,333
Nine years later....... 43,388 47,145
Ten years later........ 43,824
Net unpaid losses and loss
adj. expenses
December 31............ $53,287 $49,982 $48,760 $71,047
Reinsurance recoverable... 6,886 6,775 6,427 6,394
--------- -------- -------- --------
Gross unpaid losses and
loss adj. expenses
December 31............ $60,173 $56,757 $55,187 $77,441
--------- -------- -------- --------
--------- -------- -------- --------
</TABLE>
(Continued)
15
<PAGE>
<TABLE>
<CAPTION>
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
------- -------- ------- -------- ------- -------- -------- -------- -------- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Re-estimated net
unpaid losses and
loss adjustment
expenses................ $46,855 $45,041 $50,346
Re-estimated reinsurance
recoverable............. 5,831 4,992 5,532
--------- ------- --------
Re-estimated gross
unpaid losses and
loss adjustment
expenses............... $52,686 $50,033 $55,878
--------- ------- --------
--------- ------- --------
Gross cumulative
redundancy
(deficiency).......... $7,487 $6,724 ($691)
--------- ------- --------
--------- ------- --------
</TABLE>
The following table is derived from the table above and summarizes the
effect of reserve re-estimates net of ceded reinsurance on calendar year
operations for the same ten-year period ended December 31, 1997. The total of
each row details the amount of reserve re-estimates made in the indicated
calendar year and shows the accident years to which the re-estimates are
applicable. The total of each accident year column represents the cumulative
reserve re-estimates for the indicated accident year(s).
CALENDAR YEAR DEVELOPMENT BY ACCIDENT YEAR
<TABLE>
<CAPTION>
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 TOTAL
------- -------- ------- -------- ------- -------- -------- -------- -------- -------- ---------
AND CALENDAR
----- --------
PRIOR YEAR
------ ------
EFFECT
-------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Calendar years
1997............... ($216) ($153) $3 ($188) $46 $420 $679 $743 $960 ($3,880) ($1,586)
1996................ (391) (110) 178 (53) (104) (940) 1,253 1,381 1,433 2,647
1995................ 15 83 (28) 391 466 883 547 1,527 3,884
1994................ (144) (236) (394) (179) 315 523 4,070 3,955
1993................ 388 21 (760) (474) (652) 3,969 2,492
1992................ 171 81 (162) (1,372) 573 (709)
1991................ (213) (1,050) (964) (878) (3,105)
1990................ 483 116 1,562 2,161
1989................ 1,673 4,159 5,832
1988................ 2,771 2,771
Cumulative
re-estimates
for each ------- -------- ------- -------- ------- -------- -------- -------- -------- -------- ---------
accident year $4,537 $2,911 ($565) ($2,753) $644 $4,855 $6,549 $3,651 $2,393 ($3,880) $18,342
------- -------- ------- -------- ------- -------- -------- -------- -------- -------- ---------
------- -------- ------- -------- ------- -------- -------- -------- -------- -------- ---------
</TABLE>
16
<PAGE>
As illustrated by this table, there have been no significant adverse
developments in PICO's reserve for any accident year from 1987 through 1996
except for 1990 and 1996 which are discussed below. While PICO has historically
applied, and continues to apply, a consistent methodology in establishing its
reserves, there can be no assurance that significant adverse developments in
PICO's reserves will not occur in the future.
PICO and the California workers' compensation industry as a whole
experienced relatively high incurred losses and LAE during accident years 1989 -
1992 as a result of laws enacted in 1989 which had the unintended effect of
permitting the filing of fraudulent and abusive workers' compensation claims.
Those laws included, among others, a law allowing an injured employee to visit a
physician without giving the employer prior notice of a claim and a law
shortening the time during which a carrier had to approve or deny a claim, which
hindered carriers' ability to investigate claims suspected of involving fraud.
PICO determined reserves for accident years 1993 and 1994, and to a lesser
extent, 1995, based on the relatively high incurred loss and LAE trends for the
1989 - 1992 accident years. PICO's actual incurred losses and LAE for the 1993 -
1995 accident years proved to be lower than anticipated and PICO's original
reserves for these periods were ultimately redundant. PICO's favorable
development of reserves for the 1993 and 1994 accident years and, to a lesser
extent, for the 1995 accident year is attributable to the implementation of
significant workers' compensation reform in California in 1993 and aggressive
fraud enforcement by PICO, the industry and California authorities beginning
around the same time.
PICO determined its reserves for the 1994 - 1996 accident years with
the benefit of information indicating favorable development in the immediate
prior accident years. Development of the 1994 and 1995 accident years has more
closely approximated the development anticipated when reserves for those years
were initially established.
During 1995, PICO experienced an aggregate of approximately $3.9
million in reserve recoveries attributable primarily to favorable development on
losses and LAE for accident years 1990 - 1994. During 1994, PICO experienced an
aggregate of approximately $4.0 million in reserve recoveries, primarily
attributable to favorable development for the 1993 accident year. PICO's reserve
recoveries during 1994 and 1995 are directly related to the more favorable loss
patterns experienced by PICO in 1993 and 1994 compared with those anticipated by
PICO based on the patterns exhibited during 1990 - 1992. PICO recognized the
favorable development associated with the California reforms and related fraud
abatement activities in the early 1990's over time as more credible loss
development information became available confirming the existence of a favorable
trend.
In 1996, PICO experienced an aggregate of approximately $2.6 million in
reserve recoveries attributable primarily to favorable development on losses and
LAE for the 1993 - 1995 accident years, offset in part by mildly negative
development for the 1990 - 1992 accident years. PICO attributes this favorable
development in part to favorable industry trends as well as to PICO's continued
improvement in claims management and management of the medical and legal
components of its workers' compensation claims. In particular, in late 1995 PICO
implemented a change in the manner in which it pays legal counsel for work
performed in connection with litigated claims which had the effect of
significantly reducing PICO's LAE reserves for open claims from prior years.
During 1997, PICO experienced an aggregate of approximately $1.6
million in net reserve development. During 1997, reserve development of $3.9
million on the 1996 accident year was partially offset by reserve recoveries of
$2.4 million on accident years 1993 - 1995. PICO established its initial
reserves on the 1996 accident year based on the favorable trends for the
1993-1995 accident years. The development for the 1996 accident year resulted
from claims trends less favorable than those experienced by the Company for the
1993-1995 accident years.
17
<PAGE>
POLICYHOLDER DIVIDENDS
Workers' compensation policies can be written on a participating or
non-participating basis. Participating policies allow the Company to declare and
pay dividends to a policyholder after the expiration of the policy based upon a
policyholder's specific loss experience (or, if the policyholder is part of a
safety group, the group's specific loss experience), the Company's overall loss
experience and competitive conditions. Since January 1, 1997, substantially all
workers' compensation insurance underwritten by the Company in California,
Alaska and Texas has been written without the expectation that the Company would
pay policyholder dividends on such policies. Substantially all of the insurance
underwritten by the Company in Arizona, Oregon, Idaho and Florida is written on
participating policy forms. Currently, workers' compensation insurers in Arizona
and Florida generally use policyholder dividends to reward favorable loss
experience as a means of competitive pricing although with increasing upfront
price competition in Arizona, dividends are becoming less of a competitive
factor. In Oregon and Idaho, dividends are sometimes used as a competitive
pricing tool, although rates are more flexible in those states. Dividends play
little role in Alaska and Texas, due to the flexibility in the rating plans in
those states. The Company makes the determination of the amount of the dividends
it chooses to pay on its participating policies generally 12 to 30 months after
policy expiration, and such payments require approval by PICO's board of
directors. The Company intends to continue to issue policies in Arizona, Oregon,
Idaho and Florida that are eligible for policyholder dividend consideration,
although the Company believes it is unlikely that the Company will pay
significant policyholder dividends in those states in the future.
REINSURANCE
Insurance risk is ceded primarily to reduce the liability on individual
claims and to protect against catastrophic losses. The Company follows the
industry practice of reinsuring a portion of its risks on an excess of loss
reinsurance basis. For this coverage, the Company pays the reinsurer a portion
of the premiums received on all policies. In return, the reinsurer agrees to
reimburse the Company for all losses in excess of a predetermined amount,
commonly referred to as the insurance company's retention.
The Company maintains excess of loss reinsurance treaties with various
reinsurers for workers' compensation. Since 1974, General Reinsurance
Corporation ("GenRe") has been the Company's primary reinsurer. GenRe is
currently assigned a letter rating of "A++ (Superior)" by A.M. Best. The
Company's upper layers of reinsurance coverage are currently provided by a large
group of companies contracted through a reinsurance intermediary owned by GenRe.
All such carriers are currently assigned a rating of "A-" or better by A.M.
Best. Reinsurance receivables reflected in the Consolidated Financial Statements
are due from GenRe. Under the current workers' compensation reinsurance
treaties, various reinsurers assume liability on that portion of the loss that
exceeds $250,000 per accident, up to a maximum of $30 million per accident. The
Company's per accident retention was $150,000 until October 1993 and $200,000
thereafter until July 1, 1996. An accident is defined as a single event, whether
it affects one or more persons. Although reinsurance makes the assuming
reinsurer liable to PICO to the extent of the reinsurance ceded, it does not
legally discharge PICO from its primary liability for the full amount of the
policy liability. The Company has encountered no disputes with its reinsurers
and has not experienced any difficulty on the part of reinsurers to fulfill
their obligations under reinsurance treaties. The Company believes that suitable
alternative reinsurance treaties are readily obtainable at the present time.
The Company has entered into a quota-share reinsurance agreement with
the Venton Syndicate of Lloyds of London with respect to the underwriting risk
of its EPL product. The Company's EPL product was introduced in April 1997 and
generated gross premiums written of $65,000 for the year ended December 31,
1997.
18
<PAGE>
INVESTMENTS AND INVESTMENT RESULTS
The Company employs a conservative investment strategy emphasizing
asset quality and the matching of maturities of its fixed maturity investments
to the Company's anticipated claim payments and expenditures or other
liabilities. The Company employs Conning Asset Management Company ("Conning
Asset Management") to act as its independent investment advisor for the bulk of
the Company's investment portfolio pursuant to the terms of a written agreement
with Conning Asset Management and the Company's written investment guidelines.
Conning Asset Management has discretion to enter into investment
transactions within the Company's investment guidelines. In practice, this
discretion is generally exercised only with respect to the reinvestment of
maturing securities in similar securities. In the case of sales of securities
prior to maturity, or the acquisition of securities which differ from the types
of securities already present in the portfolio, Conning Asset Management will
routinely consult with the Company's Chief Financial Officer, who chairs the
Company's investment committee, prior to entering into such transactions. Among
other things, Conning Asset Management seeks to match the average duration of
the portfolio's assets with the estimated average duration of the Company's
liabilities. Conning Asset Management's fee is based on the amount of assets in
the portfolio and is not dependent upon investment results or portfolio
turnover. Conning Asset Management is affiliated with one of the Company's
principal stockholders. See "Certain Transactions".
The amount and types of investments that may be made by the Company's
insurance subsidiaries are regulated under the California Insurance Code and
related rules and regulations promulgated by the California Department of
Insurance ("DOI"). Subject to such applicable state laws and regulations,
investment policies and investment decisions are approved by the Company's
investment committee and are reviewed by the Board of Directors. The Company
modifies its mix of tax-exempt and taxable securities from time to time based in
large part on effective after-tax yield considerations. Management intends to
hold all of the Company's fixed maturity investments for indefinite periods of
time but these investments are available for sale in response to changes in
interest rates, tax planning considerations or other aspects of asset/liability
management.
19
<PAGE>
As of December 31, 1997, the carrying value of the Company's investment
portfolio was approximately $137.9 million and amortized cost was approximately
$135.5 million. The diversification of the Company's investment portfolio as of
December 31, 1997 is shown in the table below:
CONSOLIDATED INVESTMENT POSITION
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
-----------------------
PERCENT OF
CARRYING AMORTIZED CARRYING
TYPE OF INVESTMENT VALUE (1) COST VALUE
- ------------------ --------- --------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Fixed maturities: (2)
United States government
agencies and authorities.. $10,163 $10,000 7.4%
States, municipalities and
political subdivisions.... 79,555 77,817 57.7
Corporate securities......... 12,293 12,009 8.9
Collateralized mortgage
obligations............... 12,514 12,468 9.0
--------- --------- ---------
Total fixed maturities....... $114,525 $112,294 83.0%
Equity securities (3)........... 8,657 8,565 6.3
Invested cash................... 14,682 14,682 10.7
--------- --------- ---------
Total investments............ $137,864 $135,541 100.0%
--------- --------- ---------
--------- --------- ---------
</TABLE>
- ----------------------
(1) All securities are carried at market value except invested cash is
carried at cost, which approximates market value.
(2) All fixed maturity securities have been designated as available for sale.
(3) Excludes the Company's minority investments in Parker and CAPAX, which
had a carrying value as of December 31, 1997 of $1.9 million.
It is the Company's practice to purchase almost exclusively investment
grade fixed maturity securities for its insurance company portfolios. In
addition, the Company generally invests its parent company portfolio in
investment grade fixed maturity securities and mutual funds primarily holding
such securities, although the Company selectively invests in unrated and below
investment grade securities in this portfolio. As of December 31, 1997, the
Company did not own any below investment grade or non-performing fixed maturity
securities, or any mortgages or real estate. As of December 31, 1997,
substantially all of the Company's fixed maturity securities carried a NAIC
Class 1 designation (or a comparable rating agency designation).
At December 31, 1997, the Company owned a total of $12.5 million
amortized cost of AAA-rated Collateralized Mortgage Obligations ("CMOs"). The
Company's holdings of CMOs consist of Planned Amortization Class CMOs, which are
structured to have a higher degree of cash flow certainty over a variety of
prepayment scenarios, and have remaining average lives from six months to three
years.
20
<PAGE>
The following table sets forth certain information regarding the
investment ratings of the Company's fixed maturity investment portfolio as of
December 31, 1997:
LONG TERM FIXED MATURITY PORTFOLIO BY STANDARD & POOR'S RATING
<TABLE>
<CAPTION>
CARRYING AMORTIZED PERCENTAGE OF
RATINGS (1) VALUE COST CARRYING VALUE
- ----------- -------- --------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
AAA.......................... $72,124 $70,849 63.0%
AA........................... 18,496 18,113 16.2%
A............................ 21,874 21,332 19.1%
Not rated.................... 2,031 2,000 1.7%
-------- --------- -------------
Total........................ $114,525 $112,294 100.0%
-------- --------- -------------
-------- --------- -------------
</TABLE>
- ----------------------
(1) Ratings assigned by S&P when available, otherwise equivalent ratings
assigned by Moody's or Fitch. S&P assigns ratings ranging from "AAA" to
"D" reflecting its current opinion of the creditworthiness of the
obligor with respect to the specific security rated. The following
ratings reflect S&P's opinion of the obligor's capacity to meet its
financial commitment on the relevant obligation: AAA-Extremely Strong;
AA-Very Strong; and A-Strong.
The following table sets forth certain information regarding the
maturity profile of the Company's fixed maturity securities as of December 31,
1997 based on the earlier of the pre-escrowed date or the scheduled maturity
date:
INVESTMENT PORTFOLIO BY YEARS TO MATURITY
<TABLE>
<CAPTION>
PERCENTAGE OF
CARRYING VALUE CARRYING VALUE
-------------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
One year or less............................... $5,267 4.6%
After one year through five years.............. 62,010 54.1%
After five years through ten years............. 32,718 28.6%
After ten years................................ 2,016 1.8%
Mortgage and asset backed securities (1)....... 12,514 10.9%
--------- -------
Total.......................................... $114,525 100.0%
--------- -------
--------- -------
</TABLE>
- ----------------------
(1) Mortgage-backed securities generally are more likely to be prepaid than
other fixed maturity securities. Therefore, contractual maturities are
excluded from this table since they may not be indicative of actual
maturities.
21
<PAGE>
The Company's investment results for each of the three years ended
December 31, 1995, 1996 and 1997 were as follows:
INVESTMENT PORTFOLIO RESULTS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1995 1996 1997
------- ------- --------
<S> <C> <C> <C>
Net pre-tax investment income (1).......................... $4,817 $4,701 $5,582
Average total invested assets (2).......................... 82,851 83,644 110,576
Annual pre-tax yield on average total invested assets (3).. 5.8% 5.6% 5.0%
Net pre-tax realized investment gains...................... $37 $444 $172
</TABLE>
- --------------------
(1) Calculated net of investment expenses and excluding capital gains
and losses and provision for income taxes.
(2) Calculated based on an average of the beginning and end of period total
investments. For the purpose of this calculation, investment balances
were at cost (fixed income securities at amortized cost). The Company's
investment portfolio materially increased in October 1997 following the
Company's initial public offering.
(3) Pre-tax yield is calculated as investment income (including dividend
income in the case of equities) divided by average total invested
assets. The annual pre-tax yield as calculated above was diluted by the
increase in the Company's investment portfolio in October 1997. The
increase in the portfolio late in the year inflated the Company's
average total invested assets for 1997 as calculated above.
The following table summarizes net investment income from the
Company's portfolio for the years ended December 31, 1995, 1996 and 1997:
<TABLE>
<CAPTION>
NET INVESTMENT INCOME BY INVESTMENT TYPE
YEARS ENDED DECEMBER 31,
------------------------
(DOLLARS IN THOUSANDS)
1995 1996 1997
-------------------------------------------------------------------------------------------------------
% REALIZED % REALIZED % REALIZED
PRE - TAX GAINS PRE-TAX GAINS PRE-TAX GAINS
---------- --------- --------
INCOME YIELD (1) (LOSSES) INCOME YIELD (1) (LOSSES) INCOME YIELD (1) (LOSSES)
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fixed maturity
securities:
Tax-exempt (2)..... $2,383 5.1% $(10) $2,660 5.5% $248 $2,733 4.4% $(1)
Taxable............ 2,302 7.0 47 1,841 6.0 196 2,216 6.6 -
Equities (3).......... 51 6.9 - 62 5.8 - 121 2.3 173
Short-term............ 278 5.9 338 8.6 - 716 7.6 -
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
Total.............. $5,014 6.1% $37 $4,901 5.9% $444 $5,786 5.2% $172
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
Less investment
expense............ 197 - 200 204
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
Total.............. $4,817 5.8% $37 $4,701 5.6% $444 $5,582 5.0% $172
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
-------- ---------- -------- ------- ---------- -------- ------ --------- --------
</TABLE>
(footnotes follow on next page)
22
<PAGE>
(1) Pre-tax yield is calculated as investment income (including dividend income
in the case of equities) divided by the average of the beginning and end of
year investment balances. For the purpose of this calculation, investment
balances were at cost (fixed income securities at amortized cost).
(2) For purposes of comparison to yields on taxable securities, those yields on
tax-exempt securities are equivalent to average pre-tax yields of 6.5% for
1995, 7.1% for 1996, and 5.7% for 1997 assuming that the tax rate was 34%
and further assuming that 15% of a portion of the tax-exempt interest was
subject to federal income tax under certain provisions applicable only to
insurance companies.
(3) Excludes the Company's minority investments in Parker and CAPAX,
which had a carrying value as of December 31, 1997 of $1.9 million.
REGULATION
GENERAL
PAULA Financial and its subsidiaries are subject to regulation by the
departments of insurance in each jurisdiction in which they transact insurance.
These departments of insurance have broad regulatory, supervisory and
administrative powers over the insurance subsidiaries. Primary regulatory
authority, however, rests with the California DOI, the regulator in the
Company's insurance subsidiaries' state of domicile. While the exercise of their
authority may have company-wide ramifications, regulators in non-domiciliary
states focus primarily on the operation of an insurer within their respective
states.
State insurance regulation is generally intended for the benefit and
protection of policyholders and claimants under insurance policies rather than
stockholders. The nature and extent of such regulation varies from jurisdiction
to jurisdiction, but typically involve: (i) standards of solvency and minimum
amounts of capital and surplus which must be maintained; (ii) limits on types
and amounts of investments; (iii) restrictions on the size of risks which may be
insured by a single company; (iv) licensing of insurers and their agents; (v)
required deposits of securities for the benefit of policyholders; (vi) approval
of policy forms; (vii) establishment of statutory reporting practices and the
form and content of statutory financial statements; (viii) establishment of
methods for setting statutory loss and expense reserves; (ix) review, and in
certain instances prior-approval, of premium rates; (x) limits on transactions
among insurers and their affiliates; (xi) approval of all proposed changes of
control; (xii) approval of dividends; (xiii) setting and collecting guarantee
fund assessments; and (xiv) required filing of annual and other reports with
respect to the financial condition and operation of insurers. In addition, state
regulatory examiners perform periodic financial and underwriting examinations of
insurers.
DOMICILE AND LICENSING
PICO and PACO are domiciled in California. PICO is licensed to sell
insurance in Alaska, Arizona, California, Florida, Idaho, New Mexico, Oregon and
Texas. PACO is licensed to sell insurance in Arizona and California.
RESTRICTIONS ON ACQUISITIONS OF CONTROL
The California Insurance Code provides that any direct or indirect
acquisition or change in "control" of a domestic insurer cannot be consummated
without the prior approval of the California DOI. The California Insurance Code
provides further that, unless the California DOI upon application determines
otherwise, a presumption of "control" arises from the ownership, control,
possession with the power to vote or possession of proxies with respect to 10%
or more of the voting securities of a domestic insurer or of a person or entity
that controls a domestic insurer.
23
<PAGE>
Any person who purchases shares of the Common Stock which, when combined
with all other voting securities owned or otherwise controlled by that
person, total 10% or more of the voting securities of the Company, will be
deemed to have acquired control of the insurance subsidiaries unless the
California DOI, upon application, determines otherwise. Any such acquisition
of control is prohibited under the California Insurance Code unless prior
approval of the California DOI is obtained or the California DOI does not
disapprove the acquisition within 60 days after an application has been
filed. The California DOI is authorized to disapprove any acquisition which
(i) would cause the insurance subsidiaries to cease to qualify for their
licenses to transact insurance, (ii) would substantially lessen competition
or tend to create a monopoly, (iii) might, due to the financial condition of
the acquiring person, jeopardize the financial stability of the insurance
subsidiaries or prejudice the interests of their policyholders, (iv) would
result in a major change in the insurance subsidiaries' business or corporate
structure or management which is not fair and reasonable to policyholders, or
(v) would result in control over the insurance subsidiaries by persons whose
competence, experience and integrity indicate that it is not in the interest
of policyholders or the public to permit them to assume control.
The need for such action, and the possibility of disapproval by the
California DOI, could deter, delay or prevent certain transactions affecting
the control of the Company or the ownership of the Company's Common Stock.
Since the statutory disapproval criteria focus primarily on policyholder,
rather than stockholder, interests, these requirements could deter, delay or
prevent transactions which could be advantageous to the stockholders of the
Company.
RESTRICTIONS ON STOCKHOLDER DIVIDENDS PAYABLE BY THE INSURANCE SUBSIDIARIES
TO THE COMPANY
PAULA Financial, as a non-insurer, is generally not restricted directly
under applicable insurance laws with respect to the payment of dividends to
stockholders or the acquisition of non-regulated businesses. PAULA Financial,
however, is subject to regulation with respect to all transactions involving the
insurance subsidiaries. Additionally, as a nonoperating holding company, a
principal source of the PAULA Financial's liquidity is cash dividends received
from its subsidiaries, including the insurance subsidiaries.
California law places significant restrictions on the ability of the
insurance subsidiaries to pay dividends to PAULA Financial. All dividends from
PICO and PACO, as California-domiciled insurers, require prior notice to the
California DOI. All "extraordinary" dividends must be approved in advance by the
California DOI. A dividend is deemed "extraordinary" if, when aggregated with
all other dividends paid within the preceding twelve months, the dividend
exceeds the greater of (i) PICO's statutory net income or PACO's statutory net
gain from operations (both excluding unrealized capital gains) for the preceding
calendar year or (ii) 10% of policyholder surplus as of the preceding December
31st. Additionally, unless approved in advance by the California DOI, no
dividend may be paid by PICO or PACO except from earned surplus. Dividends paid
from earned surplus which do not exceed the definition of "extraordinary" must
be reported to the California DOI within five business days after declaration.
Insurers are prohibited from paying such dividends until ten business days after
the California DOI's receipt of such notice. The California DOI may disallow
payment of any dividend if, in the California DOI's opinion, the payment would
in any way violate the California Insurance Code or be hazardous to
policyholders, creditors or the public. Based on these limitations and statutory
results, as of December 31, 1997, PAULA Financial would be able to receive $6.4
million in dividends in 1998 from its insurance subsidiaries without obtaining
prior regulatory approval from the California DOI.
24
<PAGE>
RESTRICTIONS ON TRANSACTIONS AMONG AFFILIATES OF THE INSURANCE SUBSIDIARIES
In addition to dividend restrictions, California law restricts the
ability of the insurance subsidiaries to make other types of payments to
their affiliates, including PAULA Financial. Certain material transactions
between an insurance company and its affiliates, including sales, loans or
investments which in any twelve month period aggregate at least 3% of its
admitted assets or 25% of policyholders' surplus, whichever is less, are
subject to thirty day prior notice to the California DOI during which period
the California DOI may disapprove the transaction. All management,
administrative, cost-sharing and similar agreements between an insurance
company and its affiliates are also subject to thirty day prior notice and
non-disapproval by the California DOI. The California Insurance Code requires
that all affiliate transactions be fair and reasonable to the insurer, that
such transactions be documented according to specified standards, and that
the insurer's surplus after the transaction remains reasonable in relation to
the insurer's liabilities and adequate to its financial needs.
EXAMINATIONS
The accounts and businesses of PICO and PACO are subject to periodic
statutory examination by the California DOI and by the Departments of
Insurance in each jurisdiction in which they transact business. The
California DOI has completed its examination of PICO and PACO for the
three-year period ended December 31, 1996. The report disclosed no material
problems or adjustments to statutory surplus.
NAIC STATUTORY ACCOUNTING INITIATIVE
The NAIC's project to codify accounting practices was approved by the
NAIC in March 1998. The approval included a provision for commissioner
discretion in determining appropriate statutory accounting for insurers in
their state. Consequently, prescribed and permitted accounting practices may
continue to differ from state to state. The NAIC has indicated that
codification will become effective on January 1, 1999, although the
implementation date is ultimately dependent on an insurers state of domicile.
The Company has not determined how implementation will affect its insurance
subsidiaries' statutory financial statements and is unable to predict how
insurance rating agencies will interpret or react to any such changes. No
assurance can be given that future legislative or regulatory changes
resulting from such activities will not adversely affect the Company and its
subsidiaries.
RISK-BASED CAPITAL AND IRIS RATIOS
California, as well as numerous other states, uses analytical tools
developed by the NAIC in the course of its financial surveillance of insurers.
Among these is a methodology for assessing the adequacy of statutory surplus of
property/casualty insurers and life/health insurers using a risk-based capital
("RBC") formula. The RBC formula attempts to measure statutory capital and
surplus needs based on the risks in a company's mix of products and investment
portfolio. The formula is designed to allow state regulators to identify
potentially under-capitalized companies. Under the formula, a company determines
its RBC by taking into account certain risks related to the insurer's assets
(including risks related to its investment portfolio and ceded reinsurance) and
the insurer's liabilities (including underwriting risks related to the nature
and experience of its insurance business). The RBC rules provide for different
levels of regulatory attention depending upon the ratio of the company's total
adjusted capital to its "authorized control level" of RBC. An insurer is
obligated to submit a detailed financial plan to regulators if its RBC falls
below 2.0 times its authorized control level. Enhanced regulatory scrutiny,
including possible corrective orders, are required if an insurer's RBC falls
below 1.5 times its authorized control level, with mandatory regulatory
intervention, including possible seizure, if an insurer's RBC falls below its
authorized control level (seizure is mandatory if RBC falls below 0.7 times
authorized
25
<PAGE>
control level). As of December 31, 1997, PICO's RBC was $38.1 million in
excess of the threshold requiring the least regulatory attention, which
amount was $7.7 million. As of December 31, 1997, PACO's RBC was $4.3 million
in excess of the threshold requiring the least regulatory attention, which
amount was $0.1 million. Neither PICO nor PACO has ever triggered any RBC
level requiring a financial plan or regulatory action.
California and other states also utilize the NAIC Insurance Regulatory
Information System ("IRIS"). IRIS identifies eleven ratios for property/casualty
insurance companies and twelve ratios for life/health insurance companies. IRIS
specifies a range of "usual values" for each ratio. No statutory requirements
exist which determine regulators' response to unusual IRIS ratios. Regulators
generally allow insurers to provide written explanations for any unusual values.
If the explanations are accepted as reasonable, no regulatory action is
generally taken. If regulators remain concerned, an insurer may be subject to
regulatory examination, corrective orders, and possible seizure. Departure from
the "usual value" range on four or more ratios may lead to increased regulatory
oversight from individual state insurance commissioners. For 1997, PICO has two
ratios outside the usual values, both of which are caused by excess premium
growth. The two ratios are change in net writings and estimated current reserve
deficiency to surplus. The usual range for the change in net writings ratios is
(-33%) to 33%. PICO experienced 59% growth in 1997. The estimated current
reserve deficiency to surplus ratio is calculated as the reserve deficiency
divided by surplus. The reserve deficiency is calculated as the difference
between required reserves, estimated using a ratio of premium, and the actual
reserves maintained. Results of this ratio can be distorted by significant
changes in premium volume, which is the case for PICO in 1997. PICO's ratio was
40% and a ratio in excess of 25% is considered unusual. For 1997, PACO has one
ratio outside its usual value, which is caused by excess adequacy of investment
income. PICO and PACO are unaware of any increased regulatory scrutiny as a
result of their 1997 IRIS values.
REGULATION OF PICO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED
PICO's transaction of workers' compensation insurance is closely
regulated by departments of insurance in Alaska, Arizona, California, Florida,
Idaho, New Mexico, Oregon and Texas. In each of these states, the workers'
compensation system is a mechanism to promptly compensate and rehabilitate
injured workers without regard to fault. In each state where PICO is licensed,
other than New Mexico (with respect to agricultural workers) and Texas, employer
participation in the workers' compensation system is compulsory. Employers are
required by law either to obtain workers' compensation insurance from a licensed
insurer or to comply with specific requirements to self-insure.
Workers' compensation benefits are established by law in each of the
states where PICO is licensed. While benefit levels vary from state to state,
they fall generally into three categories: (1) medical benefits for treatment
of covered injuries or diseases; (2) disability benefits that indemnify
covered claimants for loss of income, and (3) death benefits to compensate
statutorily enumerated dependents of workers who have died because of covered
accidents or diseases. Individual state statutes, regulations, administrative
rulings and judicial opinions have created a complex body of law to determine
when an injury, disease or death is employment related, when and to what
extent it is compensable, and whether employees may sue employers, coworkers
or other parties for damages outside of the no-fault workers' compensation
system.
Workers' compensation has been the subject of significant reform efforts
in recent years, particularly in the areas of cost management and fraud
detection. For example, legislation enacted in California in 1993
significantly reformed many areas of the workers' compensation system. Among
other things, the 1993 legislation (i) granted employer's rights regarding
disclosure of insurer claims information; (ii) required insurers to provide
minimum levels of occupational safety and health loss control consultation
services; (iii) increased benefits, phased in over a three-year period
commencing July 1, 1994; (iv) tightened standards relating to stress-related
claims; (v) limited post-termination claims; (vi) placed restrictions,
including payment limitations,
26
<PAGE>
on vocational rehabilitation claims, (vii) increased measures to reduce
fraudulent claims; (viii) increased the ability of insurance companies and
employers to contract with managed care organizations and to direct
claimants' medical care; and (ix) changed procedures for medical-legal
evaluations. Similarly, legislation adopted in Oregon in 1995, among other
things, reformed requirements pertaining to pre-existing conditions,
vocational rehabilitation, payment of death benefits, review of benefit
awards and dispute resolution.
To protect persons covered under policies of workers' compensation
insurance, several states impose special deposit requirements on insurers. In
the event of an insurer insolvency, special deposits made by insurers are
utilized by the relevant department of insurance to provide a pool of funds upon
which workers' compensation claimants domiciled exclusively in that state
possess a first priority claim and can be used by the regulators to pay those
claimants. Under these requirements, PICO maintains special deposits in Arizona,
California, Idaho, Oregon and New Mexico. Additional special deposits may be
required if PICO becomes licensed in additional states, or if Alaska, Florida or
Texas enact deposit requirements.
While deposit requirements vary somewhat, they generally require
insurers to deposit cash or securities with each states' treasurer, or an
approved depository, in an amount based on a company's loss and loss expense
reserves plus a percentage of its unearned premium reserves on workers'
compensation insurance business transacted in each individual state. Thus,
the size of the required deposit correlates positively with the amount of
workers' compensation insurance sold by PICO in such state. PICO maintains
deposits of securities in California, Arizona, Oregon, Idaho and New Mexico,
having a book value as of December 31, 1997 of $43.8 million, $15.9 million,
$5.2 million, $0.4 million and $0.1 million, respectively.
An important aspect of workers' compensation insurance regulated by
individual states is the setting of premiums. Among the states where it is
currently licensed, PICO is allowed to establish its own rates under a "file and
use" system in Alaska, California and Texas. Prior approval by insurance
regulators is required for workers' compensation insurance rates in Florida, New
Mexico and Oregon. Hybrid systems exist in Arizona and Idaho, where workers'
compensation insurance rates are determined initially by the National Council on
Compensation Insurance ("NCCI"), a rating organization. Upon the request of an
individual insurer, the Arizona or Idaho DOI, as applicable, may approve rates
that deviate from those recommended by the NCCI.
Prior to January 1, 1995, California had required workers' compensation
insurers to adhere to minimum rates approved by the California DOI. Under this
system, price competition among insurers had been generally restricted to the
payment of dividends under participating policies. This system was replaced with
a file and use system, in which insurers may use any rate within 30 days after
filing it with the California DOI unless such rate is specifically disapproved.
The repeal of the former minimum rate system in California has resulted in
increased competition among workers' compensation insurers in California and has
caused a material decrease in average rates charged by PICO.
Competition among workers' compensation insurers is also affected in
several states by the presence of quasi-public workers' compensation insurance
funds, which compete against private insurers and which frequently serve as
insurers of last resort to employers unable to secure coverage elsewhere. Among
the states where PICO is licensed, active state funds exist in Arizona,
California, Idaho, New Mexico, Oregon and Texas.
REGULATION OF PACO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED
PACO, a California-domiciled insurer, is licensed in California and
Arizona. The transaction of life and health insurance is closely regulated in
these states. Such regulation includes statutorily mandated benefits, sales
disclosures, and claims settlement requirements. In 1997, PACO wrote $0.9
million in life and health premiums written in California and Arizona combined.
27
<PAGE>
MEMBERSHIP IN INSOLVENCY FUNDS AND ASSOCIATIONS
The Company's insurance subsidiaries, like other insurers, are required
to participate in insolvency funds and associations and may be subject to
assessments from time to time to cover unpaid policyholder claims of
insolvent insurers participating in the same lines of business as the
Company. The maximum assessment required by law in any one year has varied
between 1% and 2% of annual premiums written in that state. Most of these
payments are recoverable through future policy surcharges and premium tax
reductions. No material assessments have been made on the Company's insurance
subsidiaries since prior to December 31, 1990.
COMPETITION
The workers' compensation insurance industry is highly competitive.
Although there are 260 companies licensed to write workers' compensation
insurance policies in California, the 20 largest companies accounted for more
than 79% of the workers' compensation premiums written in California during 1996
(source: A.M. Best, State/Line Report, Property/Casualty, 1997 Edition). In each
state in which the Company operates, the Company's single largest competitor in
its targeted agricultural markets is the applicable state fund.
Periodically, the Company competes with alternative risk funding
arrangements such as self-insurance or captive insurance programs. Captive
insurance companies are insurance or reinsurance companies in which an insured
or a group of insureds holds significant ownership. Employers have the option of
self insuring against workers' compensation liabilities. Normally, those
companies who choose to self insure are very large employers and are not among
the targeted insurance underwriting prospects of the Company.
In those states without minimum premium laws, such as California,
Oregon, Idaho, Alaska and Texas, the Company faces competition on the basis
of price as well as on the services which it delivers to policyholders.
Arizona's single deviated rating plan has resulted in price competition among
firms with different rating plans, but not among firms with the same rating
plan as PICO. As a result of Florida's minimum rate law, there has been no
significant price competition in that state in terms of premiums charged.
Competition among workers' compensation insurance carriers in Arizona and
Florida has been based to varying degrees on emphasizing dividends to
policyholders, loss control and claims management services and maintaining
relations with and varying commission rates paid to brokers and agents. The
Company believes that its ability to compete successfully with larger
carriers and to obtain and retain its accounts is due to its claims
expertise, extensive experience in the agribusiness market and emphasis on
service to policyholders.
CERTAIN EXECUTIVE OFFICERS OF THE COMPANY
Information concerning the Company's executive officers who serve as
members of the Company's Board of Directors will be set forth in the Company's
definitive proxy materials. See "Item 10. Directors and Executive Officers of
the Registrant." Mr. Victor Gloria III and Mr. James M. Hannah also serve as
executive officers of the Company.
Mr. Gloria is Senior Vice President of PICO and is responsible for
PICO's risk management operations including claims administration, loss control
and field representative operations. Mr. Gloria has been with the Company since
1972 and has served in PICO's claims department for a majority of that time. He
has served as Manager of that Department since 1987 and was appointed Senior
Vice President in 1987. Mr. Gloria is 43.
Mr. Hannah is a Senior Vice President and Chief Underwriting Officer of
PICO and is responsible for PICO's underwriting operations. Mr. Hannah joined
the Company in March 1995. Mr. Hannah is 49.
28
<PAGE>
EMPLOYEES
As of December 31, 1997, the Company employed 264 full-time employees
including 73 in its agency and TPA operations, 165 in its underwriting
operations and 26 in corporate administration and finance. The Company considers
its relationship with its employees to be excellent. All employees with at least
one year of service are eligible to participate in the Company's Employee Stock
Ownership Plan except for those employees employed on an hourly basis.
ITEM 2. PROPERTIES.
The Company's principal executive offices, comprised of approximately
34,000 square feet of office space leased through April 1999, are located in
Pasadena, California. The Company holds an option to extend its home office
lease through April 2004. In addition, the Company maintains 20 branch offices
in various locations in the western United States and Florida in leased
facilities with various lease terms. Management believes that the Company's
facilities are suitable and adequate for their intended uses.
ITEM 3. LEGAL PROCEEDINGS
Except for ordinary, routine litigation incidental to the Company's
business, there are no pending legal proceedings to which the Company is a party
or which any of its properties are subject. The nature of the Company's business
subjects it to claims or litigation relating to policies of insurance it has
issued. Management believes that the Company is not a party to, and none of its
properties is the subject of, any pending legal proceedings which are likely to
have a material adverse effect on its business, financial conditions or results
of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the
fourth quarter of 1997.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET INFORMATION
The Company's Common Stock has traded on the Nasdaq Stock Market under
the symbol "PFCO" since the consummation of the Company's initial public
offering of its Common Stock on October 24, 1997. The high and low closing
prices of the Common Stock on the Nasdaq Stock Market during the fourth quarter
of 1997 were $25.25 and $21.25, respectively.
HOLDERS OF RECORD
As of March 17, 1998, the Common Stock was held of record by 184
holders. The Company estimates that the number of beneficial holders of the
Common Stock as of such date exceeded 800.
29
<PAGE>
DIVIDENDS
The Company has not paid cash dividends to its stockholders in either of
the two most recent fiscal years. The Company declared a quarterly dividend
of $0.04 per share of Common Stock on March 2, 1998 payable to stockholders
of record on March 17, 1998.
Although the Company currently intends to continue to pay quarterly
dividends, the declaration and payment of dividends is subject to the discretion
of the Company's Board of Directors and will depend upon, among other things,
the Company's results of operations, financial condition, cash requirements,
future prospects and capital requirements, regulatory restrictions on the
payment of dividends by the Company's insurance company subsidiaries, general
economic and business conditions and other factors deemed relevant by the Board
of Directors. There can be no assurance that the Company will declare and pay
any dividends. The ability of the Company's subsidiaries to pay dividends to the
Company is subject to substantial regulation. In addition, the Company's line of
credit restricts the payment of dividends under certain circumstances. See
Management's Discussion and Analysis of Financial Condition and Results of
Operation-Liquidity and Capital Resources", "Business-Regulation" and Note 10 of
Notes to Consolidated Financial Statements.
RECENT SALES OF UNREGISTERED SECURITIES
During 1997, the Company issued the following securities without
registration under the Securities Act of 1993, as amended (the "1933 Act"). All
such issuances were exempt from registration under the 1933 Act under Section
4(2) of the 1933 Act:
(i) 1,899,978 shares of Common Stock and 941,177 shares of Series A Preferred
Stock in September 1997 upon the Company's reincorporation from California
to Delaware in consideration of the cancellation of the common stock and
preferred stock of the Company's California predecessor. The number of
shares of Common Stock reflect the effect of the Company's two-for-one
stock split in the form of a stock dividend in connection with the
reincorporation;
(ii) 1,882,354 shares of Common Stock in October 1997 upon the conversion of
the Company's Series A Preferred Stock upon consummation of the Company's
initial public offering ("IPO");
(iii) 139,481 shares of Common Stock in October 1997 upon the conversion of
warrants to purchase 164,706 shares of Common stock upon consummation of
the Company's IPO. 109,804 of such shares were issued in consideration of
the payment of $933,334 in cash and 29,677 were issued in a cashless
exercise upon the surrender of the remaining warrants to purchase 25,225
shares of Common Stock by the holder;
(iv) 256 shares of Common Stock in February 1997 as a compensation bonus to a
Company employee with an aggregate fair market value when issued
(determined by the Company's Board of Directors) of $2,432;
(v) 1,000 shares of Common Stock in January 1997 to an unaffiliated consultant
to the Company with an aggregate fair market value when issued (determined
by the Company's Board of Directors) of $10,830; and
(vi) 2,000 shares of Common Stock in September 1997 to two unaffiliated
consultants to the Company with an aggregate fair market value when issued
of $37,000.
On October 24, 1997, the Company consummated its IPO. The Company's
Common Stock was registered under the 1933 Act on Form S-1 (Reg. No. 333-33159).
The IPO was underwritten by a syndicate of underwriters managed by Goldman,
Sachs & Co. and Conning & Company. A total of 2,875,000 shares of
30
<PAGE>
Common Stock were registered and sold in the IPO consisting of 2,400,314
shares for the Company's account and an aggregate of 474,686 shares for the
benefit of several selling security holders. The stock was sold at an
aggregate price of $53,187,500 or $18.50 per share. The Company's portion of
the aggregate sales price was $44,405,809 and the selling stockholders'
aggregate portion was $8,781,691 before underwriting discounts and expenses.
The following expenses were incurred by the Company in connection with the
IPO. All expenses reflect actual amounts incurred except as noted below:
<TABLE>
<S> <C>
Underwriting discounts and commissions $3,120,408
Finders fees 0
Underwriters' expenses paid by the Company 10,000
Other expenses* 930,227
----------
Total expenses $4,060,635
----------
----------
</TABLE>
- -----------
* Includes estimated financial printing costs.
A portion of the underwriting discounts and underwriters expenses paid
by the Company were paid to Conning & Company, the co-manager of the IPO.
Conning & Company is an affiliate of four limited partnerships which hold, along
with Conning & Company, in the aggregate, more than 10% of the Company's
outstanding Common Stock. No other expenses of the IPO were paid directly or
indirectly to any person or entity affiliated with the Company.
The net proceeds to the Company after deducting underwriting discounts
and expenses was $40,345,174. The net proceeds to the Company were used for the
following purposes during the fourth quarter of 1997. All amounts are actual,
not estimated amounts. None of such uses involved affiliates of the Company:
<TABLE>
<S> <C>
Contribution to the Company's insurance subsidiary $10,000,000
Repayment of indebtedness 12,103,130
Repurchase of securities from wholly-owned subsidiary 1,690,103
Working capital 0
Investments in mutual funds holding shorter-term
investment grade fixed income securities 5,137,500
Temporary investment in mutual funds holding
short-term investment grade fixed income securities 11,414,441
----------
Total uses $40,345,174
-----------
-----------
</TABLE>
31
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA.
The selected data presented below under the captions "Income Statement
Data" and "Balance Sheet Data" as of and for each of the years in the five-year
period ended December 31, 1997, are derived from the consolidated financial
statements of the Company, which financial statements have been audited by KPMG
Peat Marwick LLP, independent certified public accountants. The consolidated
financial statements as of December 31, 1996 and 1997 and for each of the years
in the three-year period ended December 31, 1997, and the report thereon are
included elsewhere herein. The information presented below under the caption
"Other Data" is unaudited. The selected financial data set forth below should be
read in conjunction with Management's Discussion and Analysis of Financial
Condition and Results of Operations and the Consolidated Financial Statements
and notes thereto appearing elsewhere herein.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Premiums written......................... $53,502 $53,545 $46,762 $63,606 $100,797
-------- -------- -------- -------- ---------
-------- -------- -------- -------- ---------
Premiums earned:
Workers' compensation................. $50,857 $50,977 $44,224 $54,563 $91,957
Group medical and life................ 163 312 307 941 878
Commissions.............................. 3,514 4,299 3,964 4,213 3,434
Net investment income.................... 4,495 4,536 4,817 4,701 5,582
Net realized investment gains............ 132 - 37 444 172
Other.................................... 1,375 1,712 1,569 896 1,047
-------- -------- -------- -------- ---------
Total revenue......................... $60,536 $61,836 $54,918 $65,758 $103,070
Losses and loss adjustment expenses
incurred.............................. 30,852 28,618 29,363 33,900 68,107
Dividends provided for policyholders.....
5,806 6,221 3,438 1,628 (2,713)
Operating expenses....................... 16,838 20,720 22,608 25,480 30,741
-------- -------- -------- -------- --------
Total expenses........................ $53,496 $55,559 $55,409 $61,008 $96,135
Income (loss) before taxes............... 7,040 6,277 (491) 4,750 6,935
Income tax expense (benefit)............. 1,875 1,572 (791) 827 1,776
-------- -------- --------- -------- --------
Net income............................ $5,165 $4,705 $300 $3,923 $5,159
-------- -------- -------- -------- ---------
-------- -------- -------- -------- ---------
Earnings per share (1)................... $1.46 $1.54 $0.16 $2.07 $1.88
Weighted average shares outstanding (1)..
3,530,838 3,057,088 1,850,956 1,896,464 2,737,065
Earnings per share - assuming
dilution(1).......................... $1.46 $1.23 $0.08 $1.00 $1.11
Weighted average shares outstanding -
assuming dilution (1)................. 3,530,838 3,827,487 3,763,059 3,910,715 4,664,511
</TABLE>
32
<PAGE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Investments (2).................. $81,737 $83,084 $83,991 $86,792 $137,864
Total assets..................... 108,898 117,297 118,906 125,127 188,264
Unpaid losses and loss
adjustment expenses........... 62,629 60,473 57,049 55,720 77,784
Notes payable.................... 3,370 4,205 10,824 11,279 456
Total liabilities................ 95,793 90,384 93,301 99,151 103,444
Preferred Stock (convertible and
redeemable)................... - 18,918 19,501 21,402 -
Net stockholders' equity......... 13,105 7,995 6,104 4,574 84,820
<CAPTION>
AS OF AND FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
PICO AND PACO GAAP RATIOS:
Loss ratio....................... 60.5% 55.8% 65.9% 61.1% 73.4%
Expense ratio.................... 24.4 26.7 32.3 32.1 26.9
Policyholder dividend ratio...... 11.4 12.1 7.7 2.9 (2.9)
---------- -------- ----------- ---------- --------
Combined ratio................ 96.3% 94.6% 105.9% 96.1% 97.4%
---------- -------- ----------- ---------- --------
---------- -------- ----------- ---------- --------
PICO STATUTORY DATA:
Statutory net income............. $ 2,079 $5,217 $ 3,175 $ 5,051 $6,037
Statutory surplus................ 23,085 19,381 25,992 31,135 45,822
Premiums/surplus................. 2.2x 2.6x 1.7x 1.9x 2.1x
Loss ratio....................... 66.0% 55.9% 65.9% 61.0% 73.8%
Expense ratio.................... 23.4 25.9 30.9 29.4 25.9
Policyholder dividend ratio...... 11.4 12.2 7.8 3.0 (3.0)
---------- -------- ----------- ---------- --------
Combined ratio................ 100.8% 94.0% 104.6% 93.4% 96.7%
---------- -------- ----------- ---------- --------
---------- -------- ----------- ---------- --------
OTHER DATA:
Industry average statutory Not
combined ratio (3)............ 109.0% 107.3% 107.6% 113.1% available
Number of PICO policies
(period-end) (4).............. 1,901 2,227 4,041 6,481 8,579
Number of Company employees
(period-end).................. 247 272 237 242 264
PICO Estimated Annual Premium
(period-end)(5)............... $44,133 $41,929 $41,176 $61,316 $90,526
</TABLE>
(footnotes follow on next page)
33
<PAGE>
(1) See Note 1 of Notes to Consolidated Financial Statements for a description
of the calculation of weighted average shares outstanding and earnings per
share.
(2) Investments as of December 31, 1993 are reflected at amortized cost. As of
December 31, 1994, a portion of the portfolio was classified as held to
maturity and was therefore reflected at amortized cost and the remaining
portfolio was shown at market value. Investments as of December 31, 1995,
1996 and 1997 are reflected at market value.
(3) National average for workers' compensation insurance companies. Source:
A.M. Best; Best's Insurance Reports, Property/Casualty, 1997 edition.
(4) Note that the figure for 1997 differs from the one included in the
Company's March 3, 1998 press release. The figure in the press release was
actually the number of PICO policies as of January 31, 1998.
(5) "PICO Estimated Annual Premium" means, as of any date, the estimated total
annualized premiums for all policies written by PICO in force on that date,
whether earned prior to or after such date.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company's revenues have consisted primarily of premiums earned from
workers' compensation insurance underwriting, premiums earned from group medical
insurance, commission income, net investment income and other income. Premiums
earned during a period are the direct premiums earned by the Company on in force
policies, net of reinsurance. Commission income is earned from Pan Am's
distribution of insurance for insurers other than PICO and PACO. The commission
the Company pays to Pan Am is eliminated when the Company's operations are
consolidated. Net investment income represents earnings on the Company's
investment portfolio, less investment expenses. Other income consists of third
party administration fees and other miscellaneous items.
The Company's expenses have consisted of losses and loss adjustment
expenses incurred, dividends provided for policyholders and operating expenses.
Losses include reserves for future payments for medical care and rehabilitation
costs and indemnity payments for lost wages. Loss adjustment expenses include
expenses incurred in connection with services provided by third parties,
including expenses of independent medical examinations, surveillance costs, and
legal expenses as well as staff and related expenses incurred to administer and
settle claims. Loss and loss adjustment expenses are offset in part by estimated
recoveries from reinsurers under excess of loss reinsurance treaties. Operating
expenses include commission expenses to third party insurance agencies and other
expenses that vary with premium volume, such as premium taxes, state guaranty
fund assessments and underwriting and marketing expenses, as well as general and
administrative expenses, which are less closely related to premium volume.
The Company's revenues are seasonal, and have tended to be highest in
the second and third quarters of each year. This is due primarily to the
seasonality of the size of the workforce employed by the Company's agribusiness
clients.
34
<PAGE>
The following table sets forth selected information relating to the
growth of PICO's workers' compensation insurance book of business:
<TABLE>
<CAPTION>
AS OF AND FOR THE
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Premiums written..................................................... 46,455 62,665 99,919
Premiums earned...................................................... 44,224 54,563 91,957
Policyholder persistency rate........................................ 87.8% 86.8% 83.5%
Number of policies (period-end)...................................... 4,041 6,481 8,579
</TABLE>
The Company's premiums earned are affected by changes in the
competitive and regulatory environment that impact workers' compensation
insurance rates. Prior to January 1, 1995, California had required workers'
compensation insurers to adhere to minimum rates approved by the California DOI.
Under this system, price competition among insurers had been generally
restricted to the payment of dividends under participating policies. Effective
January 1, 1995, this system was replaced with a file and use rate system, in
which insurers may use any rate after filing it with the California DOI unless
such rate is specifically disapproved. The repeal of the former minimum rate
system in California has resulted in increased competition among workers'
compensation insurers in California and has caused a material decrease in
average rates charged by PICO.
The Company's underwriting results are affected by its loss experience.
The Company believes that legislation enacted in California in 1993 contributed
to an industry-wide reduction in claims frequency and led to a stabilization of
claims severity, which has helped improve the Company's loss experience. Due in
part to the effect of these reforms, as well as to PICO's continued improvement
in claims management and management of the medical and legal components of its
workers' compensation claims, PICO experienced favorable development of reserves
for the 1993-1995 accident years and recovered reserves of $3.9 million and $2.6
million in calendar years 1995 and 1996, respectively. PICO determined reserves
for accident years 1993 and 1994, and to a lesser extent, 1995, based on the
relatively high incurred loss and LAE trends for the 1989 - 1992 accident years.
PICO's actual incurred losses and LAE for the 1993 - 1995 accident years
initially proved to be lower than anticipated and PICO's original reserves for
these periods were ultimately redundant. During calendar year 1997, the Company
experienced $1.6 million in net adverse development, largely related to the 1996
accident year. The net development in 1997 was primarily a result of less
favorable claims trends experienced by the Company for the 1996 accident year.
There can be no assurance that the Company will have any reserve recoveries in
future periods or that it will not experience additional net adverse development
in future periods. See "Business Losses and Loss Reserves".
Workers' compensation policies can be written on a participating or
non-participating basis. Participating policies allow the Company in its
discretion to declare and pay dividends to a policyholder after the expiration
of the policy based upon a policyholder's specific loss experience (or, if the
policyholder is part of a safety group, the group's specific loss experience),
the Company's overall loss experience and competitive conditions. With the
advent of open rating in California and an emphasis on, among other things,
competitive pricing at inception, the Company's dividends provided for
policyholders decreased significantly in 1996 and 1997, although the relative
mix of the Company's participating and non-participating policies has remained
relatively constant (see Note 1 of the Notes to Consolidated Financial
Statements). The Company currently does not anticipate paying any significant
additional policyholder dividends on 1997 and prior policy years. Although the
Company believes policyholder dividends are relatively insignificant as an
element in workers' compensation in California, the Company intends to continue
to issue participating policies that are eligible for policyholder dividend
consideration in states outside of California.
35
<PAGE>
PICO's and PACO's operating expenses as a percentage of premiums are an
important component of the Company's profitability. In this regard, the Company
has benefited from recent growth. For the year ended December 31, 1997, PICO's
and PACO's expense ratio improved 5.2 percentage points from 32.1% for 1996 to
26.9%.
RESULTS OF OPERATIONS
1997 COMPARED TO 1996
PREMIUMS WRITTEN. The Company's premiums written for 1997 increased 58.5% to
$100.8 million from $63.6 million in 1996. The growth in premiums written was
primarily attributable to the net addition of new policyholders and increased
policyholder payrolls, partially offset by lower premium rates resulting from
increased price competition. The premium growth was particularly strong in
California and the Northwest. In addition, the Company began writing business in
Texas and Florida in the second and third quarters of 1997, respectively.
PREMIUMS EARNED. For the reasons described above for premiums written, the
Company's premiums earned for 1997 increased 67.3% to $92.8 million from $55.5
million in 1996.
COMMISSION INCOME. Commission income decreased 18.5% to $3.4 million for
1997 from $4.2 million for 1996. The decrease was primarily the result of
decreased premiums placed with carriers other than PICO and PACO, a result of
the Company's decision to focus on writing PICO workers' compensation insurance.
Commission income is earned on premiums placed with carriers other than PICO and
PACO. Commission income paid by PICO and PACO to Pan Am is eliminated in
consolidation.
NET INVESTMENT INCOME. Net investment income increased 18.7% to $5.6 million
for 1997 from $4.7 million for 1996. The increase was the result of significant
cash flow increases from PICO's underwriting activity and to a lesser extent the
funds received in the fourth quarter as a result of the Company's initial public
offering. Average invested assets increased to $110.6 million for 1997 from
$83.6 million for 1996. The Company's average yield on its portfolio was 5.0% in
1997 and 5.6% in 1996. The 1997 average yield was diluted by the increase in the
Company's investment portfolio in October 1997 following the Company's initial
public offering. The increase in the portfolio late in the year inflated the
Company's average total invested assets for 1997.
NET REALIZED INVESTMENT GAINS. The Company had net realized investment gains
of $0.2 million for 1997 compared to $0.4 million for 1996.
OTHER INCOME. Other income increased $0.1 million to $1.0 million for 1997
from $0.9 million for 1996.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's loss ratio for
1997 increased to 73.4% from 61.1% for 1996. The Company's loss ratio for 1996
was positively impacted by net recoveries from loss and loss adjustment expense
reserves for prior years, principally 1993-1995, of $2.6 million or 4.8% of 1996
earned premium. In 1997, the Company's loss ratio included a net strengthening
of prior year reserves, principally 1996, of $1.6 million or 1.7% of 1997 earned
premium. The increase in the 1997 loss ratio is also related to lower premium
rates as a result of increased competition. The impact of the increase in loss
ratio in 1997 was offset in part by a reduction in the Company's policyholder
dividend accrual.
36
<PAGE>
DIVIDENDS PROVIDED FOR POLICYHOLDERS. With the advent of open rating in
California and an emphasis in most states in which the Company operates on,
among other things, competitive pricing at inception, the Company's dividends
provided for policyholders decreased significantly commencing in late 1995.
Currently, the Company does not anticipate paying additional significant
policyholder dividends on 1997 and prior policy years. Therefore, the related
accrual was reduced by $2.7 million in 1997.
OPERATING EXPENSES. Operating expenses increased 20.6% to $30.7 million for
1997 from $25.5 million for 1996 due in part to a $2.8 million increase in
commissions paid to unaffiliated agencies and a $1.8 million increase in
personnel costs related to the growth in the Company's insurance operations.
INCOME TAXES. Income tax expense for 1997 increased to $1.8 million from
$0.8 million for 1996. The effective combined income tax rates for 1997 and 1996
were 25.6% and 17.4%, respectively. These rates are below the combined statutory
rate due to the significant portion of the Company's investment portfolio
consisting of tax-exempt securities. The difference in effective tax rates
between 1997 and 1996 is due to a change in the mix of tax-exempt and taxable
investment income.
1996 COMPARED TO 1995
PREMIUMS WRITTEN. The Company's premiums written for 1996 increased 36.0% to
$63.6 million from $46.8 million for 1995. The increase was primarily
attributable to an increase in PICO's California writings of $11.4 million (an
increase of 39.8%) principally from newly-appointed independent agencies and the
establishment of the PTC, net of California reductions due to increased price
competition, and an increase of PICO's Oregon writings of $4.8 million (an
increase of 104.3%).
PREMIUMS EARNED. For the reasons described above for premiums written, the
Company's premiums earned for 1996 increased 24.6% to $55.5 million from $44.5
million for 1995.
COMMISSION INCOME. Commission income increased 6.3% to $4.2 million for 1996
from $4.0 million for 1995.
NET INVESTMENT INCOME. Net investment income decreased 2.4% to $4.7 million
for 1996 from $4.8 million for 1995. The Company's average yield on its
portfolio was 5.6% for 1996 compared to 5.8% for 1995, reflecting generally
lower market interest rates in 1996 compared to 1995. Average invested assets
increased $0.7 million to $83.6 million in 1996 from $82.9 million in 1995.
NET REALIZED INVESTMENT GAINS. During 1996, the Company sold $17.2 million
of its invested assets and realized $0.4 million of investment gains. There were
no material investment gains realized in 1995. During 1996, the Company
repositioned $7.0 million of its portfolio into AAA-rated agency-backed
collateralized mortgage obligations to increase yield.
OTHER INCOME. Other income decreased 42.9% to $0.9 million for 1996 from
$1.6 million for 1995, primarily as a result of the termination of a large third
party administration client contract in early 1996 which was matched with a
comparable reduction in expenses.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's loss ratio for
1996 improved to 61.1% from 65.9% for 1995. The improvement in this ratio is due
to several factors, including a reduction in the incidence and severity of
workers' compensation claims and the expedited closing of claims. Losses for
1996 include the effect of recoveries from prior years' reserves of $2.6
million, or 4.8% of 1996 premiums earned, compared with prior year recoveries of
$3.9 million for 1995, or 8.8% of 1995 premiums earned. The Company believes its
loss
37
<PAGE>
experience was improved by overall trends in the industry due to regulatory
reforms, a reduction and capitation of the Company's claims related legal
expenses, the implementation of early return to work programs by the Company's
clients and an aggressive program by the Company to combat workers' compensation
insurance fraud.
DIVIDENDS PROVIDED FOR POLICYHOLDERS. Dividends provided for policyholders
decreased to $1.6 million in 1996 from $3.4 million in 1995 and decreased as a
percentage of premiums earned for 1996 to 2.9% from 7.7% for 1995. With the
advent of open rating in California and an emphasis on, among other things,
competitive pricing at inception, the Company's dividends provided for
policyholders decreased significantly commencing in late 1995.
OPERATING EXPENSES. Operating expenses increased 12.7% to $25.5 million for
1996 from $22.6 million for 1995 due in part to a $2.2 million increase in
commissions paid to unaffiliated agencies.
INCOME TAXES. Income tax expense for 1996 was $0.8 million compared to a
$0.8 million tax recovery for 1995. The effective combined income tax rate for
1996 was 17.4%. These rates are below the combined statutory rate due to the
significant portion of the Company's investment portfolio consisting of
tax-exempt securities.
LIQUIDITY AND CAPITAL RESOURCES
THE PARENT COMPANY
As a holding company, PAULA Financial's principal sources of funds are
dividends and expense reimbursements from its operating subsidiaries, proceeds
from loans, and proceeds from the sale of its capital stock. PAULA Financial's
principal uses of funds are capital contributions to its subsidiaries, payment
of operating expenses and dividends to its stockholders.
California law places significant restrictions on the ability of the
insurance subsidiaries to pay dividends to PAULA Financial. All dividends from
PICO and PACO, as California-domiciled insurers, require prior notice to the
California DOI. All "extraordinary" dividends must be approved in advance by the
California DOI. A dividend is deemed "extraordinary" if, when aggregated with
all other dividends paid within the preceding twelve months, the dividend
exceeds the greater of (i) PICO's statutory net income or PACO's statutory net
gain from operations (both excluding unrealized capital gains) for the preceding
calendar year or (ii) 10% of policyholder surplus as of the preceding December
31st. Additionally, unless approved in advance by the California DOI, no
dividend may be paid by PICO or PACO except from earned surplus. Based on these
limitations and statutory results, as of December 31, 1997, PAULA Financial
would be able to receive $6.4 million in dividends in 1998 from its insurance
subsidiaries without obtaining prior regulatory approval from the California
DOI.
The Company retained $16.6 million from the proceeds of its initial
public offering at the parent company level. Management believes that this cash,
funds available under the Credit Agreement described below and expense
reimbursements and dividends from its operating subsidiaries will be sufficient
to meet the parent company's operating cash needs for at least two and one-half
years.
In March 1997, PAULA Financial entered into the Credit Agreement with a
commercial bank providing PAULA Financial with a revolving credit facility of
$15.0 million until December 31, 1999. As of March 15, 1998, no amounts were
outstanding under this facility. At such time PAULA Financial may elect to
convert all or a portion of the borrowings then outstanding under such facility
into a term loan payable in quarterly
38
<PAGE>
installments and maturing on December 31, 2001. Borrowings under the Credit
Agreement bear interest at variable interest rates. The Credit Agreement
limits the Company's ability to (i) enter new lines of business; (ii) incur
or assume debt; (iii) pay dividends and repurchase or retire capital stock
upon a default or event of default; and (iv) make acquisitions, investments
and capital expenditures. The Credit Agreement contains financial covenants
with respect to minimum stockholders' equity, minimum statutory surplus, a
ratio of debt to stockholders' equity, a ratio of PICO's premiums written to
statutory surplus and excess statutory reserves, a debt service coverage
ratio, A.M. Best rating and risk-based capital levels. Each of PAULA
Financial's non-insurance subsidiaries has guaranteed all obligations of
PAULA Financial under the Credit Agreement.
OPERATING SUBSIDIARIES
The sources of funds of the Company's operating subsidiaries are cash
flows from operating activities, investment income and capital contributions
from PAULA Financial. The insurance company operating subsidiaries' major uses
of funds are claim payments and underwriting and administrative expenses and
maintaining the required surplus to expand their insurance business. The agency
and TPA operating subsidiaries' major use of funds are operating expenses. The
nature of the workers' compensation insurance business is such that claim
payments are made over a longer period of time than the period over which
related premiums are collected. Operating cash flows and the portion of the
investment portfolio consisting of cash and liquid securities have historically
met the insurance company operating subsidiaries' liquidity requirements.
Operating cash flows and intercompany loans from PAULA Financial have
historically met the agency and TPA subsidiaries' liquidity requirements.
The Company's investments consist primarily of taxable and tax-exempt
United States government and other investment grade securities and investment
grade fixed maturity commercial paper and, to a lesser extent, equity
securities. The Company does not generally invest in below investment grade
fixed maturity securities, mortgage loans or real estate. The Company has
invested in the equity securities of the two founders of PTC other than Pan Am
as part of the parent company's investment portfolio. The Company's investments
in fixed maturity securities are carried at market value as such securities may
be sold in response to changes in interest rates, tax planning considerations or
other aspects of asset/liability management. As of December 31, 1997, the
carrying value of the Company's fixed maturity securities portfolio was $114.5
million and 98.3% of the portfolio was rated "A" or better by S&P, Moody's or
Fitch. See "Business Investments and Investment Results".
California workers' compensation insurance companies are required to
maintain some of their investments on deposit with the California DOI for the
protection of policyholders. Other states in which PICO is licensed have also
required PICO to post deposits for the protection of those states'
policyholders. Pursuant to applicable state laws, PICO had, as of December 31,
1997, securities with a book value of $65.4 million held by authorized
depositories pursuant to these deposit requirements. In addition to the
deposits, the insurance company operating subsidiaries must maintain capital and
surplus levels related to premiums written and the risks retained by the
subsidiaries.
YEAR 2000 CONSIDERATIONS
The Company is currently working to resolve the potential impact of the
year 2000 on the processing of date-sensitive information systems. The year 2000
problem is the result of the Company's and its vendors' computer programs being
written using two digits (rather than four) to define the applicable year. Any
of those programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000, which could result in
miscalculations or system failures. The Company believes that it has identified
substantially all of its application software programs which require
modification in order to become year 2000
39
<PAGE>
compliant and has a formal plan to correct and test the programs affected by
the conversion from a two-digit year to a four-digit year. The Company
expects the early phases of the project to be completed during late 1998. The
final phases of the project is scheduled to be completed by the third quarter
of 1999. The review of systems also included the identification of vendors
that may have a significant impact on the Company's operations and their
expected completion of any conversions. Based on preliminary information,
costs of addressing potential problems are not currently expected to have a
material adverse impact on the Company's financial position, results of
operations or cash flows in future periods. However, if the Company or its
vendors are unable to resolve such processing issues in a timely manner, it
could result in a material financial risk. Accordingly, the Company plans to
devote the necessary resources to resolve all significant year 2000 issues in
a timely manner.
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 is
effective for periods beginning after December 15, 1997, including interim
periods. SFAS 130 requires companies to report comprehensive income and its
components in a financial statement and display the accumulated balance of other
comprehensive income separately from retained earnings and additional
paid-in-capital. Comprehensive income includes all changes in equity during a
period except those resulting from investments by stockholders and distributions
to stockholders. The Company has not determined the impact of SFAS 130.
Also, in June 1997, the FASB issued Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS 131"). This statement specifies revised guidelines for
determination of an entity's operating segments and the type and level of
financial information to be disclosed. SFAS 131 is effective for periods
beginning after December 15, 1997, including interim periods. The Company has
not determined the impact of SFAS 131.
During the fourth quarter of 1997, the American Institute of Certified
Accountants issued Statement of Position No. 97-3, "Accounting by Insurance and
Other Enterprises for Insurance-Related Assessments" ("SOP 97-3"). SOP 97-3
addresses the recognition and measurement of assets and liabilities related to
guaranty funds and other assessments. SOP 97-3 is effective for fiscal years
beginning after December 15, 1998, although early adoption is encouraged. The
Company has not determined the impact of SOP 97-3.
FORWARD-LOOKING STATEMENTS
The discussions above contains statements that constitute
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of
1934, as amended. The words "believe," "estimate," "expect," "intend,"
"anticipate," and similar expressions and variations thereof identify certain of
such forward-looking statements, which speak only as of the dates on which they
are made. PAULA Financial undertakes no obligation to publicly update or revise
any forward-looking statement, whether as a result of new information, future
events, or otherwise. Readers are cautioned that any such forward-looking
statements are not guarantees of future performance and involve risks and
uncertainties, and that actual results may differ materially from those
indicated in the forward-looking statements as a result of various factors.
Readers are cautioned not to place undue reliance on these forward-looking
statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
Not Applicable.
40
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report........................................................... F-2
Consolidated Balance Sheets as of December 31, 1996 and 1997........................... F-3
Consolidated Statements of Income for each of the three years in the period ended
December 31, 1997................................................................... F-5
Consolidated Statements of Stockholders' Equity for each of the three years in the
period ended December 31, 1997...................................................... F-6
Consolidated Statements of Cash Flows for each of the three years in the period ended
December 31, 1997................................................................... F-8
Notes to Consolidated Financial Statements............................................. F-10
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
PAULA Financial:
We have audited the accompanying consolidated balance sheets of PAULA
Financial and subsidiaries as of December 31, 1996 and 1997 and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the years in the three-year period ended December 31, 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
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 provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of PAULA
Financial and subsidiaries as of December 31, 1996 and 1997 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 1997 in conformity with generally accepted accounting
principles.
/s/ KPMG Peat Marwick LLP
Los Angeles, California
March 3, 1998
F-2
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
<S> <C> <C>
Investments:
Fixed maturities, available-for-sale, at market (amortized cost
$80,252 and $112,294 at December 31, 1996 and 1997,
respectively)................................................... $ 81,371 114,525
Preferred stock, at market (cost $1,014 and $3,019 at December 31,
1996 and 1997, respectively).................................... 1,033 3,112
Common stock, at market (cost $734 and $5,546 at December 31, 1996
and 1997, respectively)......................................... 777 5,545
Invested cash, at cost (approximates market)....................... 3,611 14,682
-------- --------
Total investments............................................. 86,792 137,864
-------- --------
Cash, unrestricted.................................................... 6,264 3,279
Cash, restricted...................................................... 832 1,491
Accrued investment income............................................. 1,483 1,819
Receivables:
Accounts receivable, net of allowance for uncollectible accounts
($500 and $600 at December 31, 1996 and 1997, respectively).... 6,274 16,607
Unbilled premiums.................................................. 5,279 7,713
Reinsurance recoverable on paid losses and loss adjustment
expenses........................................................ 172 -
Reinsurance recoverable on unpaid losses and loss adjustment
expenses........................................................ 6,427 6,394
Income taxes recoverable........................................... 432 1,579
Other.............................................................. 317 304
-------- --------
Total receivables............................................. 18,901 32,597
-------- --------
Property and equipment, at cost:
Office furniture, fixtures and equipment........................... 6,668 7,395
Automobiles........................................................ 590 707
Leasehold improvements............................................. 211 221
-------- --------
7,469 8,323
Less accumulated depreciation...................................... (5,403) (6,152)
-------- --------
Net property and equipment.................................... 2,066 2,171
-------- --------
Other assets.......................................................... 2,077 4,328
Excess of cost over net assets acquired, net.......................... 1,883 1,468
Deferred income taxes................................................. 4,829 3,247
-------- --------
$125,127 188,264
-------- --------
-------- --------
(Continued)
F-3
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS, CONTINUED
(DOLLARS IN THOUSANDS)
LIABILITIES AND STOCKHOLDERS' EQUITY
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
<S> <C> <C>
Unpaid losses and loss adjustment expenses............................. $ 55,720 77,784
Unearned premiums...................................................... 10,655 15,390
Accrued policyholder dividends......................................... 3,981 -
Due to underwriters and assureds....................................... 2,176 2,967
Accounts payable and accrued expenses.................................. 3,891 6,847
Notes payable.......................................................... 3,789 456
Note payable to bank................................................... 7,490 -
Obligation on stock held by ESOP....................................... 11,449 -
-------- --------
99,151 103,444
-------- --------
Series A Preferred Stock, convertible and redeemable (see Note 8),
$0.01 par value. Authorized 5,000,000 shares; issued 941,177
shares at December 31, 1996......................................... 21,402 -
Stockholders' equity:
Common stock, $0.01 par value. Authorized 15,000,000 shares; issued
2,167,456 shares and 6,321,177 shares at December 31, 1996 and
1997, respectively............................................... 22 63
Additional paid-in capital.......................................... 1,748 67,176
Retained earnings................................................... 16,668 16,048
Net unrealized gain on investments.................................. 778 1,533
-------- --------
19,216 84,820
Less:
Treasury stock, at cost (264,196 shares at December 31, 1996).... (2,972) -
Obligation on stock held by ESOP................................. (11,449) -
Guarantee of notes payable of ESOP............................... (221) -
-------- --------
Net stockholders' equity....................................... 4,574 84,820
Commitments and contingencies
-------- --------
$125,127 188,264
-------- --------
-------- --------
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Income:
Premiums earned:
Workers' compensation........................ $44,224 54,563 91,957
Group medical and life....................... 307 941 878
Commissions..................................... 3,964 4,213 3,434
Net investment income........................... 4,817 4,701 5,582
Net realized investment gains................... 37 444 172
Other........................................... 1,569 896 1,047
------- ------ -------
54,918 65,758 103,070
------- ------ -------
Expenses:
Losses and loss adjustment expenses incurred.... 29,363 33,900 68,107
Dividends provided for policyholders............ 3,438 1,628 (2,713)
Operating....................................... 22,608 25,480 30,741
------- ------ -------
55,409 61,008 96,135
------- ------ -------
Income (loss) before income tax
expense (benefit).............................. (491) 4,750 6,935
Income tax expense (benefit)....................... (791) 827 1,776
------- ------ -------
Net income.............................. $300 3,923 5,159
------- ------ -------
------- ------ -------
Earning per share:
Earnings per share............................. $0.16 2.07 1.88
Earnings per share - assuming dilution......... 0.08 1.00 1.11
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
NET OBLIGATION
ADDITIONAL UNREALIZED ON GUARANTEE OF NET
NUMBER OF COMMON PAID-IN RETAINED GAIN (LOSS) TREASURY STOCK HELD NOTES PAYABLE STOCKHOLDERS'
SHARES STOCK CAPITAL EARNINGS ON INVESTMENTS STOCK BY ESOP OF ESOP EQUITY
---------- ------- ---------- --------- -------------- -------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31,
1994............. 2,345,544 $24 689 18,381 (621) - (10,037) (441) 7,995
Net income........ - - - 300 - - - - 300
Change in
carrying value of
preferred stock.. - - - (583) - - - - (583)
Restricted stock
grants........... 28,700 - 259 - - - - - 259
Restricted stock
forfeitures...... (9,500) - (86) - - - - - (86)
Retirement of
common stock..... (169,816) (2) (12) (1,981) - - - - (1,995)
Issuance of
common stock..... 71,462 - 564 - - - - - 564
Net change in un-
realized gain on
investments (net
of tax).......... - - - - 2,149 - - - 2,149
Repurchase of
common stock..... - - - - - (4,458) - - (4,458)
Change in oblig-
ation of stock
held by ESOP..... - - - - - - 1,837 - 1,837
Change in guar-
arantee of notes
payable of ESOP.. - - - - - - - 122 122
--------- --- ------ ------ ----- ------ ------ ----- ------
Balance at Dec-
ember 31, 1995.. 2,266,390 22 1,414 16,117 1,528 (4,458) (8,200) (319) 6,104
--------- --- ------ ------ ----- ------ ------ ----- ------
Net income........ - - - 3,923 - - - - 3,923
Change in carrying
value of
preferred stock. - - - (1,901) - - - - (1,901)
Restricted stock
grants.......... 22,500 - 177 - - - - - 177
Restricted stock
forfeitures..... (1,400) - (12) - - - - - (12)
Retirement of
common stock.... (132,098) - (10) (1,471) - 1,486 - - 5
Issuance of
common stock.... 12,064 - 179 - - - - - 179
Net change in
unrealized
gain on
investments
(net of tax).... - - - - (750) - - - (750)
Change in
obligation of
stock held by
ESOP............ - - - - - - (3,249) - (3,249)
Change in guar-
antee of ESOP
notes payable - - - - - - - 98 98
--------- --- ------ ------ ----- ------ ------ ----- ------
Balance at Dec-
ember 31, 1996.. 2,167,456 22 1,748 16,668 778 (2,972) (11,449) (221) 4,574
--------- --- ------ ------ ----- ------ ------ ----- ------
(Continued)
F-6
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<CAPTION>
NET OBLIGATION
ADDITIONAL UNREALIZED ON GUARANTEE OF NET
NUMBER OF COMMON PAID-IN RETAINED GAIN (LOSS) TREASURY STOCK HELD NOTES PAYABLE STOCKHOLDERS'
SHARES STOCK CAPITAL EARNINGS ON INVESTMENTS STOCK BY ESOP OF ESOP EQUITY
---------- ------- ---------- --------- -------------- -------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31,
1996............ 2,167,456 22 1,748 16,668 778 (2,972) (11,449) (221) 4,574
Net income........ - - - 5,159 - - - - 5,159
Change in
carrying value
of preferred
stock........... - - - (2,261) - - - (2,261)
Conversion of
preferred stock. 1,882,354 19 23,641 - - - - - 23,660
Conversion of
warrants........ 139,481 1 1,481 (549) - - - - 933
Common stock
awards.......... 3,256 - 46 - - - - - 46
Restricted stock
forfeitures..... (1,150) - (10) - - - - - (10)
Retirement of
common stock.... (270,534) (3) (51) (2,969) - 2,972 - - (51)
Issuance of common
stock.......... 2,400,314 24 40,321 - - - - - 40,345
Net change in
unrealized gain
on investments
(net of tax).... - - - - 755 - - - 755
Elimination of
obligation of
stock held
by ESOP......... - - - - - - 11,449 - 11,449
Change in
guarantee of
notes payable
of ESOP......... - - - - - - - 221 221
--------- --- ------ ------ ----- ------ ------ ----- ------
Balance at
December 31,
1997............ 6,321,177 63 67,176 16,048 1,533 - - - 84,820
--------- --- ------ ------ ----- ------ ------ ----- ------
--------- --- ------ ------ ----- ------ ------ ----- ------
</TABLE>
See accompanying notes to consolidated financial statements.
F-7
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income........................................ $300 3,923 5,159
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization.................. 1,357 1,509 1,370
Amortization of fixed maturity premium, net 965 797 623
(Gain) loss on sale of property and
equipment.................................... 37 (12) 16
Gain on sales and calls of equity and fixed
maturities................................... (37) (444) (172)
(Increase) decrease in receivables............. (3,888) 946 (14,032)
(Increase) decrease in deferred income taxes 799 (282) 1,193
Increase (decrease) in unpaid losses and loss
adjustment expenses.......................... (3,424) (1,328) 22,064
Increase (decrease) in accrued policyholder
dividends.................................... 69 (1,027) (3,981)
Increase (decrease) in accounts payable and
accrued expenses............................. 1,095 (1,544) 3,747
Increase in unearned premiums.................. 395 6,046 4,735
Other, net..................................... 72 80 (861)
--------- ---------- ----------
Net cash provided by (used in) operating
activities............................. (2,260) 8,664 19,861
--------- ---------- ----------
Cash flows from investing activities:
Proceeds from sale of available for sale fixed
maturities..................................... 22,615 17,236 -
Proceeds from maturities and calls of available
for sale fixed maturities...................... 454 7,930 14,840
Proceeds from sale of common stock................ - - 499
Proceeds from sale of property and equipment...... 139 146 1
Purchase of common stock.......................... - - (5,138)
Purchase of preferred stock....................... - (1,014) (2,013)
Purchase of available for sale fixed maturities... (21,700) (26,456) (47,606)
Purchase of property and equipment................ (1,138) (1,029) (1,126)
Purchase of other assets.......................... - (703) (1,189)
Purchase of insurance agency...................... (65) (38) -
--------- ---------- ----------
Net cash provided by (used in) investing
activities............................. 305 (3,928) (41,732)
--------- ---------- ----------
</TABLE>
(Continued)
F-8
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
--------- ---------- ----------
<S> <C> <C> <C>
Cash flows from financing activities:
Borrowings (repayments) under line of
credit agreement, net.................... 3,122 1,968 (7,490)
Payments on notes payable................... (1,054) (1,782) (3,350)
Issuance of notes payable................... 214 269 238
Sale of common stock........................ 4 343 41,278
Retirement of common stock.................. (1,994) (1,486) (60)
--------- ---------- ----------
Net cash provided by (used in)
financing activities............. 292 (688) 30,616
--------- ---------- ----------
Net increase (decrease) in cash and
invested cash.................... (1,663) 4,048 8,745
Cash and invested cash at beginning of period.. 8,322 6,659 10,707
--------- ---------- ----------
Cash and invested cash at end of period........ $6,659 10,707 19,452
--------- ---------- ----------
--------- ---------- ----------
</TABLE>
Supplemental schedule of noncash financing activities:
In 1995, the Company purchased common stock from the retiring chairman
through the issuance of a note payable in the amount of $4,458 (see note 8).
In 1995, the Company granted to employees 28,700 shares of restricted
common stock for a total value of $259. Also in 1995, 9,500 shares were
forfeited at a value of $86 (see note 9).
In November 1995, the Company acquired Desert Benefits, Inc. for a
total purchase price of $700. Common stock was issued to settle $560 of the
purchase price (see note 12).
In 1996, the Company granted to employees 22,500 shares of restricted
common stock for a total value of $177. Also in 1996, 1,400 shares were
forfeited at a value of $12 (see note 9).
In 1996, the Company purchased Guinn Sinclair Insurance Services for a
total purchase price of $221. Common stock was issued to settle $176 of the
purchase price (see note 12).
See accompanying notes to consolidated financial statements.
F-9
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF OPERATIONS
PAULA Financial and subsidiaries (collectively referred to as the
Company) is an integrated insurance organization specializing in the production,
underwriting and servicing of workers' compensation and accident and health
insurance for agribusiness clients in California, Arizona, Oregon, Idaho,
Alaska, Texas, Florida and New Mexico. For the year ended December 31, 1997,
California, Arizona and Oregon accounted for 70%, 13% and 11%, respectively, of
premiums earned. The Company operates from many offices located throughout prime
agricultural areas and places coverage with its insurance company subsidiaries
and nonaffiliated insurance companies.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts
of PAULA Financial and its wholly owned subsidiaries. The principal subsidiaries
are: Pan American Underwriters, Inc., Pan American Underwriters Insurance Agents
and Brokers, Inc., Agri-Comp Insurance Agency, Inc. and PAULA Trading Company
Insurance Agents and Brokers, Inc. (insurance brokerages); Pan Pacific Benefit
Administrators, Inc. (third-party administration operation); PAULA Mexico S.A.
de C.V.; PAULA Insurance Company (casualty insurance); and PAULA Assurance
Company (group accident and health and life insurance). All significant
intercompany balances and transactions have been eliminated in consolidation.
Where necessary, prior years' information has been reclassified to
conform to the 1997 presentation.
In preparing the consolidated financial statements, management is
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
as of the date of the consolidated financial statements and revenues and
expenses for the period. Actual results could differ significantly from those
estimates.
INVESTMENTS AND CASH
At December 31, 1996 and 1997, the entire investment portfolio is
classified as available-for-sale and is reflected at estimated fair value with
unrealized gains and losses recorded as a separate component of stockholders'
equity, net of related deferred income taxes. The premium and discount on fixed
maturities and collateralized mortgage obligations are amortized using the
scientific method. Amortization and accretion of premiums and discounts on
collateralized mortgage obligations are adjusted for principal paydowns and
changes in expected maturities. Investments in which the decline in market value
is deemed other than temporary are reduced to the estimated realizable value
through a charge to income.
On November 21, 1995, the Company transferred its entire
held-to-maturity portfolio to available-for-sale. The amortized cost at the
transfer date was $37,508. The transfer resulted in an unrealized gain of $396,
net of the tax impact. The transfer was made in accordance with implementation
guidance provided in the Financial Accounting Standards Board's Special Report,
"A Guide to Implementation of Statement 115 on Accounting for Certain
Investments in Debt and Equity Securities."
F-10
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Invested cash consists primarily of commercial paper.
Realized gains and losses on sales of investments are computed on the
specific-identification basis.
Restricted cash consists of premiums collected by the insurance
brokerage subsidiaries but not yet remitted to insurance companies which is
restricted as to use by law in the states in which the brokerage subsidiaries
operate.
For purposes of cash flow disclosure, cash and invested cash is defined
as cash and invested cash that have original maturities of less than three
months.
REVENUE RECOGNITION
Premiums are earned by the insurance subsidiaries on a monthly pro rata
basis over the terms of the policies. Commission income is recorded on the
effective date of the policy or the billing date, whichever is later.
PROPERTY AND EQUIPMENT
Depreciation and amortization is provided over the estimated useful
lives of the respective assets, primarily using the modified accelerated cost
recovery system (which approximates the double-declining-balance method).
Principal estimated useful lives used in computing the depreciation provisions
are five years for automobiles and five to seven years for furniture and
equipment.
Leasehold improvements are depreciated on a straight-line basis over
the term of the lease or the estimated useful life of the improvement if less
than the lease term.
EXCESS OF COST OVER NET ASSETS ACQUIRED
Excess of cost over net assets acquired is amortized on a straight-line
basis over seven years. The Company assesses the recoverability of this
intangible asset by determining whether the amortization of the balance over its
remaining life can be recovered through the undiscounted future operating cash
flows of the acquired operation. Accumulated amortization totaled $766 and
$1,140 at December 31, 1996 and 1997, respectively.
UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
The liability for unpaid losses and loss adjustment expenses represents
(a) case basis estimates of reported losses and loss adjustment expenses and (b)
estimates based on past experience of unreported losses and loss adjustment
expenses, net of anticipated salvage and subrogation. Management believes that
the provisions for losses and loss adjustment expenses are adequate to cover the
net cost of incurred losses and loss adjustment expenses; however, the liability
is by necessity based on estimates, and accordingly, there can be no assurance
that the ultimate liability will not differ from such estimates.
F-11
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
There is a high level of uncertainty inherent in the evaluation of the
liability for unpaid losses and loss adjustment expenses. The ultimate costs of
such claims are dependent upon future events, the outcomes of which are affected
by many factors. Loss reserving procedures and settlement philosophy, current
and perceived social and economic factors, inflation, current and future court
rulings and jury attitudes, and many other economic, scientific, legal,
political and social factors can all have significant effects on the ultimate
costs of claims. Changes in Company operations and management philosophy may
also cause actual developments to vary from the past.
POLICYHOLDER DIVIDENDS
The insurance subsidiaries underwrite workers' compensation, accident
and health and life insurance policies. Participating workers' compensation
policies represented approximately 89%, 84%, and 84% of net written premium for
the years ended December 31, 1995, 1996 and 1997, respectively. Dividends are
recorded as a liability based on estimates of ultimate amounts expected to be
declared by the insurance subsidiaries' Boards of Directors, at their
discretion. Given the efficient levels of up-front pricing and current reserve
levels, the Company does not anticipate paying significant additional
policyholder dividends on 1997 and prior policy years.
INCOME TAXES
The Company accounts for income taxes under the asset and liability
method. Accordingly, deferred tax assets and liabilities are recognized for the
estimated future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates in effect for the year in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values of financial instruments are estimates of the fair
values at a specific point in time using appropriate valuation methodologies.
These estimates are subjective in nature and involve uncertainties and
significant judgment in the interpretation of current market data. Therefore,
the fair values presented are not necessarily indicative of amounts the Company
could realize or settle currently. The Company does not necessarily intend to
dispose of or liquidate such instruments prior to maturity.
The fair values of notes payable and note payable to bank are estimated
using discounted cash flow analyses based on current market interest rates. The
estimated fair values approximate the related carrying values.
EARNINGS PER SHARE (EPS)
The Company adopted Statement of Financial Accounting Standards No.
128, "Earnings per Share" ("SFAS 128") and Staff Accounting Bulletin No. 98
"Earnings per Share" ("SAB 98") as of December 31, 1997 and has restated 1995
and 1996 share and per share data to conform to the provisions of SFAS 128 and
SAB 98. The EPS calculations for the years ended December 31, 1995, 1996 and
1997 were based upon the weighted average number of shares of common stock
outstanding. The EPS - assuming dilution calculations were based upon the
weighted average number of shares of common stock outstanding adjusted for the
effect of convertible securities, and options
F-12
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
and warrants considered to be common stock equivalents. Stock options and
warrants are considered to be common stock equivalents, except when their effect
is antidilutive.
The following table reconciles the weighted average shares of common
stock outstanding used in the EPS calculation to that used in the EPS - assuming
dilution calculation. There is no difference in the earnings used in the two
calculations.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Shares used in EPS calculation.................. 1,850,956 1,896,464 2,737,065
Convertible preferred stock..................... 1,882,354 1,882,354 1,526,512
Warrants........................................ 15,558 40,114 48,804
Options......................................... 14,191 91,783 352,130
---------- ---------- ----------
Shares used in EPS - assuming dilution
calculation................................ 3,763,059 3,910,715 4,664,511
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
(2) INVESTMENTS
Investments in fixed maturities are all held in investment grade
securities. Fair values were obtained from published securities quotation
services.
FIXED MATURITIES
The amortized cost and estimated fair value of investments in fixed
maturities classified as available for sale at December 31, 1996 and 1997 are as
follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1996
-----------------
GROSS GROSS
AMORTIZED COST UNREALIZED UNREALIZED ESTIMATED
GAINS LOSSES FAIR VALUE
-------------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations of U.S. Government
corporations and agencies........................................ $16,619 207 (27) 16,799
Obligations of states and political subdivisions.................... 47,238 798 (28) 48,008
Corporate securities................................................ 9,370 193 (3) 9,560
Collateralized mortgage obligations................................. 7,025 2 (23) 7,004
-------------- ---------- ---------- ----------
Total......................................................... $80,252 1,200 (81) 81,371
-------------- ---------- ---------- ----------
-------------- ---------- ---------- ----------
</TABLE>
F-13
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------
GROSS GROSS
----- -----
AMORTIZED UNREALIZED UNREALIZED ESTIMATED
--------- ---------- ---------- ---------
COST GAINS LOSSES FAIR VALUE
---- ----- ------ ----------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations of U.S. Government
corporations and agencies........................................ $10,000 175 (12) 10,163
Obligations of states and political subdivisions.................... 77,817 1,738 - 79,555
Corporate securities................................................ 12,009 287 (3) 12,293
Collateralized mortgage obligations................................. 12,468 56 (10) 12,514
-------- ----- --- -------
Total......................................................... $112,294 2,256 (25) 114,525
-------- ----- --- -------
-------- ----- --- -------
</TABLE>
The amortized cost and estimated fair value of fixed maturities
classified as available for sale at December 31, 1997 by the earlier of the
pre-escrowed date or contractual maturity are shown below. Expected maturities
will differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
<TABLE>
<CAPTION>
AMORTIZED ESTIMATED
--------- ---------
COST FAIR VALUE
---- ----------
<S> <C> <C>
Due in one year or less...................................................... $5,240 5,267
Due after one year through five years........................................ 60,690 62,010
Due after five years through ten years....................................... 31,905 32,718
Due after ten years.......................................................... 1,991 2,016
Collateralized mortgage obligations.......................................... 12,468 12,514
-------- -------
$112,294 114,525
-------- -------
-------- -------
</TABLE>
Fixed maturities with a book value of $66,096 were on deposit with
various regulatory authorities as of December 31, 1997 as required.
PREFERRED STOCK
Unrealized investment gains (losses) on preferred stock at December 31,
1996 and 1997 are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
<S> <C> <C>
Gross unrealized gains....................................................... $19 93
Gross unrealized losses...................................................... - -
--- --
$19 93
--- --
--- --
</TABLE>
F-14
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
COMMON STOCK
Unrealized investment gains (losses) on common stock at December 31,
1996 and 1997 are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
<S> <C> <C>
Gross unrealized gains....................................................... $72 -
Gross unrealized losses...................................................... (29) (1)
--- ---
$43 (1)
---- ---
---- ---
</TABLE>
NET INVESTMENT INCOME
Net investment income is summarized as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Interest........................................ $4,963 4,839 5,665
Dividends....................................... 51 62 121
------ ----- -----
5,014 4,901 5,786
Less investment expenses........................ (197) (200) (204)
------ ----- -----
$4,817 4,701 5,582
------ ----- -----
------ ----- -----
</TABLE>
An affiliate of a significant holder of the Company's stock also acts
as the Company's investment advisor. Fees paid for such investment services
totaled $119, $146 and $160 in 1995, 1996 and 1997, respectively.
NET REALIZED INVESTMENT GAINS (LOSSES)
Net realized investment gains (losses) are as follows:
<TABLE>
<CAPTION>
YEARS ENDED
-----------
DECEMBER 31,
------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Fixed maturities:
Gross realized gains......................... $81 449 -
Gross realized losses........................ (44) (5) (1)
Common stock:
Gross realized gains......................... - - 173
Gross realized losses........................ - - -
--- --- ---
$37 444 172
---- --- ---
---- --- ---
</TABLE>
F-15
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(3) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the liability for unpaid losses and loss adjustment
expenses is summarized as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Balance at beginning of period.......... $60,473 57,049 55,720
Less reinsurance recoverable on unpaid
losses and loss adjustment expenses 6,886 6,775 6,427
------- ------ ------
Net balance at beginning of period...... 53,587 50,274 49,293
------- ------ ------
Incurred related to:
Current period....................... 33,261 36,554 66,840
Prior periods........................ (3,898) (2,654) 1,267
------- ------ ------
Total incurred.................... 29,363 33,900 68,107
------- ------ ------
Paid related to:
Current period....................... 10,870 13,143 20,809
Prior periods........................ 21,806 21,738 25,201
------- ------ ------
Total paid........................ 32,676 34,881 46,010
------- ------ ------
Net balance at end of period............ 50,274 49,293 71,390
Plus reinsurance recoverable on unpaid
losses and loss adjustment expenses 6,775 6,427 6,394
------- ------ ------
Balance at end of period................ $57,049 55,720 77,784
------- ------ ------
------- ------ ------
</TABLE>
The favorable development in 1995 and 1996 in the liability for unpaid
losses and loss adjustment expenses for prior years relates principally to
reduced claim frequency and stable severity.
F-16
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(4) NOTES PAYABLE
A summary of notes payable at December 31, 1996 and 1997 is as follows:
<TABLE>
<CAPTION>
DECEMBER 31
-----------
1996 1997
---- ----
<S> <C> <C>
Notes payable to former stockholders (interest 8.75% at December 31, 1996, due at
various dates through January 1999), secured by 283,188 shares of the Company's
common stock at December 31, 1996................................................... $3,143 -
Notes payable to former stockholders (interest at 8.25% at December 31, 1996, due at
various dates through 1997), unsecured.............................................. 51 -
Note payable (interest at 8.25% at December 31, 1996 and 1997, due 1998),
unsecured........................................................................... 105 50
Note payable (interest at 0.0% at December 31, 1996 and 1997, due 1999),
unsecured........................................................................... 269 168
Note payable (interest at 0.0% at December 31, 1997, due 1998), secured by common
stock of borrower................................................................. - 238
Notes payable of employee stock ownership plan (interest at 8.25% at December 31,
1996, due March 1999), secured by 37,014 shares of the Company's common stock at
December 31, 1996, guaranteed by the Company...................................... 221 -
------ ---
$3,789 456
------ ---
------ ---
</TABLE>
Aggregate annual commitments under notes payable are as follows at
December 31, 1997:
<TABLE>
<S> <C>
1998........................................................................ $389
1999........................................................................ 67
------
$456
------
------
</TABLE>
Total interest paid by the Company on all notes during the years ended
December 31, 1995, 1996 and 1997 was $419, $1,300 and $1,014, respectively.
(5) NOTE PAYABLE TO BANK
At December 31, 1996, the Company had an unsecured line of credit with
a commercial bank of $10,500. As of December 31, 1996, the Company had drawn
$7,490 on the line of credit. The interest rate on the line of credit was based
on various indices. The average interest rate at December 31, 1996 was 7.8%. The
line of credit required no principal payments during its term and matured
December 31, 1998. The line of credit imposed certain financial covenants.
On March 31, 1997, the Company entered into a $15,000 unsecured line of
credit with another commercial bank. The line of credit requires no principal
payments during its term and matures December 31, 1999 and, at the Company's
option, converts to a two-year term note. The interest rate on the line of
credit is based on various indices. The line of credit imposes certain financial
covenants. On March 31, 1997, the Company drew on the line of credit to repay in
full and terminate the first line of credit. The line of credit was subsequently
paid off in October 1997 and at December 31, 1997, the Company's available line
of credit was $15,000.
F-17
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(6) INCOME TAXES
The Company and its subsidiaries file a consolidated Federal income tax
return. Income tax expense (benefit) for the years ended December 31, 1995, 1996
and 1997 is shown as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, FEDERAL STATE TOTAL
------------------------ ------- ----- -------
<S> <C> <C> <C>
1995:
Current............................................................ $(1,615) 25 (1,590)
Deferred........................................................... 799 - 799
--------- ------ ---------
$(816) 25 (791)
--------- ------ ---------
--------- ------ ---------
1996:
Current............................................................ $1,079 30 1,109
Deferred........................................................... (282) - (282)
--------- ------ ---------
$797 30 827
--------- ------ ---------
---------- ------ ---------
1997:
Current............................................................ $503 80 583
Deferred........................................................... 1,193 - 1,193
--------- ------ ---------
$1,696 80 1,776
--------- ------ ---------
--------- ------ ---------
</TABLE>
The total tax expense (benefit) is different from the applicable
Federal income tax rate of 34% for the reasons reflected in the following
reconciliation:
<TABLE>
<CAPTION>
YEARS ENDED
------------
DECEMBER 31,
------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Expected tax expense (benefit).......................................... $(167) 1,615 2,358
Municipal bond interest................................................. (688) (782) (679)
Dividends-received deduction............................................ (10) (5) (36)
Nondeductible expenses.................................................. 55 55 80
State income taxes, net of Federal benefit.............................. 17 20 53
Other, net.............................................................. 2 (76) -
----- ----- -----
$(791) 827 1,776
----- ----- -----
----- ----- -----
</TABLE>
F-18
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Temporary differences which give rise to a significant portion of
deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
DECEMBER 31
------------
1996 1997
---- ----
<S> <C> <C>
Deferred tax assets:
Loss reserve discounting............................................. $3,917 4,948
Policyholder dividends............................................... 1,354 -
Unearned premiums.................................................... 725 1,046
Other................................................................ 778 1,002
------ -----
Gross deferred tax assets........................................ 6,774 6,996
------ -----
Deferred tax liabilities:
Unbilled premiums.................................................... (1,466) (2,215)
Tax on net unrealized gain on securities carried at market value..... (401) (790)
Other................................................................ (78) (744)
------ ------
Gross deferred tax liabilities.................................. (1,945) (3,749)
------ ------
Net deferred tax asset.......................................... $4,829 3,247
------ ------
------ ------
</TABLE>
The recoverability of the net deferred tax asset is demonstrated by
taxes paid in prior years and available tax planning strategies. Management
believes that it is more likely than not that the results of future operations
and various tax planning strategies will generate sufficient taxable income in
the periods necessary to realize the net deferred tax asset.
The Company paid $375, $1,400 and $2,300 of Federal income taxes during
the years ended December 31, 1995, 1996 and 1997, respectively.
(7) REINSURANCE
In the ordinary course of business, the insurance subsidiaries cede
insurance for the purpose of obtaining greater risk diversification and
minimizing the maximum net loss potential arising from large claims. The
insurance subsidiaries, however, are contingently liable in the event that their
reinsurers become unable to meet their contractual obligations. A large portion
of the reinsurance is effected under reinsurance contracts known as treaties.
PAULA Insurance Company (PICO) maintains excess of loss and catastrophic
reinsurance arrangements to protect it against losses above its retention on
workers' compensation policies. The maximum retention on workers' compensation
policies is $200 in 1995 through June 30, 1996 and $250 for the last six months
of 1996 and all of 1997 for each loss occurrence.
The following amounts have been deducted in the accompanying
consolidated financial statements as a result of reinsurance ceded:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Premiums earned............................................... $1,836 2,056 3,226
Losses and loss expenses incurred............................. 811 940 573
</TABLE>
F-19
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Substantially all reinsurance balances are with General Reinsurance
Corporation.
(8) STOCKHOLDERS' EQUITY
In August 1994, the Company completed a private placement of 941,177
shares of Series A - convertible preferred stock. Gross proceeds of $16,000 were
received from three institutional investor groups which obtained the stock for
their own portfolios or investment funds. In addition to a cash commission paid
in connection with the private placement, the Company issued warrants to
purchase 164,706 shares of common stock at the fair market value at the date of
issuance of $8.50 per share to the placement agents.
The preferred stock had dividend and voting rights consistent with
common stockholders on an if-converted basis, and had a liquidation preference
of $17.00 per share plus all accrued and unpaid dividends. The preferred stock
was convertible into common shares on a one-for-two basis at the holder's option
or automatically upon consummation of a qualified initial public offering with
aggregate proceeds in excess of $20,000 and a per share price greater than
$12.75 (a "Qualified Initial Public Offering"). The preferred stock was
redeemable at the holder's option beginning December 31, 1998 at the greater of
fair value as determined by an independent party or 1.15 times the Company's
book value per share assuming conversion of the preferred stock. Such redemption
right terminated upon the effectiveness of a registration statement for a
Qualified Initial Public Offering. The preferred stock restricted both dividend
payments and the repurchase of stock from the Company's employees and directors
so long as the preferred stock remained outstanding. The preferred stock
purchase agreement imposed certain additional covenants. The carrying value of
the preferred stock was accreted based on the redemption formula outlined in the
preferred stock agreement.
Concurrent with the initial public offering, the preferred shares were
converted into 1,882,354 shares of common stock. Additionally, the warrants to
purchase 164,706 shares of common stock were exercised. Cash totaling $933 was
received for the exercise of 109,804 warrants while the remaining warrants were
exercised in a cashless transaction in which 29,677 shares of common stock were
issued.
Prior to the initial public offering, the Company was obligated under
the terms of its ESOP to repurchase shares allocated to ESOP participants when
the participants qualified for a distribution (i.e., retirement or break in
service) in the event the participants choose to sell such shares and the ESOP
was unable to repurchase the shares directly (see note 9). This obligation was
eliminated upon completion of the initial public offering as the stock is now
publicly traded.
Prior to the initial public offering, the purchase price of the
Company's shares was determined annually by an independent appraisal firm, as
required, and was approved by the ESOP committee. This appraisal was used for
determining the market value of the shares with respect to the ESOP.
In January 1995, the Company agreed to repurchase 518,618 shares of
common stock and options to acquire 40,000 shares, for a purchase price of
$11.25 per share and $2.75 per option, from the retiring Chairman of the Board.
The per share price was based on a third-party offer. The amount of the
repurchase totaled $6,284, of which $1,486 was paid in each of January 1995 and
1996 and the remaining balance was paid in 1997.
F-20
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
On September 23, 1997, the Company declared a two-for-one stock split
effected in the form of a dividend to stockholders of record on September 23,
1997. All data with respect to equity classification, earnings per share and
share information, including price per share, where applicable, in the
consolidated financial statements and notes thereto have been retroactively
adjusted to reflect the split.
On October 24, 1997, the Company completed its initial public offering
by selling 2,400,314 shares of its common stock to the underwriters of the
Company's initial public offering at $18.50 per share for net proceeds of
$40,345 after deducting underwriting discounts and expenses of the offering.
PAULA Financial is dependent on the transfer of funds from its
subsidiaries. Dividends and advances from PICO and PACO are restricted by law
and minimum capitalization requirements and, above certain thresholds, are
subject to approval by insurance regulatory authorities. Net assets of the
insurance subsidiaries in the amount of $39,800 and $55,497 at December 31, 1996
and 1997, respectively, are restricted as to their availability for advances or
dividends to PAULA Financial due to insurance regulatory requirements.
(9) EMPLOYEE BENEFIT PLANS
The Company maintains a defined contribution employee stock ownership
plan (ESOP) covering all full-time employees, excluding hourly employees. The
ESOP has assets principally comprised of 1,094,126 shares of the Company's
common stock at December 31, 1996 and 1997. The Company can make annual
contributions to the ESOP in cash or shares of the Company's common stock in
amounts determined by the Company's Board of Directors, except that such
contributions must be in cash to the extent the ESOP requires liquid funds to
meet its obligations. The Company expensed cash contributions of $150, $150 and
$125 in the years ended December 31, 1995, 1996 and 1997, respectively.
Prior to the initial public offering, the Company was obligated under
the terms of its ESOP to repurchase shares distributed to ESOP participants when
the participants qualified for a distribution (i.e., retirement or break in
service) in the event the participants chose to sell such shares and the ESOP
was unable to repurchase the shares directly. Such shares had to be paid for
within five years. (see note 8)
The Company maintains a 401(k) plan covering substantially all
employees. Employees may contribute up to 17% of their compensation. The Company
makes a matching contribution of 50% of the employee contribution, limited to 6%
of compensation. Total employer costs under the plan were $208, $208 and $224
for the years ended December 31, 1995, 1996 and 1997, respectively.
Employees of the Company receive an annual year-end bonus based upon
the profitability of the Company. Amounts expensed under bonus programs were
$427, $1,053 and $1,068 for the years ended December 31, 1995, 1996 and 1997,
respectively.
In 1994, the Company adopted a stock incentive plan, reserving 550,000
shares of common stock, which provides for granting of stock options and
restricted stock bonuses to officers and directors and key employees of the
Company. Options and restricted stock are granted at the discretion of the
Executive Compensation Committee of the Board of Directors. Prior to the initial
public offering, options were granted at fair value as determined by the
Executive Compensation Committee of the Board of Directors.
F-21
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Stock options vest either immediately or over periods not to exceed
five years and carry an exercise price equal to or in excess of the fair market
value of the common stock on the date of grant. The stock options are
exercisable for a ten-year term.
Changes in the status of options granted under the plan are summarized
as follows:
<TABLE>
<CAPTION>
1995
---- WEIGHTED
EXERCISE AVERAGE
SHARES PRICE EXERCISE PRICE
------- ------------- --------------
<S> <C> <C> <C>
Beginning of year.................................... 167,300 $8.50 - 9.03 8.53
Granted........................................ 31,000 9.03 9.03
Canceled....................................... (2,350) 9.03 9.03
Exercised or redeemed.......................... (80,000) 8.50 8.50
------- ------------ -------
End of year.......................................... 115,950 $8.50 - 9.03 8.67
------- ------------ -------
------- ------------ -------
Exercisable.......................................... 95,000 $8.50 - 9.03 8.67
------- ------------ -------
------- ------------ -------
<CAPTION>
1996
---- WEIGHTED
EXERCISE AVERAGE
SHARES PRICE EXERCISE PRICE
------- ------------- --------------
<S> <C> <C> <C>
Beginning of year.................................... 115,950 $8.50 - 9.03 8.67
Granted........................................ 289,300 7.88 - 12.50 8.83
Canceled....................................... (600) 9.03 9.03
Exercised or redeemed.......................... - - -
------- ------------- ---------
End of year.......................................... 404,650 $7.88 - 12.50 8.78
------- ------------- ---------
------- ------------- ---------
Exercisable.......................................... 280,700 $7.88 - 12.50 8.78
------- ------------- ---------
------- ------------- ---------
<CAPTION>
1997
---- WEIGHTED
EXERCISE AVERAGE
SHARES PRICE EXERCISE PRICE
------- ------------- --------------
<S> <C> <C> <C>
Beginning of year.................................... 404,650 $7.88 - 12.50 8.78
Granted........................................ - - -
Canceled....................................... (1,800) 9.03 - 9.50 9.45
Exercised or redeemed.......................... - - -
------- ------------- ---------
End of year.......................................... 402,850 $7.88 - 12.50 8.78
------- ------------- ---------
------- ------------- ---------
Exercisable.......................................... 328,700 $7.88 - 12.50 8.58
------- ------------- ---------
------- ------------- ---------
</TABLE>
Pursuant to the plan, the Company granted 28,700 shares at $9.03 per
share and 22,500 shares at $7.88 per share of restricted common stock in 1995
and 1996, respectively. The per share price for these awards was based on an
annual independent appraisal. The restrictions lapse pursuant to various vesting
schedules. Holders of restricted stock are entitled to vote such shares and
receive dividends, which are not subject to restrictions. As of December 31,
1997, the restrictions on an aggregate of 8,175 shares of restricted stock have
lapsed; 9,500,
F-22
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
1,400 and 1,150 shares in 1995, 1996, and 1997, respectively, were forfeited
based upon voluntary termination. No restricted stock was granted in the year
ended December 31, 1997.
At December 31, 1997, 28,000 shares of common stock were available for
issuance under the plan.
In addition, in 1996, the Company issued options to purchase an
aggregate of 316,000 shares of common stock to officers and directors of the
Company outside the Plan. The options carry an exercise price of $9.50 per
share. Also, outstanding is an option to purchase an aggregate of 60,000 shares
of common stock to an officer of the Company outside of the plan granted at
$8.50 per share in 1994. The options were granted at fair value as determined by
the Executive Compensation Committee of the Board of Directors. Such options
have the same terms as options granted under the plan and are immediately
exercisable.
In 1997, the Company adopted its 1997 Stock Incentive Plan, reserving
200,000 shares of common stock, none of which have been granted as of December
31, 1997.
The Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" (Opinion 25), and related
interpretations in accounting for its employee stock options and adopt the
disclosure requirements of Statement of Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" (Statement 123). Had compensation cost
for the Company's stock-based compensation plan been reflected in the
accompanying consolidated financial statements based on the fair value at the
grant dates for option awards consistent with the method of Statement 123, the
Company's net income would have been reduced to the pro forma amounts indicated
below:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Net income:
As reported $300 3,923 5,159
Pro forma 257 3,326 4,730
Earnings per share:
As reported $0.16 2.07 1.88
Pro forma 0.14 1.75 1.73
Earnings per share-
assuming
dilution:
As reported $0.08 1.00 1.11
Pro forma 0.07 0.85 1.01
</TABLE>
The fair value for these options was estimated at the date of grant
using the minimum value method. The risk free interest rate used for options
granted during 1995 and 1996 was 6.4%. An average option exercise period of
seven years was used. Pro forma net income reflects only options granted in 1995
and 1996. During the initial phase-in period of Statement 123, the full impact
of calculating compensation cost for stock options is not reflected
F-23
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
in the pro forma net income amounts presented above because compensation cost is
reflected over the options' vesting periods and compensation cost for options
granted prior to January 1, 1995 is not considered.
(10) STATUTORY ACCOUNTING PRACTICES
The insurance subsidiaries are required to file statutory financial
statements with state insurance regulatory authorities. Accounting practices
used to prepare these statutory financial statements differ from generally
accepted accounting principles (GAAP). Such differences include the following:
(1) reserves for losses and loss adjustment expenses must meet certain minimum
requirements, (2) reserves for policyholder dividends are recorded as a
restriction on surplus until declared, (3) Federal income taxes are recorded
when payable, (4) fixed maturities are carried at admitted values, (5) certain
assets are non-admitted and (6) acquisition expenses are expensed when incurred.
Amounts reported to regulatory authorities as compared to amounts included in
the accompanying consolidated financial statements on a GAAP basis for the years
ended December 31, 1995, 1996 and 1997 follow:
<TABLE>
<CAPTION>
AS INCLUDED
IN THE
ACCOMPANYING
CONSOLIDATED AS REPORTED
FINANCIAL TO REGULATORY
STATEMENTS AUTHORITIES
<S> <C> <C>
Years ended December 31
1995:
Net earnings................................. $2,052 3,122
------- -------
------- -------
Stockholders' equity......................... $41,003 30,271
------- -------
------- -------
1996:
Net earnings................................. $5,770 5,080
------- -------
------- -------
Stockholders' equity......................... $45,202 35,144
------- -------
------- -------
1997:
Net earnings................................. $6,017 6,439
------- -------
------- -------
Stockholders' equity......................... $61,974 50,230
------- -------
------- -------
</TABLE>
Statutory accounting practices for the insurance subsidiaries are
prescribed or permitted by the Department of Insurance of the State of
California. Prescribed accounting practices include a variety of publications of
the National Association of Insurance Commissioners (NAIC) as well as state
laws, regulations and general administrative rules. Permitted statutory
accounting practices encompass all accounting practices that are not prescribed;
such practices differ from state to state, may differ from company to company
within a state and may change in the future. Furthermore, the National
Association of Insurance Commissioners has a project to codify
F-24
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
statutory accounting practices, the result of which is expected to constitute
the only source of "prescribed" statutory accounting practices. Accordingly,
that project will likely change the definition of what comprises prescribed
versus permitted statutory accounting practices and may result in changes to the
accounting policies that insurance enterprises use to prepare their statutory
financial statements.
Insurance regulatory authorities impose various restrictions on the
payment of dividends and advances by insurance companies. As of December 31,
1997, the maximum dividend and advance payments that may be made during 1998 by
the insurance subsidiaries to PAULA Financial without prior approval of the
regulatory authorities are limited to the greater of net income for the
preceding year or 10% of policyholder surplus as of the preceding December 31
and approximate $6.4 million.
(11) COMMITMENTS AND CONTINGENCIES
The Company leases buildings for its home office and certain other
premises under long-term operating leases that expire in various years to 2002.
Certain of these leases contain renewal provisions. Certain of these leases are
with related parties. Rent expense was $1,483, $1,657 and $1,613 for the years
ended December 31, 1995, 1996 and 1997, respectively. Included in rent expense
is rent paid to related parties of the Company totaling $230 and $149 and $52
for the years ended December 31, 1995, 1996 and 1997, respectively.
Approximate aggregate minimum rental commitments under operating leases
at December 31, 1997 are as follows:
<TABLE>
<S> <C>
1998.................................................. $1,478
1999.................................................. 730
2000.................................................. 219
2001.................................................. 167
2002 and thereafter................................... 62
------
$2,656
------
------
</TABLE>
In the ordinary course of business, the Company's subsidiaries are
defendants in various lawsuits. Management believes that the ultimate
disposition of the litigation will not result in a material impact to the
financial position or operating results of the Company.
The NAIC has adopted a risk-based capital formula for both property and
casualty and life insurance companies. These formulas calculate a minimum level
of capital and surplus which should be maintained by each insurer. At December
31, 1997, both PICO and PACO's adjusted capital and surplus exceeded their
respective risk-based capital requirements.
(12) ACQUISITIONS
In November 1995, the Company acquired the assets of Desert Benefits,
Inc., an insurance agency specializing in agribusiness and rural market medical
benefit programs, for total consideration of $700. The purchase price was
comprised of a $140 cash payment and the issuance of common stock for the
remaining balance (71,066 shares). The acquisition has been accounted for using
the purchase method of accounting and the operations
F-25
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
have been included in the accompanying consolidated financial statements from
the date of acquisition. The purchase price has principally been allocated to
the excess of cost over net assets acquired.
In August 1996, the Company acquired the assets of Guinn Sinclair
Insurance Services, an insurance agency specializing in farm labor contractor
insurance needs, for total consideration of $221. The purchase price was
comprised of a $44 cash payment and the issuance of common stock for the
remaining balance (11,764 shares). The acquisition has been accounted for as an
asset purchase and the operations have been included in the accompanying
consolidated financial statements from the date of acquisition. The purchase
price has principally been allocated to the excess of cost over net assets
acquired.
(13) SUBSEQUENT EVENT
On March 2, 1998, the Board of Directors declared a cash dividend of
$0.04 per share to stockholders of record on March 17, 1998, to be paid by the
Company on March 31, 1998.
F-26
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information called for by this item is incorporated by reference to
the Company's definitive proxy statement to be filed pursuant to Regulation 14A
of the Securities Exchange Act of 1934, as amended, with the Securities Exchange
Commission not later than 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION.
The information called for by this item is incorporated by reference to
the Company's definitive proxy statement to be filed pursuant to Regulation 14A
of the Securities Exchange Act of 1934, as amended, with the Securities Exchange
Commission not later than 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information called for by this item is incorporated by reference to
the Company's definitive proxy statement to be filed pursuant to Regulation 14A
of the Securities Exchange Act of 1934, as amended, with the Securities Exchange
Commission not later than 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information called for by this item is incorporated by reference to
the Company's definitive proxy statement to be filed pursuant to Regulation 14A
of the Securities Exchange Act of 1934, as amended, with the Securities Exchange
Commission not later than 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.
III-1
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
Financial Statements, Financial Statement Schedules and Exhibits:
1. Financial Statements: See the Consolidated Financial Statements
included herein under Part I, Item 8.
2. Financial Statement Schedules: The following Consolidated
Financial Statement schedules are attached hereto at the
end of this Report on Form 10-K:
<TABLE>
<CAPTION>
SCHEDULE NO. DESCRIPTION
------------ -----------
<C> <S>
I Summary of Investments
II Condensed Financial Information of Registrant
III Supplementary Insurance Information
IV Reinsurance
V Valuation and Qualifying Accounts and Reserves
VI Supplemental Property and Casualty Insurance Information
</TABLE>
3. Exhibits:
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
----------- -----------
<C> <S>
2.1 Asset Purchase Agreement dated December 8, 1994 by and between
Registrant, Oregon Ag Insurance Services, Inc., Agri-Comp.
Inc., Oregon-Comp. Inc. and Oregon Risk Management, Inc.*
2.2 Asset Purchase Agreement dated November 10, 1995 by and
between Pan American Underwriters, Inc. (PAU), Desert
Benefits, Inc., Employee Benefits & Insurance Services,
Fredric J. Klicka and Fredric J. Klicka II.*
2.3 Agreement dated July 25, 1996 by and among Registrant, PAULA
Insurance Company (PICO), James G. Parker Insurance Associates
(Parker) and certain individual stockholders of Parker.*
2.4 Asset Purchase Agreement dated August 23, 1996 by and among
PAU, Guinn Sinclair Insurance Services, Margaret Funnell and
Yolanda Ibarrez.*
2.5 Series A Preferred Stock Purchase Agreement dated
March 11, 1997 by and between PICO and CAPAX Management &
Insurance Services (CAPAX).*
3.1 Certificate of Incorporation of Registrant.**
3.2 Reserved.
3.3 Bylaws of Registrant.*
4.1 Reserved.
4.2 Specimen certificate of Common Stock.**
IV-1
<PAGE>
10.1 Lease for Registrant's Pasadena, California office, between
Pasadena Gateway Plaza, as Lessor, and PAU, as Lessee, dated
January 1, 1989 and last amended May 12, 1995 and the
Assignment and Assumption of Lease and Consent between LACERA
Gateway Property, Inc., PAU and PICO.*
10.2 Lease for Registrant's Lake Oswego, Oregon office, dated
September 23, 1996 and amended May 13, 1997 between WCB
Thirty-Two Limited Partnership, as Lessor, and PICO, as
Lessee.*
10.3 Lease for Registrant's Fresno, California office dated
October 18, 1994 and amended January 10, 1997 between
Altaffer Survivor Trust, as Lessor, and PAU, as Lessee.*
10.4 Agreement of Reinsurance, No. 7448, dated February 16, 1990
and last amended July 1, 1996 between General Reinsurance
Corporation and PICO.*
10.5 Workers' Compensation and Employers' Liability Excess of Loss
Reinsurance Agreement, No. 380, dated July 1, 1995 and last
amended July 1, 1996 between PICO and certain reinsurers named
therein.*
10.6 PAULA Financial and Subsidiaries 1994 Stock Incentive Plan.*
10.7 PAULA Financial and Subsidiaries 1997 Stock Incentive Plan.*
10.8 Form of Stock Option Agreement (Immediate Vesting - Non-Plan)
issued in connection with the grant of stock
options under the 1994 Plan.*
10.9 Form of Stock Option Agreement (Executive - Non-Plan) issued
in connection with the grant of stock options other than under
the 1994 Plan.*
10.10 Form of Stock Option Agreement (Immediate Vesting) issued
under the 1994 Plan.*
10.11 Form of Stock Option Agreement (Executive) issued under the
1994 Plan.*
10.12 Form of Stock Option Agreement (Stepped Vesting) issued under
the 1994 Plan.*
10.13 Form of Indemnification Agreement between Registrant and each
of its directors.*
10.14 Convertible Revolving Loan Note dated March 31, 1997 made by
Registrant in favor of Sanwa Bank California.*
10.15 Credit Agreement dated March 31, 1997 between Registrant and
Sanwa Bank California.*
10.16 Form of Credit Guaranty dated March 31, 1997 made by each of
PAU, Pan American Underwriters Insurance Agents & Brokers,
Inc. (PAUIAB), Agri-Comp Insurance Agency, Inc. and Pan
Pacific Benefit Administrators, Inc. (PPBA).*
10.17 Series A Preferred Stock Purchase Agreement dated August 3,
1994 between Registrant and certain purchasers of Series A
Preferred Stock.*
10.18 Reserved.
10.19 Reserved.
10.20 Reserved.
10.21 Asset Management Agreement dated February 1, 1995 between PICO
and Conning.*
10.22 Agency and Affiliates Cost Allocation and Reimbursement
Agreement dated March 1, 1992 and last amended December 1,
1996 between PAU and PAUIAB, as Agency, and PICO, PACO and
PPBA, as Affiliates.*
10.23 PAULA Insurance Company Insurance Carrier and Affiliates Cost
Allocation and Reimbursement Agreement dated March 1, 1992 and
last amended December 9, 1994 between PICO, as Carrier, and
PACO, PAU, PAUIAB and PPBA, as Affiliates.*
10.24 PAULA Financial Parent and Affiliates Cost Allocation and
Reimbursement Agreement dated January 1, 1993 and last amended
December 9, 1994 between Registrant, as Parent, and PICO,
PACO, PAU, PAUIAB and PPBA, as Affiliates.*
10.25 Managing Agreement dated January 1, 1993 and last amended
April 28, 1995 between PACO and PPBA, as Manager.*
10.26 Federal Income Tax Allocation Agreement dated April 10, 1997
between Registrant and its subsidiaries.*
IV-2
<PAGE>
10.27 Agency Agreement dated March 1, 1992 and last amended April 1,
1997 between PAU and PICO.*
10.28 Agency Agreement dated March 1, 1992 and last amended April 1,
1997 between PAUIAB and PICO.*
10.29 Agency Agreement dated December 8, 1994 and last amended April
1, 1997 among Agri-Comp Insurance Agency, Inc. and PICO.*
10.30 Purchase Option dated March 11, 1997 between Registrant and
CAPAX.*
10.31 Plan of Reorganization and Agreement of Merger dated September
22, 1997 between PAULA Financial (Delaware) and PAULA
Financial (California).**
11 Statement re computation of per share earnings.
21 List of subsidiaries of PAULA Financial.*
23 Consent of KPMG Peat Marwick LLP.
27.1 Financial Data Schedule - Year ended December 31, 1997
27.2 Financial Data Schedule - Year ended December 31, 1996 and
six months ended June 30, 1997 - Restated.
27.3 Financial Data Schedule - Three and nine months ended
September 30, 1997 - Restated
</TABLE>
- ----------
* Incorporated by reference from the exhibit of the same number filed as
an exhibit to the Company's Registration Statement on Form S-1 (Reg. No.
333-33159) filed on August 8, 1997 under the 1933 Act (the "Registration
Statement").
** Incorporated by reference from the exhibit of the same number filed as an
exhibit to Amendment No. 1 to the Registration Statement.
(b) REPORTS ON FORM 8-K.
The Company filed no reports on Form 8-K during the fourth quarter of 1997.
IV-3
<PAGE>
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.
PAULA FINANCIAL
By: /s/ Bradley K. Serwin
---------------------
SENIOR VICE PRESIDENT
MARCH 30, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the registrant
and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ Jeffrey A. Snider Chairman of the Board, President and March 30, 1998
--------------------- Chief Executive Officer
Jeffrey A. Snider (Principal Executive Officer)
/s/ James A. Nicholson Senior Vice President and Chief Financial March 30, 1998
---------------------- Officer (Principal Financial and Principal
James A. Nicholson Accounting Officer)
/s/ John B. Clinton Director March 30, 1998
-------------------
John B. Clinton
/s/ Jerry M. Miller Director March 30, 1998
---------------------
Jerry M. Miller
/s/ Robert Puccinelli Director March 30, 1998
---------------------
Robert Puccinelli
/s/ Bradley K. Serwin Director March 30, 1998
---------------------
Bradley K. Serwin
/s/ Andrew M. Slavitt Director March 30, 1998
---------------------
Andrew M. Slavitt
/s/ Gerard Vecchio Director March 30, 1998
------------------
Gerard Vecchio
/s/Ronald W. Waisner Director March 30, 1998
--------------------
Ronald W. Waisner
</TABLE>
IV-4
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
PAULA Financial:
Under date of March 3, 1998, we reported on the consolidated
balance sheets of PAULA Financial and subsidiaries as of December 31, 1996 and
1997, and the related consolidated statements of income, stockholders' equity
and cash flows for each of the years in the three-year period ended December 31,
1997 which are included in the Annual Report on Form 10-K. In connection with
our audits of the aforementioned consolidated financial statements, we also
audited the related financial statement schedules in the Annual Report on Form
10-K. These financial statement schedules are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statement schedules based on our audits.
In our opinion, such financial statement schedules, when considered
in relation to the basic consolidated financial statements taken as a whole,
present fairly, in all material respects, the information set forth therein.
/s/ KPMG Peat Marwick LLP
Los Angeles, California
March 3, 1998
S-1
<PAGE>
SCHEDULE I
PAULA FINANCIAL AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
-----------------------
COLUMN A COLUMN B COLUMN C COLUMN D
AMOUNT AT WHICH SHOWN
TYPE OF INVESTMENTS COST VALUE IN THE BALANCE SHEET
- ------------------- ---- ----- ----------------------
<S> <C> <C> <C>
Fixed maturities:
Bonds:
U.S. Treasury securities and obligations of U.S. Government corporations
and agencies......................................................... $10,000 $10,163 $10,163
States, municipalities and political subdivisions...................... 77,817 79,555 79,555
Corporate securities................................................... 12,009 12,293 12,293
Collateralized mortgage obligations.................................... 12,468 12,514 12,514
-------- -------- --------
Total fixed maturities............................................ 112,294 114,525 114,525
Equity securities:
Common stock........................................................... 5,546 5,545 5,545
Nonredeemable preferred stock.......................................... 3,019 3,112 3,112
-------- -------- --------
Total equity securities........................................... 8,565 8,657 8,657
Short-term investments.................................................... 14,682 14,682 14,682
-------- -------- --------
Total investments................................................. $135,541 $137,864 $137,864
-------- -------- --------
-------- -------- --------
</TABLE>
S-2
<PAGE>
SCHEDULE II.1
PAULA FINANCIAL AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PAULA FINANCIAL
BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
ASSETS
<S> <C> <C>
Common stock, at market (cost $5,138 at December 31, 1997).............................. $ - $ 5,138
Cash and invested cash.................................................................. 539 13,647
Property and equipment, net............................................................. 94 43
Investment in subsidiaries.............................................................. 48,209 65,137
Deferred income taxes................................................................... 241 11
Other assets............................................................................ 182 1,885
------- -------
$49,265 $85,861
------- -------
------- -------
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S> <C> <C>
Liabilities:
Notes payable........................................................................... $10,854 $ 406
Accounts payable and other liabilities.................................................. 986 635
Obligation on stock held by ESOP........................................................ 11,449 -
------- -------
23,289 1,041
Series A Preferred stock, convertible, redeemable after December 31, 1998, $0.01 par
value; Authorized 5,000,000 shares: issued and outstanding 941,177 shares at December
31, 1996............................................................................. 21,402 -
Stockholders' equity:
Common stock, $0.01 par value; Authorized 15,000,000 shares:
issued, 2,167,456 shares in 1996 and 6,321,177 shares in 1997....................... 22 63
Additional paid-in capital.............................................................. 1,748 67,176
Retained earnings....................................................................... 16,668 16,048
Net unrealized gain on investments...................................................... 778 1,533
Treasury stock.......................................................................... (2,972) -
Obligation on stock held by ESOP........................................................ (11,449) -
Guarantee of notes payable of ESOP...................................................... (221) -
------- -------
Net stockholders' equity.......................................................... 4,574 84,820
------- -------
$49,265 $85,861
------- -------
------- -------
</TABLE>
See notes to condensed financial information
S-3
<PAGE>
SCHEDULE II.2
PAULA FINANCIAL AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PAULA FINANCIAL
STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Income:
Net investment income.......................................... $120 $31 $169
Service fees................................................... 1,057 871 977
Other.......................................................... 202 112 293
--------- --------- ---------
1,379 1,014 1,439
Expenses:
Interest expense............................................... 742 635 747
Service fees................................................... 135 865 96
Operating...................................................... 1,325 1,649 1,535
--------- --------- ---------
2,202 3,149 2,378
Loss from operations before income tax benefit and equity in net
income of subsidiaries......................................... (823) (2,135) (939)
Income tax benefit............................................. (182) (727) (309)
--------- --------- ---------
Loss from operations before equity in net income of subsidiaries.. (641) (1,408) (630)
Equity in net income of subsidiaries.............................. 941 5,331 5,789
--------- --------- ---------
Net income................................................ $300 $3,923 $5,159
--------- --------- ---------
--------- --------- ---------
Earnings per share................................................ $0.16 $2.07 $1.88
Weighted average shares outstanding............................... 1,850,956 1,896,464 2,737,065
Earnings per share - assuming dilution............................ $0.08 $1.00 $1.11
Weighted average shares outstanding - assuming dilution........... 3,763,059 3,910,715 4,664,511
See notes to condensed financial information
</TABLE>
S-4
<PAGE>
SCHEDULE II.3
PAULA FINANCIAL AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PAULA FINANCIAL
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income........................................................... $300 $3,923 $5,159
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Depreciation and amortization..................................... 83 45 31
Income from subsidiaries.......................................... (941) (5,331) (5,789)
Dividends received from subsidiaries.............................. 935 820 -
Loss on sale of fixed assets...................................... 33 5 6
(Increase) decrease in other assets............................... 759 (539) (1,703)
Increase (decrease) in accounts payable and other liabilities..... 151 536 (351)
Other............................................................. (80) (195) (111)
------ ------ -------
Net cash provided by (used in) operating activities............ 1,240 (736) (2,758)
------ ------ -------
Cash flows from investing activities:
Purchase of common stock.......................................... - - (5,138)
Proceeds from sale of property and equipment...................... 80 88 13
Purchase of property and equipment................................ (89) (74) -
Capital contribution to subsidiary................................ - - (10,000)
------ ------ -------
Net cash provided by (used in) investing activities............ (9) 14 (15,125)
------ ------ -------
Cash flows from financing activities:
Borrowings (repayments) under line of credit agreement, net....... 2,822 2,268 (7,490)
Payments on notes payable......................................... (2,923) (1,627) (2,975)
Issuance of notes payable......................................... 214 269 238
Sale of common stock.............................................. 4 343 41,278
Retirement of common stock........................................ (1,994) - (60)
------ ------ -------
Net cash provided (used in) financing activities............... (1,877) 1,253 30,991
------ ------ -------
Net increase (decrease) in cash and invested cash.................... (646) 531 13,108
Cash and invested cash at beginning of period........................ 654 8 539
------ ------ -------
Cash and invested cash at end of period.............................. $8 $539 $13,647
------ ------ -------
------ ------ -------
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes...................... $1 $1 $1
------ ------ -------
------ ------ -------
Cash paid during the period for interest.......................... $363 $557 $1,007
------ ------ -------
------ ------ -------
</TABLE>
See notes to condensed financial information
S-5
<PAGE>
SCHEDULE II.4
PAULA FINANCIAL AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PAULA FINANCIAL
NOTES TO CONDENSED FINANCIAL INFORMATION
DECEMBER 31, 1996 AND 1997
(IN THOUSANDS)
1. BASIS OF PRESENTATION
In accordance with the requirements of Regulation S-X of the Securities
and Exchange Commission, the financial statements of the registrant are
condensed and omit many disclosures presented in the consolidated financial
statements and the notes thereto.
2. NOTES PAYABLE
The following is a summary of the notes payable balances at period end:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1996 1997
---- ----
<S> <C> <C>
Note payable to bank........................................... $7,490 $ -
Notes payable to former shareholders........................... 3,143 -
Notes payable - 406
Notes of employee stock ownership plan......................... 221 -
------- -----
Balance at end of period....................................... $10,854 $406
------- -----
------- -----
</TABLE>
Maturities of notes payable for the next five years are as follows:
<TABLE>
<CAPTION>
FISCAL YEAR DECEMBER 31, 1997
----------- -----------------
<S> <C>
1998................................................................. $339
1999................................................................. 67
----
Total................................................................ $406
----
----
</TABLE>
3. DIVIDENDS FROM SUBSIDIARIES
During 1995 and 1996, a cash dividend of $935 and $820, respectively,
was paid to PAULA Financial by its consolidated subsidiaries. During 1997, no
cash dividends were paid to PAULA Financial by its consolidated subsidiaries.
4. CONTINGENCIES
The Company is subject to various litigation which arises in the
ordinary course of business. Based upon discussions with counsel, management is
of the opinion that such litigation will not have a material adverse effect on
the consolidated financial position of the Company or its consolidated results
of operations.
S-6
<PAGE>
SCHEDULE III
PAULA FINANCIAL AND SUBSIDIARIES
SUPPLEMENTAL INSURANCE INFORMATION
(IN THOUSANDS)
<TABLE>
<CAPTION>
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN
A B C D E F G H I J K
- - - - - - - - - - -
FUTURE
POLICY OTHER AMORTIZATION
BENEFITS, POLICY BENEFITS, OF
DEFERRED LOSSES, CLAIMS CLAIMS, DEFERRED
POLICY CLAIMS AND NET LOSSES AND POLICY OTHER
ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INVESTMENT SETTLEMENT ACQUISITION OPERATING PREMIUMS
COSTS EXPENSES PREMIUM PAYABLE REVENUE INCOME EXPENSES COSTS EXPENSES WRITTEN
----- -------- ------- ------- ------- ------ -------- ----- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995
Workers
Compensation.... $645 $56,757 $4,609 - $44,224 $4,220 $29,164 $922 $13,847 $44,619
Group A&H........ - 210 - - 27 167 98 - 45 27
Group life....... - 82 - - 280 161 101 - 475 280
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
Total......... $645 $57,049 $4,609 - $44,531 $4,548 $29,363 $922 $14,367 $44,926
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
1996
Workers
Compensation.... $1,330 $55,187 $10,655 - $54,563 $4,288 $33,293 $2,421 $17,256 $60,609
Group A&H........ - 400 - - 551 152 407 - 338 551
Group Life....... - 133 - - 390 145 200 - 234 390
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
Total......... $1,330 $55,720 $10,655 - $55,504 $4,585 $33,900 $2,421 $17,828 $61,550
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
1997
Workers
Compensation.... $2,191 $77,441 $15,390 - $91,957 $5,066 $67,915 $9,074 $24,544 $99,919
Group A&H........ - 242 - - 563 155 98 - 278 563
Group Life....... - 101 - - 315 139 94 - 131 315
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
Total......... $2,191 $77,784 $15,390 - $92,835 $5,360 $68,107 $9,074 $24,953 $100,797
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
------ ------- ------- ----- ------- ------ ------- ------ ------- --------
</TABLE>
S-7
<PAGE>
SCHEDULE IV
PAULA FINANCIAL AND SUBSIDIARIES
REINSURANCE
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
-------- -------- -------- -------- -------- --------
CEDED TO ASSUMED FROM ASSUMED TO NET
OTHER OTHER PERCENTAGE OF
DESCRIPTION GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT AMOUNT
----------- ------------ --------- --------- ---------- ------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1995
Premiums:
Workers' compensation insurance............................. $45,951 $1,836 $109 $44,224 0.2%
Group A&H................................................... 27 - - 27 0.0%
Group Life.................................................. 280 - - 280 0.0%
------- ------ ---- ------- ----
Total Premiums.............................................. $46,258 $1,836 $109 $44,531 0.2%
------- ------ ---- ------- ----
------- ------ ---- ------- ----
YEAR ENDED DECEMBER 31, 1996
Premiums:
Workers' compensation insurance............................. $56,197 $2,056 $422 $54,563 0.8%
Group A&H................................................... 551 - - 551 0.0%
Group Life.................................................. 390 - - 390 0.0%
------- ------ ---- ------- ----
Total Premiums.............................................. $57,138 $2,056 $422 $55,504 0.8%
------- ------ ---- ------- ----
------- ------ ---- ------- ----
YEAR ENDED DECEMBER 31, 1997
Premiums:
Workers' compensation insurance............................. $94,603 $3,226 $580 $91,957 0.6%
Group A&H................................................... 563 - - 563 0.0%
Group Life.................................................. 315 - - 315 0.0%
------- ------ ---- ------- ----
Total Premiums.............................................. $95,481 $3,226 $580 $92,835 0.6%
------- ------ ---- ------- ----
------- ------ ---- ------- ----
</TABLE>
S-8
<PAGE>
SCHEDULE V
PAULA FINANCIAL AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(IN THOUSANDS)
<TABLE>
<CAPTION>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E
-------- -------- -------- -------- --------
ADDITIONS
---------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
OF PERIOD EXPENSE ACCOUNTS DEDUCTIONS OF PERIOD
--------- ------- -------- ---------- ---------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1995
Allowance for uncollectible accounts.......................... $350 $ 8 $ - $ - $358
--------- ------- -------- ---------- ---------
--------- ------- -------- ---------- ---------
YEAR ENDED DECEMBER 31, 1996
Allowance for uncollectible accounts.......................... $358 $142 $ - $ - $500
--------- ------- -------- ---------- ---------
--------- ------- -------- ---------- ---------
YEAR ENDED DECEMBER 31, 1997
Allowance for uncollectible accounts.......................... $500 $100 $ - $ - $600
--------- ------- -------- ---------- ---------
--------- ------- -------- ---------- ---------
</TABLE>
S-9
<PAGE>
SCHEDULE VI
PAULA FINANCIAL AND SUBSIDIARIES
SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION
(IN THOUSANDS)
<TABLE>
<CAPTION>
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN
A B C D E F G H I J K
- - - - - - - - - - -
CLAIMS AND CLAIM
DISCOUNT IF ADJUSTMENT
ANY, EXPENSES INCURRED
DEDUCTED IN RELATED TO:
RESERVES RESERVES -----------
UNPAID FOR FOR UNPAID AMORTIZATION
DEFERRED CLAIMS AND CLAIMS AND OF DEFERRED PAID CLAIMS
POLICY CLAIMS CLAIM NET POLICY & CLAIM
ACQUISITION ADJUSTMENT ADJUSTMENT UNEARNED EARNED INVESTMENT CURRENT PRIOR ACQUISITION ADJUSTMENT PREMIUMS
COSTS EXPENSE EXPENSES PREMIUM PREMIUM INCOME YEAR YEAR COSTS EXPENSES WRITTEN
----- ------- -------- ------- ------- ------ ---- ---- ----- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995
Workers
Compensation... $645 $56,757 $- $4,609 $44,224 $4,220 $33,048 $(3,884) $922 $32,469 $44,619
1996
Workers
Compensation... $1,330 $55,187 $- $10,655 $54,563 $4,288 $35,938 $(2,646) $2,421 $34,514 $60,609
1997
Workers
Compensation... $2,191 $77,441 $- $15,390 $91,957 $5,066 $66,330 $1,586 $9,074 $45,629 $99,919
</TABLE>
S-10
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT DESCRIPTION
NUMBER -----------
-------
<C> <S>
11 Statement re computation of per share earnings.
23 Consent of KPMG Peat Marwick LLP.
27.1 Financial Data Schedule - Year ended December 31,1997
27.2 Financial Data Schedule - Year ended December 31, 1996
and six months ended June 30, 1997 - Restated
27.3 Financial Data Schedule - Three and nine months ended
September 30, 1997 - Restated
</TABLE>
<PAGE>
EXHIBIT 11
PAULA FINANCIAL AND SUBSIDIARIES
COMPUTATION OF BASIC AND DILUTED EARNINGS PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------
1995 1996 1997
----- ----- -------
<S> <C> <C> <C>
Net income 300 3,923 5,159
----- ----- -------
----- ----- -------
Weighted average shares outstanding for calculating
basic earnings per share 1,851 1,897 2,737
Convertible preferred stock 1,882 1,882 1,527
Warrants 16 40 49
Options 14 92 352
----- ----- -------
Total shares for calculating diluted earnings
per share 3,763 3,911 4,665
----- ----- -------
----- ----- -------
Basic earnings per share 0.16 2.07 1.88
----- ----- -------
----- ----- -------
Diluted earnings per share 0.08 1.00 1.11
----- ----- -------
----- ----- -------
</TABLE>
<PAGE>
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors
PAULA Financial:
We consent to the incorporation by reference in the registration statements
(No. 333-42627 and No. 333-45517) on Form S-8 of PAULA Financial and
subsidiaries of our report dated March 3, 1998, relating to the consolidated
balance sheets of PAULA Financial and subsidiaries as of December 31, 1996
and 1997, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1997, and all related schedules, which report appears in the
December 31, 1997, annual report on Form 10-K of PAULA Financial.
/s/ KPMG Peat Marwick LLP
Los Angeles, California
March 30, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 114,525
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 8,657
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 137,864
<CASH> 4,770
<RECOVER-REINSURE> 0
<DEFERRED-ACQUISITION> 2,191
<TOTAL-ASSETS> 188,264
<POLICY-LOSSES> 77,784
<UNEARNED-PREMIUMS> 15,390
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 456
0
0
<COMMON> 63
<OTHER-SE> 84,757
<TOTAL-LIABILITY-AND-EQUITY> 188,264
92,835
<INVESTMENT-INCOME> 5,582
<INVESTMENT-GAINS> 172
<OTHER-INCOME> 4,481
<BENEFITS> 68,107
<UNDERWRITING-AMORTIZATION> 30,741
<UNDERWRITING-OTHER> (2,713)
<INCOME-PRETAX> 6,935
<INCOME-TAX> 1,776
<INCOME-CONTINUING> 5,159
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 5,159
<EPS-PRIMARY> 1.88
<EPS-DILUTED> 1.11
<RESERVE-OPEN> 49,293
<PROVISION-CURRENT> 66,840
<PROVISION-PRIOR> 1,267
<PAYMENTS-CURRENT> 20,809
<PAYMENTS-PRIOR> 25,201
<RESERVE-CLOSE> 71,390
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<RESTATED>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 12-MOS 6-MOS
<FISCAL-YEAR-END> DEC-31-1996 DEC-31-1997
<PERIOD-START> JAN-01-1996 JAN-01-1997
<PERIOD-END> DEC-31-1996 JUN-30-1997
<DEBT-HELD-FOR-SALE> 81,371 86,605
<DEBT-CARRYING-VALUE> 0 0
<DEBT-MARKET-VALUE> 0 0
<EQUITIES> 1,810 2,929
<MORTGAGE> 0 0
<REAL-ESTATE> 0 0
<TOTAL-INVEST> 86,792 93,379
<CASH> 7,096 6,642
<RECOVER-REINSURE> 172 61
<DEFERRED-ACQUISITION> 1,330 1,805
<TOTAL-ASSETS> 125,127 141,920
<POLICY-LOSSES> 55,720 64,972
<UNEARNED-PREMIUMS> 10,655 13,364
<POLICY-OTHER> 0 0
<POLICY-HOLDER-FUNDS> 3,981 3,586
<NOTES-PAYABLE> 11,279 11,468
21,402 22,776
0 0
<COMMON> 22 20
<OTHER-SE> 4,552 5,522
<TOTAL-LIABILITY-AND-EQUITY> 125,127 141,920
55,504 41,778
<INVESTMENT-INCOME> 4,701 2,499
<INVESTMENT-GAINS> 444 0
<OTHER-INCOME> 5,109 2,063
<BENEFITS> 33,900 28,447
<UNDERWRITING-AMORTIZATION> 25,480 14,752
<UNDERWRITING-OTHER> 1,628 309
<INCOME-PRETAX> 4,750 2,832
<INCOME-TAX> 827 538
<INCOME-CONTINUING> 3,923 2,294
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 3,923 2,294
<EPS-PRIMARY> 2.07 1.21
<EPS-DILUTED> 1.00 0.56
<RESERVE-OPEN> 50,274 49,293
<PROVISION-CURRENT> 36,554 29,245
<PROVISION-PRIOR> (2,654) (798)
<PAYMENTS-CURRENT> 13,143 5,130
<PAYMENTS-PRIOR> 21,738 14,075
<RESERVE-CLOSE> 49,293 58,535
<CUMULATIVE-DEFICIENCY> 0 0
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<RESTATED>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 9-MOS
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1997
<PERIOD-START> JUL-01-1997 JAN-01-1997
<PERIOD-END> SEP-30-1997 SEP-30-1997
<DEBT-HELD-FOR-SALE> 89,027 89,027
<DEBT-CARRYING-VALUE> 0 0
<DEBT-MARKET-VALUE> 0 0
<EQUITIES> 3,524 3,524
<MORTGAGE> 0 0
<REAL-ESTATE> 0 0
<TOTAL-INVEST> 102,947 102,947
<CASH> 8,832 8,832
<RECOVER-REINSURE> 98 98
<DEFERRED-ACQUISITION> 2,056 2,056
<TOTAL-ASSETS> 153,559 153,559
<POLICY-LOSSES> 68,334 68,334
<UNEARNED-PREMIUMS> 14,705 14,705
<POLICY-OTHER> 0 0
<POLICY-HOLDER-FUNDS> 4,022 4,022
<NOTES-PAYABLE> 12,029 12,029
23,663 23,663
0 0
<COMMON> 20 20
<OTHER-SE> 7,667 7,667
<TOTAL-LIABILITY-AND-EQUITY> 153,559 153,559
23,418 65,195
<INVESTMENT-INCOME> 1,351 3,850
<INVESTMENT-GAINS> 173 173
<OTHER-INCOME> 1,072 3,136
<BENEFITS> 16,051 44,498
<UNDERWRITING-AMORTIZATION> 7,620 22,372
<UNDERWRITING-OTHER> 436 745
<INCOME-PRETAX> 1,907 4,739
<INCOME-TAX> 636 1,174
<INCOME-CONTINUING> 1,271 3,565
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 1,271 3,565
<EPS-PRIMARY> 0.67 1.87
<EPS-DILUTED> 0.30 0.87
<RESERVE-OPEN> 58,535 49,293
<PROVISION-CURRENT> 15,852 45,097
<PROVISION-PRIOR> 195 (603)
<PAYMENTS-CURRENT> 7,046 12,176
<PAYMENTS-PRIOR> 5,846 19,921
<RESERVE-CLOSE> 61,690 61,690
<CUMULATIVE-DEFICIENCY> 0 0
</TABLE>
