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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(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, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-23181
PAULA FINANCIAL
(Exact name of registrant as specified in its charter)
DELAWARE 95-4640368
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) identification number)
PAULA FINANCIAL
300 NORTH LAKE AVENUE, SUITE 300
PASADENA, CA 91101
(Address of principle executive offices)
(626) 304-0401
(Registrant's telephone number, including area code)
Securities Registered pursuant to Section 12(b) of the Act:
NONE
Securities Registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
(Title of Class)
RIGHTS TO PURCHASE PREFERRED STOCK, $0.01 PAR VALUE
(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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(Cover page 1 of 2 pages)
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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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
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The aggregate market value of the voting stock held by nonaffiliates of
the registrant was $36,635,594 as of March 15, 1999.
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
As of March 15, 1999, the registrant had outstanding 5,928,967 shares of
Common Stock, $0.01 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
1999 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 on Form S-1
(Reg. No. 333-33159) filed on August 8, 1997, from Amendment No. 1 thereto,
and from the Company's Quarterly Report on Form 10-Q for the quarter ending
September 30, 1998.
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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 other principal
subsidiary is PAULA Assurance Company ("PACO"), a life and health carrier. The
Company transacts all of its business in the United States.
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 important to its success. The Company views its 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 continues to grow outside of its historic California and
Arizona markets. Since 1994, the Company has become licensed in seven
additional states: Oregon, Idaho, Texas, Florida, Alaska, Nevada and New
Mexico. In addition, the Company has entered into a reinsurance fronting
arrangement allowing it to underwrite risks in most other states. The Company
has begun to use this facility to write agribusiness risks in the midwestern and
southeastern United States. 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.
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 business 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. PAULA
Trading Company ("PTC") member agencies with expertise in these industries have
been the key factor behind the Company's growth in non-agribusiness industries.
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 and 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 Company believes it gains significant marketing benefits from the
endorsements Pan Am has developed for the Company. These endorsements by more
than 25 prominent trade associations have allowed the Company to be identified
with brand names significant to agribusiness customers. Trade associations
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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.
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 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 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, with many years
of claims experience and manages its number of open claims per examiner below
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.
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.
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AGRIBUSINESS UNDERWRITING EXPERTISE
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 25 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 many of the same classes of business in which it has
historically focused. This experience has enabled the Company to differentiate
risks by creating many farm classes and subclasses, reflecting the unique
characteristics of job classifications and differences in farming operations.
TRADE ASSOCIATION ENDORSEMENTS AND SAFETY GROUPS. The Company enjoys the
endorsement of more than 25 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 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 those of its customers as a whole. The trade association endorsements, in
particular, are also a good source of marketing opportunities through access to
association mailing lists. Approximately one-third 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, most 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.
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 most states 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. <PAGE>
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TRADE ASSOCIATIONS AND SAFETY GROUPS
Two significant factors in the Company's insurance operations have been the
efforts of Pan Am to obtain endorsements from agricultural trade associations
and to promote the formation and operation of 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, 1998, no single trade association or safety
group 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 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.
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 32,
with commission revenues (before intercompany eliminations) of $8.7 million in
1998. 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 1998, Pan Am
placed 53.5% 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 vulnerable
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 agents.
For 1998, 30% of PICO's premiums written was sold through Pan Am.
Pan Am has approximately 59 full-time equivalent employees operating from
17 offices in California, Arizona and Oregon; 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, primarily through the PTC membership arrangement. 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 a membership fee to the
PTC. PTC members have access to PAULA's innovative product features such as an
employment practices liability insurance ("EPL") product 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 lower insurance business acquisition costs.
INDEPENDENT INSURANCE AGENTS
The Company appoints a limited number of independent insurance agents, who
are not affiliated with the PTC, to sell its workers' compensation insurance,
primarily in states outside of California. 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, the Company has expanded into Alaska,
Florida, New Mexico and Texas. The Company has been licensed to write insurance
in Nevada and expects to commence operations there in July 1999. The Company
also writes insurance risks in other states through a reinsurance fronting
facility put in place in late 1998. The Company has focused its expansion in
states with significant labor-intensive agribusiness insurance opportunities.
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, 1998, workers' compensation premiums earned accounted for 88.8% of
the Company's revenues.
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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 EPL insurance in California, 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 $632,000 for the year
ended December 31, 1998.
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, 1998, 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 $11,156 as of December 31,
1998. 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.
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.
On accounts larger than $75,000 in EAP, the Company's underwriters
generally 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.
Once an account is written, a service plan is put into place utilizing
appropriate members of the Company's team of bilingual field representatives and
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. 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 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. The Company uses its bilingual, state-certified loss control
personnel to hold safety seminars to train insureds' employees.
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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, often in
consultation with senior claims officers, loss control officers and/or the chief
operating officer.
The Company's underwriting department consists of 8 senior underwriters
with extensive experience in property/casualty underwriting and 17 other
underwriting staff members. Each of the senior underwriters is given
individually determined binding authority.
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 canceled, 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
immediately reflected in lower rates, thereby providing an opportunity for the
Company's loss ratio to improve as each accounts' claims experience is reduced.
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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. 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 periodically
holds special one-day arbitration conferences with retired workers' compensation
judges to attempt to settle pending claims.
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 many 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.
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 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.
10
<PAGE>
CLAIMS PERSONNEL
The Company's claims management is conducted under the direction of 17
claims management personnel with extensive experience in the industry. The
Company's claims examiners are responsible for the management of caseloads per
examiner which are lower than the industry average. Due to the combination of
experience and more manageable caseloads, the Company's claims personnel can be
more effective at managing claims through more frequent contact with
policyholders, injured workers and medical providers. Moreover, the Company's
claims personnel are able to more quickly and cost effectively respond to
changes in mandated workers' compensation benefits.
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.
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
11
<PAGE>
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.
The Company employs an actuarial staff of two and also utilizes an outside
actuarial firm.
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 Generally Accepted
Accounting Principles ("GAAP") and those calculated in accordance with Statutory
Accounting Principles ("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>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Unpaid loss and loss adjustment expenses beginning of year.............. $77,784 $55,720 $57,049
Less: reinsurance recoverable on unpaid losses and LAE.................. 6,394 6,427 6,775
PACO reserves.................................................. 343 533 292
------------ ------------ ------------
Net PICO balance, beginning of year.................................. $71,047 $48,760 $49,982
------------ ------------ ------------
Incurred related to:
Current period....................................................... 107,850 66,330 35,938
Prior periods........................................................ 6,268 1,586 (2,646)
------------ ------------ ------------
$114,118 $67,916 $33,292
------------ ------------ ------------
Paid related to:
Current period....................................................... 34,374 20,495 12,833
Prior periods........................................................ 39,989 25,134 21,681
------------ ------------ ------------
$74,363 $45,629 $34,514
------------ ------------ ------------
Net PICO balance, end of year........................................ 110,802 71,047 48,760
Plus: reinsurance recoverable on unpaid losses and LAE.................. 25,137 6,394 6,427
PACO reserves.................................................. 377 343 533
------------ ------------ ------------
Unpaid loss and loss adjustment expenses, end of year................... $136,316 $77,784 $55,720
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
12
<PAGE>
The table below shows changes in historical workers' compensation net loss
and LAE reserves for PICO for each year since 1988. 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 restated
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 1991 to be $10,000 was first reserved in
1988 at $8,000, the $2,000 deficiency would be included in the cumulative
redundancy (deficiency) for each of the years 1988 through 1991 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.
13
<PAGE>
CHANGES IN HISTORICAL NET RESERVES FOR LOSSES AND LAE
(IN THOUSANDS)
<TABLE>
<CAPTION>
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Unpaid losses and loss
adjustment expenses at
end of year............ $52,893 $49,994 $49,104 $57,909 $59,492 $56,792 $53,287 $49,982 $48,760 $71,047 $110,802
Reserve re-estimated as of:
One year later......... 47,061 47,833 52,209 58,618 57,000 52,837 49,403 47,335 50,346 77,315
Two years later........ 46,462 50,060 53,491 60,095 57,115 50,480 48,189 45,041 50,910
Three years later...... 47,725 49,970 54,316 60,733 55,305 50,647 46,855 45,814
Four years later....... 47,473 50,321 55,269 59,806 56,725 50,056 47,928
Five years later....... 47,064 51,095 54,808 60,286 56,813 50,707
Six years later........ 47,444 51,025 55,184 60,794 57,225
Seven years later...... 47,346 51,348 55,738 61,188
Eight years later...... 47,847 51,714 55,932
Nine years later....... 48,216 51,913
Ten years later........ 48,093
Cumulative redundancy
(deficiency).............. 4,800 (1,919) (6,828) (3,279) 2,267 6,085 5,359 4,168 (2,150) (6,268)
Cumulative paid as of:
One year later......... 16,761 19,757 21,736 25,543 23,464 21,711 21,742 21,680 25,133 39,989
Two years later........ 29,212 32,602 36,021 40,328 37,040 34,721 33,601 33,007 38,328
Three years later...... 36,832 40,456 43,482 48,429 45,529 41,855 39,372 38,784
Four years later....... 41,251 44,254 47,923 53,416 50,395 45,253 42,807
Five years later....... 43,271 46,682 50,713 56,250 52,941 47,231
Six years later........ 44,676 48,430 52,442 58,261 54,642
Seven years later...... 45,562 49,406 53,801 59,406
Eight years later...... 46,465 50,333 54,558
Nine years later....... 47,145 50,926
Ten years later........ 47,341
Net unpaid losses and loss
adj. expenses
December 31............ $49,982 $48,760 $71,047 $110,802
Reinsurance recoverable... 6,775 6,427 6,394 25,137
--------- -------- --------- -------
Gross unpaid losses and
loss adj. expenses
December 31............ $56,757 $55,187 $77,441 $135,939
------- ------- ------- --------
------- ------- ------- --------
(Continued)
</TABLE>
14
<PAGE>
<TABLE>
<CAPTION>
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Re-estimated net unpaid
losses and loss
adjustment expenses.... $45,814 $50,910 $77,315
Re-estimated reinsurance
recoverable............ 7,659 8,190 9,172
--------- ---------- ---------
Re-estimated gross unpaid
losses and loss
adjustment expenses.... $53,473 $59,100 $86,487
--------- ---------- ---------
--------- ---------- ---------
Gross cumulative redundancy
(deficiency)........... $3,284 ($3,913) ($9,046)
--------- ---------- ---------
--------- ---------- ---------
</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, 1998. 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
(IN THOUSANDS)
<TABLE>
<CAPTION>
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 TOTAL
AND ---- ---- ---- ---- ---- ---- ---- ---- ---- CALENDAR
PRIOR YEAR
----- EFFECT
------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Calendar years
1998................ ($123) ($76) $5 ($200) ($18) ($239) ($422) $300 $209 ($5,704) ($6,268)
1997................ (369) 3 (188) 46 420 679 743 960 (3,880) (1,586)
1996................ (501) 178 (53) (104) (940) 1,253 1,381 1,433 2,647
1995................ 98 (28) 391 466 883 547 1,527 3,884
1994................ (380) (394) (179) 315 523 4,070 3,955
1993................ 409 (760) (474) (652) 3,969 2,492
1992................ 252 (162) (1,372) 573 (709)
1991................ (1,263) (964) (878) (3,105)
1990................ 599 1,562 2,161
1989................ 5,832 5,832
----------------------------------------------------------------------------------------------------------------
Cumulative
re-estimates
for each
accident year $4,554 ($641) ($2,748) $444 $4,837 $6,310 $3,229 $2,693 ($3,671) ($5,704) $9,303
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE>
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.
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 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 1994 and 1995, PICO experienced an aggregate of
approximately $7.8 million in reserve recoveries attributable primarily to
favorable development on losses and LAE for accident years 1990-1994. 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.
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.
During 1998, PICO experienced an aggregate of approximately $6.3 million
in net reserve development, principally related to the 1997 accident year.
In the first two quarters of 1998 the Company saw reserve development on the
1997 accident year for California business in excess of its expectations
given prior year reserving trends. The Company's second quarter reserve
adjustment, expressed as a percentage of related premiums, implied a pricing
deficiency for those periods. The Company began to address this pricing
deficiency early in 1998 through rate increases and non-renewal activity.
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.
16
<PAGE>
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. In
connection with a new reinsurance arrangement entered into in October 1998,
the Company has also chosen to quota-share a portion of its retained claims
exposure. In a quota-share reinsurance contract, the Company and the
reinsurer share premiums, losses and LAE on a proportional basis based on
each parties interest in the quota-shared risk.
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 excess of loss reinsurer.
GenRe is currently assigned a letter rating of "A++ (Superior)" by A.M. Best.
The Company's upper layers of reinsurance coverage (in excess of $10.0 million)
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. 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 $60.0
million per accident. An accident is defined as a single event, whether it
affects one or more persons. In July 1998, the Company modified its prior
existing excess of loss reinsurance treaty on the $250,000 excess of $250,000
layer to retain the first $2.0 million in annual aggregate losses, with a
corresponding reduction in the Company's reinsurance rate. In October 1998, the
Company entered into a two year excess of loss and quota-share reinsurance
arrangement with Reliance Insurance Company ("Reliance"). Under this
arrangement, the Company has ceded various portions of its exposure for claims
in excess of $10,000 and has quota-shared a portion of its risks under $10,000.
Reliance is rated A- (Excellent) by A.M. Best.
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 claim. 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 excess of loss reinsurance treaties
for the excess of $250,000 per accident layers are readily obtainable at the
present time. The Company does not expect to be able to replace or renew its
Reliance quota-share and $10,000 to $250,000 layer reinsurance treaty at current
terms upon expiration.
The Company has also 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 $632,000 for the year ended December 31,
1998.
17
<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.
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 on
effective after-tax yield and tax planning 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.
During the third quarter of 1998, the Company repositioned a substantial
portion of the investment portfolio from tax exempt to taxable securities. The
overall asset quality and duration of the portfolio was unchanged. The
repositioning was done for tax planning purposes.
18
<PAGE>
As of December 31, 1998, the carrying value of the Company's investment
portfolio was approximately $177.6 million and amortized cost was approximately
$178.2 million. The diversification of the Company's investment portfolio as of
December 31, 1998 is shown in the table below:
CONSOLIDATED INVESTMENT POSITION
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1998
---------------------------------------------
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 $13,766 $13,445 7.8%
States, municipalities and political subdivisions 24,346 24,082 13.7%
Corporate securities........................... 79,625 79,927 44.8%
Collateralized mortgage obligations
and other asset backed securities.......... 53,055 53,925 29.9%
--------------- ------------- --------------
Total fixed maturities......................... $170,792 $171,379 96.2%
Equity securities (3)............................. 4,259 4,251 2.4%
Invested cash..................................... 2,572 2,572 1.4%
--------------- ------------- --------------
Total investments.............................. $177,623 $178,202 100.0%
--------------- ------------- --------------
--------------- ------------- --------------
</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 James G. Parker Insurance
Associates ("Parker") and CAPAX Management & Insurance Services ("CAPAX"),
which had a carrying value as of December 31, 1998 of $1.7 million.
It is the Company's practice to purchase almost exclusively investment
grade fixed maturity securities and mutual funds primarily holding such
securities for its insurance company portfolios. In addition, the Company
generally invests its parent company portfolio in similar investments, although
the Company selectively invests in unrated and below investment grade securities
in this portfolio. As of December 31, 1998, the Company owned one bond with a
carrying value of $1.6 million which was non-performing. In 1998, the Company
realized an other than temporary decline of $0.1 million on this bond. At this
time, the Company is unable to predict whether or not it will realize additional
other than temporary declines on this security. As of December 31, 1998 the
Company did not own any mortgages or real estate. As of December 31, 1998, 97.0%
of the Company's fixed maturity securities carried a NAIC Class 1 designation
(or a comparable rating agency designation).
19
<PAGE>
At December 31, 1998, the Company owned a total of $53.9 million amortized
cost of mortgage backed and other asset backed securities. Mortgage backed
securities accounted for $31.4 million of the total. Approximately 84% of the
mortgage backed securities holdings were AAA-rated Agency pass through and
collateralized mortgage obligations ("CMO's"). The balance of the mortgage
backed securities holdings consisted of short maturity non-Agency mortgage
backed assets, also rated AAA. As of December 31, 1998, the average life of the
mortgage backed security portfolio was just over five years.
Asset backed holdings totaled $22.5 million at year end and primarily
consisted of traditional AAA rated automobile loan and credit card receivable
backed financings. In addition, the Company had modest exposures to AA-rated
Home Equity Loan and AAA-rated Collateralized Bond obligation debt issues. As
of December 31, 1998, the average life of the asset backed securities portfolio
was just over four years.
The primary objective of the mortgage and asset backed holdings is to
provide incremental investment income while controlling maturity extension and
prepayment risks.
The following table sets forth certain information regarding the investment
ratings of the Company's fixed maturity investment portfolio as of December 31,
1998:
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............................................................. $86,747 $86,945 50.8%
AA.............................................................. 26,326 25,875 15.4%
A............................................................... 44,848 44,000 26.3%
BBB to B........................................................ 11,321 12,659 6.6%
Not rated....................................................... 1,550 1,900 0.9%
--------------- ----------------- ------------------
Total........................................................... $170,792 $171,379 100.0%
--------------- ----------------- ------------------
--------------- ----------------- ------------------
</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.
20
<PAGE>
The following table sets forth certain information regarding the maturity
profile of the Company's fixed maturity securities as of December 31, 1998 based
on the earlier of the pre-escrowed date or the scheduled maturity date:
INVESTMENT PORTFOLIO BY YEARS TO MATURITY
<TABLE>
<CAPTION>
PERCENTAGE OF
MATURITY CARRYING VALUE CARRYING VALUE
- -------- -------------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
One year or less..................................................................... $7,541 4.4%
After one year through five years.................................................... 56,205 32.9%
After five years through ten years................................................... 48,590 28.4%
After ten years...................................................................... 5,401 3.2%
Mortgage and asset backed securities (1)............................................. 53,055 31.1%
--------------- ----------------
Total................................................................................ $170,792 100.0%
--------------- ----------------
--------------- ----------------
</TABLE>
- -------
(1) Mortgage- and asset-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.
The Company's investment results for each of the years in the three year
period ended December 31, 1998 were as follows:
INVESTMENT PORTFOLIO RESULTS
<TABLE>
<CAPTION>
Years Ended December 31,
1998 1997 1996
---- ---- ----
(dollars in thousands)
<S> <C> <C> <C>
Net pre-tax investment income (1).................................... $9,540 $5,582 $4,701
Average total invested assets (2).................................... 156,872 110,576 83,644
Annual pre-tax yield on average total invested assets (3)............ 6.1% 5.0% 5.6%
Net pre-tax realized investment gains................................ $1,706 $172 $444
</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 1997
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.
21
<PAGE>
The following table summarizes net investment income from the Company's
portfolio for the years ended December 31, 1998, 1997 and 1996:
NET INVESTMENT INCOME BY INVESTMENT TYPE
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
(DOLLARS IN THOUSANDS)
1998 1997
------------------------------------- -------------------------------------
PRE- PRE-
TAX REALIZED TAX REALIZED
YIELD GAINS YIELD GAINS
------ ------
INCOME (1) (LOSSES) INCOME (1) (LOSSES)
------ --- -------- ------ --- --------
<S> <C> <C> <C> <C> <C> <C>
Fixed maturity
securities:
Tax-exempt (2)..... $3,148 6.2% $1,846 $2,733 4.4% $(1)
Taxable............ 5,338 5.9 (362) 2,216 6.6 -
Equities (3).......... 500 7.8 222 121 2.3 173
Short-term............ 910 10.3 - 716 7.6 -
----------- ------------- ----------- ------------
Total.............. $9,896 6.3% $1,706 $5,786 5.2% $172
----------- ------------- ----------- ------------
Less investment expense
356 - 204 -
----------- ------------- ----------- ------------
----------- ------------- ----------- ------------
Total.............. $9,540 6.1% $1,706 $5,582 5.0% $172
----------- ------------- ----------- ------------
----------- ------------- ----------- ------------
</TABLE>
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
(DOLLARS IN THOUSANDS)
1996
-----------------------------------
REALIZED
PRE- GAINS
TAX
INCOME YIELD (1) (LOSSES)
------ --------- --------
<S> <C> <C> <C>
Fixed maturity
securities:
Tax-exempt (2)..... $2,660 5.5% $248
Taxable............ 1,841 6.0 196
Equities (3).......... 62 5.8 -
Short-term............ 338 8.6 -
----------- ------------
Total.............. $4,901 5.9% $444
----------- ------------
Less investment expense
200 -
----------- ------------
Total.............. $4,701 5.6% $444
----------- ------------
----------- ------------
</TABLE>
(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
8.0% for 1998, 5.7% for 1997, and 7.1% for 1996 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, 1998 of $1.7 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.
22
<PAGE>
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, Nevada,
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.
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 a complete 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.
23
<PAGE>
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, 1998, PAULA Financial would be able to receive $5.4
million in dividends in 1999 from its insurance subsidiaries without obtaining
prior regulatory approval from the California DOI.
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.
24
<PAGE>
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 California DOI has indicated that codification
will become effective on January 1, 2001. 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 control level). As of December 31, 1998, PICO's RBC was $34.1 million
in excess of the threshold requiring the least regulatory attention, which
amount was $15.7 million. As of December 31, 1998, PACO's RBC was $4.6 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
25
<PAGE>
ratios may lead to increased regulatory oversight from individual state
insurance commissioners. For 1998, PICO has two ratios outside the usual
values. The two ratios are change in net writings and two-year overall
operating ratio. The usual range for the change in net writings ratios is
(33%) to 33%. PICO experienced 38% growth in 1998. PICO's two-year overall
operating ratio was 101% and a ratio in excess of 100% is considered
unusual. For 1998, PACO has two ratios outside its usual value, one of which
is caused by more than adequate investment income and the other related to
change in premium. PICO and PACO are unaware of any increased regulatory
scrutiny as a result of their 1998 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,
Nevada, 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, 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, Nevada 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.
26
<PAGE>
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, New Mexico and Nevada, having a book value
as of December 31, 1998 of $55.8 million, $16.1 million, $7.2 million, $0.3
million, $3.7 million and $0.2 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,
Nevada, 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, Nevada, 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 1998, PACO wrote $0.8
million in life and health premiums in California and Arizona combined.
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
27
<PAGE>
reductions. No material assessments have been made on the Company's insurance
subsidiaries since prior to December 31, 1990. The Company was assessed 2%
of gross written premium in the state of Florida in 1998.
COMPETITION
The workers' compensation insurance industry is highly competitive. In most
states in which the Company operates, the Company's single largest competitor in
its targeted agricultural markets is the applicable state fund. More recently,
the Company has faced increased competition from alternative risk funding
arrangements such as self-insurance or captive insurance programs. Captive
insurance companies are insurance or reinsurance companies in which an insured,
a group of insureds or an insurance agent 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. When the Company commences operations in
Nevada in July 1999, rates will be set by the Nevada DOI and the Company expects
competition to be based on service and dividends to policyholders. 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.
The Company has entered into arrangements with two nationwide reinsurance
companies which enable the Company to cause those companies to write qualifying
workers' compensation insurance in states where the Company is not licensed and
cede virtually all of the premiums and related risk to the Company. Under the
arrangements, the Company is responsible for ensuring the writing carrier's
compliance with its filed rating plans and the payment of claims in accordance
with applicable state insurance laws. In this regard, the Company operates
under the indirect regulation of the Departments of Insurance in these several
states.
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, Mr. James M. Hannah and Mr. James J.
Muza 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 44.
28
<PAGE>
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 50.
Mr. Muza is a Vice President and Chief Actuary of PICO and is responsible
for rate making and reserve setting functions. Mr. Muza joined the Company in
July 1998 following 15 years with California Casualty Insurance Company. Mr.
Muza is 45.
EMPLOYEES
As of December 31, 1998, the Company employed 309 full-time employees
including 61 in its agency and TPA operations, 222 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
35,000 square feet of office space leased through April 2000, are located in
Pasadena, California. The Company is currently evaluating various alternatives
for its headquarters office after its current lease expires. In addition, the
Company maintains 22 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 material 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 1998.
29
<PAGE>
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 and
1998 were as follows:
<TABLE>
<CAPTION>
High Low
---- ---
<S> <C> <C>
Fourth Quarter 1997 (1) 25.250 21.250
First Quarter 1998 24.250 22.625
Second Quarter 1998 25.625 19.375
Third Quarter 1998 22.000 6.750
Fourth Quarter 1998 11.875 6.875
</TABLE>
- ------------
(1) From October 24, 1997 through December 31, 1997
HOLDERS OF RECORD
As of March 15, 1999, the Common Stock was held of record by 216 holders.
The Company estimates that the number of beneficial holders of the Common Stock
as of such date exceeded 800.
DIVIDENDS
The Company did not pay cash dividends to its stockholders prior to the
first quarter of 1998. Since the first quarter of 1998, the Company has
declared and paid quarterly dividends of $0.04 per share of Common Stock. The
most recent dividend is payable to stockholders of record on March 15, 1999.
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 continue to
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.
30
<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, 1998, are derived from the consolidated financial
statements of the Company, which financial statements have been audited by KPMG
LLP, independent certified public accountants. The consolidated financial
statements as of December 31, 1998 and 1997 and for each of the years in the
three-year period ended December 31, 1998, 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,
------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Gross premiums written....................... $152,448 $100,797 $63,606 $46,762 $53,545
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Net premiums earned:
Workers' compensation..................... $127,997 $91,957 $54,563 $44,224 $50,977
Group medical and life.................... 773 878 941 307 312
Commissions.................................. 3,234 3,434 4,213 3,964 4,299
Net investment income........................ 9,540 5,582 4,701 4,817 4,536
Net realized investment gains................ 1,706 172 444 37 -
Other........................................ 842 1,047 896 1,569 1,712
--------------------------------------------------------------------------
Total revenue............................. $144,092 $103,070 $65,758 $54,918 $61,836
Losses and loss adjustment expenses incurred.
114,483 68,107 33,900 29,363 28,618
Dividends provided for policyholders......... 677 (2,713) 1,628 3,438 6,221
Operating expenses........................... 37,636 30,741 25,480 22,608 20,720
--------------------------------------------------------------------------
Total expenses............................ $152,796 $96,135 $61,008 $55,409 $55,559
Income (loss) before taxes................... (8,704) 6,935 4,750 (491) 6,277
Income tax expense (benefit)................. (3,827) 1,776 827 (791) 1,572
--------------------------------------------------------------------------
Net income (loss)......................... ($4,877) $5,159 $3,923 $300 $4,705
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Earnings (loss) per share (1)................ ($0.78) $1.88 $2.07 $0.16 $1.54
Weighted average shares outstanding (1)...... 6,228,479 2,737,065 1,896,464 1,850,956 3,057,088
Earnings (loss) per share - assuming
dilution(1)............................... ($0.78) $1.11 $1.00 $0.08 $1.23
Weighted average shares outstanding -
assuming dilution (1)..................... 6,228,479 4,664,511 3,910,715 3,763,059 3,827,487
</TABLE>
31
<PAGE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Investments (2)..................... $177,623 $137,864 $86,792 $83,991 $83,084
Total assets........................ 254,948 188,264 125,127 118,906 117,297
Unpaid losses and loss adjustment expenses 136,316 77,784 55,720 57,049 60,473
Notes payable....................... 2,667 456 11,279 10,824 4,205
Total liabilities................... 180,912 103,444 99,151 93,301 90,384
Preferred Stock (convertible and
redeemable)...................... - - 21,402 19,501 18,918
Net stockholders' equity............ 74,036 84,820 4,574 6,104 7,995
<CAPTION>
AS OF AND FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
PICO AND PACO GAAP RATIOS:
Loss ratio.......................... 88.9% 73.4% 61.1% 65.9% 55.8%
Expense ratio....................... 26.4 26.9 32.1 32.3 26.7
Policyholder dividend ratio......... 0.5 (2.9) 2.9 7.7 12.1
-----------------------------------------------------------------
Combined ratio................... 115.8% 97.4% 96.1% 105.9% 94.6%
-----------------------------------------------------------------
-----------------------------------------------------------------
PICO STATUTORY DATA:
Statutory net income (loss)......... ($7,182) $6,037 $ 5,051 $ 3,175 $ 5,217
Statutory surplus................... 49,870 45,822 31,135 25,992 19,381
Premiums/surplus.................... 2.7x 2.1x 1.9x 1.7x 2.6x
Loss ratio.......................... 89.2% 73.8% 61.0% 65.9% 55.9%
Expense ratio....................... 25.0 25.9 29.4 30.9 25.9
Policyholder dividend ratio......... 0.5 (3.0) 3.0 7.8 12.2
-----------------------------------------------------------------
Combined ratio................... 114.7% 96.7% 93.4% 104.6% 94.0%
-----------------------------------------------------------------
-----------------------------------------------------------------
OTHER DATA:
Number of PICO policies
(period-end)....................... 10,867 8,579 6,481 4,041 2,227
Number of Company employees
(period-end)....................... 309 264 242 237 272
PICO Estimated Annual Premium
(period-end)(3).................. $121,230 $90,526 $61,316 $41,176 $41,929
</TABLE>
(footnotes follow on next page)
32
<PAGE>
(1) See Note 1 of Notes to Consolidated Financial Statements for a description
of the calculation of weighted average shares outstanding and earnings
(loss) per share.
(2) 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, 1997 and 1998 are reflected at market value.
(3) "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 have been 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.
33
<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,
------------------------
1998 1997 1996
---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Gross premiums written............................................... $151,675 $99,919 $62,665
Net premiums earned.................................................. $127,997 $91,957 $54,563
Policyholder persistency rate........................................ 73.0% 83.5% 86.8%
Number of policies (period-end)...................................... 10,867 8,579 6,481
</TABLE>
RESULTS OF OPERATIONS
1998 COMPARED TO 1997
GROSS PREMIUMS WRITTEN. The Company's gross premiums written for 1998
increased 51.2% to $152.4 million from $100.8 million in 1997. The growth in
premiums written was primarily attributable to the net addition of new
policyholders, increased policyholder payrolls and rate increases in California,
particularly in the second half of the year. These increases were partially
offset by lower premium rates from increased price competition, especially in
the first two quarters of the year. The premium growth was particularly strong
in Texas. California continued to account for approximately 70% of gross
premiums written.
NET PREMIUMS EARNED. For the reasons described above for gross premiums
written, the Company's net premiums earned for 1998 increased 38.7% to
$128.8 million from $92.8 million in 1997. The Company's net premiums earned
increased at a lower rate than gross written premiums because of the impact of
premiums ceded of $14.4 million in the fourth quarter under the Reliance
reinsurance arrangement.
COMMISSION INCOME. Commission income decreased slightly to $3.2 million for
1998 from $3.4 million for 1997. The decrease was primarily the result of
decreased workers' compensation premiums placed with carriers other than PICO, 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 70.9% to
$9.5 million for 1998 from $5.6 million for 1997. 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 of 1997 from the
Company's initial public offering. Average invested assets increased to
$156.9 million for 1998 from $110.6 million for 1997. The Company's average
yield on its portfolio was 6.1% in 1998 and 5.0% in 1997. 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.
NET REALIZED INVESTMENT GAINS. The Company had net realized investment
gains of $1.7 million for 1998 compared to $0.2 million for 1997. The increase
is a result of a tax planning strategy to reposition a portion of the investment
portfolio from tax exempt to taxable securities.
34
<PAGE>
OTHER INCOME. Other income decreased $0.2 million to $0.8 million for 1998
from $1.0 million for 1997.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's net loss ratio
for 1998 increased to 88.9% from 73.4% for 1997. The increase in the 1998 loss
ratio is due to higher 1998 losses on the Company's California book of business
and to a reserving action taken by the Company in the second quarter of 1998 to
increase loss reserves on the 1997 and 1998 accident years by a total of $14.8
million. In the first two quarters of 1998, the Company saw reserve development
on the 1997 accident year for California business in excess of its expectations,
given prior year reserving trends. The Company's second quarter 1998 reserve
adjustment implied a pricing deficiency for the 1997 and six month 1998 periods.
The Company began to address this pricing deficiency early in 1998 through rate
increases and non-renewal activity.
DIVIDENDS PROVIDED FOR POLICYHOLDERS. Dividends provided for policyholders
as a percentage of premiums earned for 1998 was 0.5% compared to (2.9%) for
1997. 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. In 1997, the prior year accrual was
reduced by $2.7 million. During 1998, the Company paid $0.3 million in
policyholder dividends related to certain Arizona policies in which the loss
experience developed better than anticipated and accrued a small amount for
future dividend obligations.
OPERATING EXPENSES. Operating expenses increased 22.4% to $37.6 million for
1998 from $30.7 million for 1997 due in part to a net $4.7 million increase in
variable expenses, principally commissions paid to unaffiliated agencies and a
$1.8 million increase in personnel costs related to the growth in the Company's
insurance operations. Variable expenses include the benefit of $3.0 million in
ceding commissions received in the fourth quarter of 1998 in conjunction with
the Reliance reinsurance arrangement.
INCOME TAXES. Income tax benefit for 1998 was $3.8 million compared to an
expense of $1.8 million for 1997. The effective combined income tax rates for
1998 and 1997 were (44.0%) and 25.6%, respectively. These rates vary from the
combined statutory rate due to the investment income on tax-exempt securities.
NET INCOME (LOSS). Net loss for 1998 was $4.9 million compared to net income
of $5.2 million in 1997. The 1998 net loss is primarily attributable to actions
taken by the Company to increase loss reserves on the 1997 and 1998 accident
years by a total of $14.8 million in the second quarter of 1998.
1997 COMPARED TO 1996
GROSS PREMIUMS WRITTEN. The Company's gross premiums written for 1997
increased 58.5% to $100.8 million from $63.6 million in 1996. The growth in
gross 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.
NET PREMIUMS EARNED. For the reasons described above for gross premiums
written, the Company's net premiums earned for 1997 increased 67.3% to
$92.8 million from $55.5 million in 1996.
35
<PAGE>
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 net loss ratio
for 1997 increased to 73.4% from 61.1% for 1996. The Company's net 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 net loss ratio in 1997 was offset in part by a reduction in the
Company's policyholder dividend accrual.
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.
36
<PAGE>
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 the sale of its capital stock and income from its investment portfolio.
PAULA Financial's principal uses of funds are capital contributions to its
subsidiaries, payment of operating expenses, investments in new ventures,
dividends to its stockholders and repurchase of Company common stock.
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, 1998, PAULA Financial
would be able to receive $5.4 million in dividends in 1999 from its insurance
subsidiaries without obtaining prior regulatory approval from the California
DOI. No dividends were paid by the insurance subsidiaries to PAULA Financial
during 1998.
Management believes that the remaining proceeds from the Company's initial
public offering held at the parent company level, 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 the next twelve months.
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, 1999, $8.1 million was
outstanding under this facility. The use of the credit facility was for
repurchase of the Company's common stock and investments in new ventures. On
December 31, 1999, 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 installments and maturing on December 31, 2001. The Company is
currently in discussions with the bank to renew and extend the Credit Agreement
at the end of its initial term in December 1999. 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. As of December 31, 1998, the Company was in compliance with its debt
covenants.
37
<PAGE>
On August 12, 1998, the Company announced the approval of the Board of
Directors of a 500,000 share stock repurchase program. On October 29, 1998, the
Board authorized an additional 500,000 shares bringing the total authorization
under the program to 1,000,000 shares. The shares are expected to be
repurchased over the next 30 months through open market and/or privately
negotiated purchases. As of December 31, 1998, the Company had repurchased
409,800 shares at an average price of $7.84 per share.
In early 1999, the Company made an investment in the recently formed Altus
Insurance Holdings, LLC, the parent company of Altus Casualty Company Ltd.
("Altus"), a specialty workers' compensation insurance company. The Company
made a capital commitment of $5.5 million and has the option to acquire
additional equity and provide quota-share reinsurance to Altus through PICO.
In March 1999, the Company announced that Pan Am had agreed to purchase the
insurance agency assets of the Sacramento and Stockton, California offices of
CAPAX for approximately $3.2 million. The Company will fund the transaction
with $2.1 million in cash plus $1.1 million in CAPAX securities which the
Company currently holds. The transaction is expected to close in April, subject
to certain conditions.
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, 1998, the
carrying value of the Company's fixed maturity securities portfolio was
$170.8 million and 92.5% 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,
1998, securities with a book value of $83.3 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.
38
<PAGE>
YEAR 2000 CONSIDERATIONS
THE FOLLOWING IS A YEAR 2000 READINESS DISCLOSURE STATEMENT.
OVERVIEW. The Company's Year 2000 Project (the "Project") is steadily
proceeding. The Project involves resolving the potential impact of the Year
2000 on the processing of date-sensitive information by the Company's internal
computer systems and equipment and by the computer systems and equipment
utilized by third parties with whom the Company maintains material
relationships.
The Company believes that it has identified substantially all of its own
information technology systems ("IT Systems") and non-information technology
(embedded technology) systems ("Non-IT Systems") which require modification in
order to become Year 2000 compliant. In addition, the Company believes that it
has identified those third parties whose inability to handle date-sensitive
processing could materially and adversely impact the Company if corrective
action is not taken in a timely manner.
The Company has identified five major internal IT Systems which require
attention as part of the Project: General Ledger ("GL"), Agency Operations
("Agency"), Underwriting, which includes policy issuance, maintenance of policy
records, billing and auditing ("Underwriting"), Claims Adjudication ("Claims")
and Third Party Administration, which includes life insurance and accident and
health insurance policy issuance, maintenance and billing operations ("TPA").
The Company's approach to each of these systems differs based on the Company's
use of the system and whether the system was purchased from a third party or
developed in-house.
GL SYSTEM. The Company has completed in-house construction and testing of a
new GL system which is Year 2000 compliant.
AGENCY SYSTEM. The Company has completed the process of out-sourcing its
Agency System needs to James G. Parker Insurance Associates ("Parker"), one of
the founders of the PAULA Trading Company. Parker utilizes an agency software
system provided by a third party vendor which is Year 2000 compliant according
to a written statement received from the vendor.
UNDERWRITING SYSTEM. The Company's in-house Underwriting system is not yet
fully Year 2000 compliant. The Company has therefore chosen to make its
existing Underwriting system Year 2000 compliant using a technique known as
"windowing," which is a solution that will work for many years, but not
permanently. Windowing is faster and requires less testing than permanent
solutions. The Company believes permanent solutions are not necessary in light
of the new system under development.
The Company has purchased a software tool to perform the windowing project
and has retained several consultants familiar with the software tool to perform
the project. The consultants will work under the supervision of the Company's
information services staff. The Company has identified the programs to be
modified, prioritized those programs based on their earliest expected date of
failure and has begun using the software tool to perform the correction to the
programs. The Company has prepared a testing environment to perform the
corrective procedures and to test the results in a realistic data environment.
39
<PAGE>
Although the windowing project is proceeding more slowly than anticipated,
the Company expects the windowing project, involving correction and testing of
all necessary Underwriting system programs, to be completed during the end of
the second quarter of 1999. This represents a delay of approximately 45 days
from the Company's prior disclosures.
The Company is currently constructing a new in-house Underwriting system
that will be Year 2000 compliant, but this new system is not expected to address
the Company's Year 2000 issues in a timely fashion.
CLAIMS SYSTEM. The Company's Claims system is licensed from a third party
vendor. The Claims system uses two distinct products, one for claims telephonic
reporting and one for claims adjudication. The Company has added custom
features to the standard version of each of the products provided by the vendor.
The Company's current version of these two system products are not Year 2000
compliant.
The Company has received delivery of a standard upgrade to its Claims
adjudication system which is Year 2000 compliant, according to the vendor,
which is currently being tested by the Company. The Company and the vendor
have identified customized features which must be added to the upgraded
Claims adjudication system and the vendor has agreed to perform the
customization. The Company expects the customization to be completed during
June 1999 and final installation, testing and training to be complete by
early in the third quarter of 1999. This represents a delay of approximately
45 days from the Company's prior disclosures.
The Company has determined that it cannot modify the programs of the
existing version of the Claims system to make it Year 2000 compliant.
However, the Company does not believe that continuing to utilize the non-Year
2000 compliant version of the Claims adjudication system through the third
quarter of 1999 will materially impair operations. The Company expects to
implement the customized upgrade early during the third quarter. If
necessary, the Company will commence using the "standard" version of the
claims system upgrade it has already received and installed.
The Company's Claims telephonic reporting system will not be made Year
2000 compliant by the vendor. As scheduled, the Company has modified its
Claims telephonic reporting system to properly process claims during 1999,
but this modification will not allow claims processing in 2000. The Company
has chosen to move to a vendor maintained, Year 2000 compliant,
mainframe-based telephonic reporting system. This is expected to be
effective during the middle of the second quarter of 1999, a delay of
approximately 45 days from the Company's prior disclosures.
TPA SYSTEM. The Company has licensed a third party claims administration
software product that the Company uses for all TPA functions. The Company has
received from the vendor a Year 2000 upgrade to the version used by the Company
which will be installed and tested by the end of the first quarter 1999, on
schedule.
NON-IT SYSTEMS. The Company has addressed its primary Year 2000 issues
relating to Non-IT Systems by purchasing a new IBM mainframe computer to run its
IT Systems. The Company intends to purchase a new second mainframe from IBM to
extend the Company's computing capacity during the second quarter of 1999. At
that time, the Company's old IBM mainframe will be relegated to a back-up role.
The Company has obtained satisfactory evidence that the operating system of the
Company's new mainframe computers are Year 2000 compliant from IBM's Internet
website.
40
<PAGE>
The Company is continuing to inventory its other Non-IT Systems as part of
the Project. These systems include the Company's personal computer network,
telephone switching equipment and other office equipment. Once these systems
are inventoried, the Company will prioritize the impact of their failure due to
Year 2000 issues and then begin testing and correcting to bring them into Year
2000 compliance. The Company expects the inventory and prioritization phases
to be completed by the end of the first quarter of 1999 and corrective action to
be completed by the end of the second quarter of 1999.
The Company does not believe that it is materially exposed to any
Company-specific Non-IT System Year 2000 issues other than those addressed by
purchasing new mainframe computers due to the nature of the Company's
business. The Company has no material property, plant or equipment.
THIRD PARTY YEAR 2000 ISSUES. The Company has made good progress in
obtaining Year 2000 compliance assurances from third parties with whom the
Company has material trading arrangements, or upon whom the Company relies to
a material extent in its normal operations. The Company will continue working
to satisfy itself that each third party performing important functions for
the Company has taken necessary measures to ensure that their IT and Non-IT
Systems will be Year 2000 compliant in a timely manner. The Company believes
it will suffer no material disruption of its operations from its trading
partners' Year 2000 issues. The Company has not, and will not, attempt to
assess the Year 2000 compliance of regulatory authorities, statistical rating
bureaus or public utilities as the Company cannot cause such entities to
increase their efforts to become Year 2000 compliant.
COSTS. The total cost associated with required program modifications,
software upgrades and equipment purchases to become Year 2000 compliant is
not expected to be material to the Company's financial position, results of
operations or cash flows. The Company's total budget for its Year 2000
compliance program, which began in 1997, is $875,000. This estimate does not
include the Company's potential share of Year 2000 costs that may be incurred
by the Company's trading partners which the Company may choose to bear to
increase the likelihood of their timely Year 2000 compliance.
Of the total budget amount, $80,000 was spent in 1997, $300,000 was
spent in 1998, and $495,000 will be spent during 1999. The costs associated
with the Company's new Underwriting System are not included in the Year 2000
budget. The Company is utilizing cash flow from operations to fund its Year
2000 budget needs.
CONTINGENCIES. The Company continues to review its alternatives in the
event that it is not able to complete its Year 2000 compliance plans in a timely
manner. These alternatives include, without limitation, purchasing third party
insurance company software packages, acceleration of the construction of the
Company's new Underwriting system and outsourcing the non-compliant Company
functions to third parties. Each of these alternatives is less advantageous to
the Company than its current Year 2000 compliance plan and, if required, could
have an adverse effect on the Company's financial position, results of
operations or cash flows.
RISKS. The failure to correct a material Year 2000 problem could result in
an interruption in, or a failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, financial condition and cash flow. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the
uncertainty of the Year 2000 readiness of regulatory authorities, statistical
rating bureaus and public utilities, the Company is unable to determine at
41
<PAGE>
this time whether the consequences of Year 2000 failures will have a material
impact on the Company's results of operations, financial condition or cash
flows. The Company believes the Project will significantly reduce the Company's
level of uncertainty about the Year 2000 problem.
CONSULTANTS. The Company has not used the services of independent Year
2000 consultants to assess its IT System and Non-IT System needs, although the
Company is utilizing the services of independent consultants in its Underwriting
System windowing project and in constructing its new Underwriting system. The
Company continues to review its Year 2000 program with its outside auditors on a
regular basis.
NEW ACCOUNTING STANDARDS
During the first quarter of 1998, the Company adopted the provisions of
Financial Accounting Standards Board ("FASB") Statement No. 130, "Reporting
Comprehensive Income" ("SFAS 130"). 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. In accordance
with the reporting requirements of SFAS 130, the Company has included
consolidated statements of comprehensive income in the accompanying
consolidated financial statements.
Also, during the first quarter of 1998, the Company adopted the
provisions of FASB Statement 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. Based on the
guidance included in SFAS 131, the Company has determined that it operates in
a single segment: the production, underwriting and servicing of workers'
compensation and accident and health insurance.
In 1998, the American Institute of Certified Accountants issued
Statement of Position No. 98-1, "Accounting for Costs of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 addresses the
accounting for various costs associated with the development of software for
internal use. SOP 98-1 requires that costs incurred in the Preliminary
Project and Post-Implementation/Operation Stages be expenses as incurred
while certain costs incurred in the Application Development Stage are to be
capitalized. The Company adopted the provisions of SOP 98-1 effective
January 1, 1998.
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.
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for
fiscal years beginning after June 15, 1999 and establishes standards for the
reporting for derivative instruments. It requires changes in the fair value
of a derivative instrument and the changes in fair value of assets or
liabilities hedged by that instrument to be included in income. To the
extent that the hedge transaction is effective, income is equally offset by
both investments. Currently the changes in fair value of
42
<PAGE>
derivative instruments and hedged items are reported in net unrealized gain
(loss) on securities. The Company has not adopted SFAS 133. However, the
effect of adoption on the consolidated financial statements at December 31,
1998 would not be material.
FORWARD-LOOKING STATEMENTS
In connection with, and because it desires to take advantage of the "safe
harbor" provisions of the Private Securities Litigation Reform Act of 1995, the
Company cautions readers to recognize the existence of certain forward-looking
statements in this Form 10-K and in any other statement made by, or on behalf
of, the Company, whether or not in future filings with the Securities and
Exchange Commission. Forward-looking statements are statements not based on
historical information and which relate to future operations, strategies,
financial results or other developments. Some forward-looking statements may be
identified by the use of terms such as "expects," "believes," "anticipates,"
"intends," or "judgment." Forward-looking statements are necessarily based upon
estimates and assumptions that are inherently subject to significant business,
economic and competitive uncertainties, many of which are beyond the Company's
control and many of which, with respect to future business decisions, are
subject to change. Examples of such uncertainties and contingencies include,
among other important factors, those affecting the insurance industry in
general, such as the economic and interest rate environment, legislative and
regulatory developments and market pricing and competitive trends, and those
relating specifically to the Company and its businesses, such as the level of
its insurance premiums and fee income, the claims experience of its insurance
products, the performance of its investment portfolio, the successful completion
by the Company of its Year 2000 compliance program, acquisitions of companies or
blocks of business, and the ratings by major rating organizations of its
insurance subsidiaries. These uncertainties and contingencies can affect actual
results and could cause actual results to differ materially from those expressed
in any forward-looking statements made by, or on behalf of, the Company. The
Company disclaims any obligation to update forward-looking information.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The Company's consolidated balance sheet includes a substantial amount of
assets and liabilities whose fair values are subject to market risks. Due to
the Company's significant level of investments in fixed maturity securities
(bonds), interest rate risk represents the largest market risk factor affecting
the Company's consolidated financial position, although the Company also has
limited exposure to equity price risk. The following sections address the
significant market risks associated with the Company's financial activities as
of December 31, 1998.
Caution should be used in evaluating the Company's overall market risk from
the information below, since actual results could differ materially from the
estimates and assumptions used below and because unpaid losses and loss
adjustment expenses and reinsurance recoverables on unpaid losses and loss
adjustment expenses are not included in the hypothetical effects of changes in
market conditions discussed below. As of December 31, 1998 unpaid losses and
loss adjustment expenses represent 75% of the Company's total liabilities and
reinsurance recoverables on unpaid losses and loss adjustment expenses
represents 10% of the Company's total assets.
43
<PAGE>
INTEREST RATE RISK
The Company employees a conservative investment strategy emphasizing
asset quality and the matching of maturities of its fixed maturity
investments to the Company's anticipated claim payments, expenditures and
other liabilities. The Company's fixed maturity portfolio includes
investments in CMO's which are exposed to accelerated prepayment risk
generally caused by interest rate movements. As of December 31, 1998, the
Company's fixed maturity portfolio represented 67% of the Company's total
assets and 96% of the Company's invested assets. 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. The Company does not utilize stand-alone
derivatives to manage interest rate risks.
The Company has historically utilized a moderate level of corporate
borrowings and debt. The Company strives to maintain the highest credit
ratings so that the cost of debt is minimized. As of December 31, 1998,
notes payable and notes payable to bank account for 1% of total liabilities.
The Company's fixed maturity investments, including CMOs, notes payable
and notes payable to bank are subject to interest rate risk. Increases and
decreases in prevailing interest rates generally translate into decreases and
increases in fair values of those instruments. Additionally, fair values of
interest rate sensitive instruments may be affected by the credit worthiness
of the issuer, CMO prepayment rates, relative values of alternative
investments, the liquidity of the instrument and other general market
conditions.
The table below summarizes the estimated effects of hypothetical
increases and decreases in interest rates. It is assumed that the changes
occur immediately and uniformly to each category of instrument containing
interest rate risks. The hypothetical changes in market interest rates
reflect what could be deemed best or worst case scenarios. The hypothetical
fair values are based upon the same prepayment assumptions utilized in
computing fair values as of December 31, 1998. Should interest rates
decline, mortgage holders are more likely to refinance existing mortgages at
lower rates. Acceleration of repayments could adversely affect future
investment income, if reinvestment of the cash received from repayments is in
lower yielding securities. Such changes in prepayment rates are not taken
into account in the following disclosures.
44
<PAGE>
<TABLE>
<CAPTION>
INTEREST RATE RISK
(in thousands)
---------------------------------------------------------------------------------
Hypothetical
Estimated Fair Percentage
Value after Increase
Hypothetical Change in Hypothetical (Decrease) in
Fair Value at Interest Rate Change in Stockholders'
December 31, 1998 (bp=basis pts.) Interest Rate Equity
---------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Assets:
United States government agencies
and authorities $13,766 100 bp decrease $13,980 $214
100 bp increase 13,559 (207)
200 bp increase 13,356 (410)
States, municipalities and political
subdivisions $24,346 100 bp decrease $25,572 $1,226
100 bp increase 23,107 (1,239)
200 bp increase 21,910 (2,436)
Corporate securities $79,625 100 bp decrease $83,180 $3,555
100 bp increase 76,287 (3,338)
200 bp increase 73,114 (6,511)
Collateralized mortgage obligations
and other asset backed securities $53,055 100 bp decrease $54,478 $1,423
100 bp increase 50,978 (2,077)
200 bp increase 48,818 (4,237)
Liabilities:
Notes payable $67 100 bp decrease $67 -
100 bp increase 67 -
200 bp increase 67 -
Notes payable to bank $2,600 100 bp decrease $2,600 -
100 bp increase 2,600 -
200 bp increase 2,600 -
</TABLE>
The interest rate on the Company's note payable to bank is adjustable based
on certain market indices.
45
<PAGE>
EQUITY PRICE RISK
The Company generally does not invest in equity securities for trading
purposes. As of December 31, 1998, equity securities represent 2% of the
Company's total assets. The carrying values of publicly traded investments
subject to equity price risks are based on quoted market prices as of the
balance sheet date. Market prices are subject to fluctuation and,
consequently, the amount realized in the subsequent sale of the investment
may significantly differ from the reported market value. Fluctuation in the
market price of a security may result from perceived changes in the
underlying economic characteristics of the investee, the relative prices of
alternative investments and general market conditions. Furthermore, amounts
realized in the sale of a particular security may be affected by the relative
quantity of the security being sold. The carrying values of privately held
investments are subject to equity price risks which are based on the
foregoing market price considerations and also on the underlying value of the
issuer and other buyer's perceptions of such value, as well as lack of
liquidity considerations.
The table below summarizes the Company's equity price risks as of
December 31, 1998 and shows the effects of a hypothetical 10% increase and
10% decrease in the market prices as of December 31, 1998. The selected
hypothetical change does not reflect what could be considered the best or
worst case scenarios.
<TABLE>
<CAPTION>
EQUITY PRICE RISK
(in thousands)
---------------------------------------------------------------------------------
Hypothetical
Percentage
Estimated Fair Increase
Value after (Decrease) in
Fair Value at Hypothetical Price Hypothetical Stockholders'
December 31, 1998 Change Price Change Equity
---------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Preferred stock $1,040 10% increase $1,144 $104
10% decrease 936 (104)
Common stock $3,219 10% increase $3,541 $322
10% decrease 2,897 (322)
</TABLE>
46
<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, 1998 and 1997................................ F-3
Consolidated Statements of Operations for each of the three years in the period ended
December 31, 1998........................................................................ F-5
Consolidated Statements of Comprehensive Income (Loss) for each of the three years in the
period ended December 31, 1998........................................................... F-6
Consolidated Statements of Stockholders' Equity for each of the three years in the period
ended December 31, 1998.................................................................. F-7
Consolidated Statements of Cash Flows for each of the three years in the period ended
December 31, 1998........................................................................ F-9
Notes to Consolidated Financial Statements.................................................. F-11
</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, 1998 and 1997 and the related
consolidated statements of operations, comprehensive income (loss),
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 1998. 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, 1998 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, 1998 in conformity with generally
accepted accounting principles.
/s/ KPMG LLP
Los Angeles, California
March 2, 1999
F-2
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
---- ----
<S> <C> <C>
Investments:
Fixed maturities, available-for-sale, at market (amortized cost
$171,379 and $112,294 at December 31, 1998 and 1997,
respectively).................................................... $170,792 $114,525
Preferred stock, at market (cost $999 and $3,019 at December 31,
1998 and 1997, respectively)..................................... 1,040 3,112
Common stock, at market (cost $3,252 and $5,546 at
December 31, 1998 and 1997, respectively)........................ 3,219 5,545
Invested cash, at cost (approximates market)........................ 2,572 14,682
------------- --------------
Total investments.............................................. $177,623 $137,864
------------- --------------
Cash, unrestricted..................................................... 2,747 3,279
Cash, restricted....................................................... 1,398 1,491
Accrued investment income.............................................. 2,613 1,819
Receivables:
Accounts receivable, net of allowance for uncollectible accounts
($901 and $600 at December 31, 1998 and 1997, respectively)...... 17,800 16,607
Unbilled premiums................................................... 9,046 7,713
Reinsurance recoverable on paid losses and loss adjustment
expenses......................................................... 715 -
Reinsurance recoverable on unpaid losses and loss adjustment
expenses......................................................... 25,137 6,394
Income taxes recoverable............................................ 1,939 1,579
Other............................................................... 740 304
------------- --------------
Total receivables.............................................. $55,377 $32,597
------------- --------------
Property and equipment, at cost:
Office furniture, fixtures and equipment............................ 8,763 7,395
Automobiles......................................................... 851 707
Leasehold improvements.............................................. 202 221
------------- --------------
9,816 8,323
Less accumulated depreciation....................................... (6,941) (6,152)
------------- --------------
Net property and equipment..................................... $2,875 $2,171
------------- --------------
Other assets........................................................... 4,562 4,328
Excess of cost over net assets acquired, net........................... 1,447 1,468
Deferred income taxes.................................................. 6,306 3,247
------------- --------------
$254,948 $188,264
------------- --------------
------------- --------------
</TABLE>
(Continued)
F-3
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS, CONTINUED
(DOLLARS IN THOUSANDS)
LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1998 1997
---- ----
<S> <C> <C>
Unpaid losses and loss adjustment expenses............................. $136,316 $77,784
Unearned premiums...................................................... 20,234 15,390
Accrued policyholder dividends......................................... 335 -
Due to underwriters and assureds....................................... 1,930 2,967
Reinsurance payable.................................................... 7,855 819
Accounts payable and accrued expenses.................................. 11,575 6,028
Notes payable.......................................................... 67 456
Note payable to bank................................................... 2,600 -
------------ ------------
$180,912 $103,444
------------ ------------
Stockholders' equity:
Preferred stock, $0.01 par value. Authorized 4,058,823 shares; none
issued and outstanding........................................... $ - $ -
Common stock, $0.01 par value. Authorized 15,000,000 shares; issued
6,338,815 shares and 6,321,177 shares at December 31, 1998 and
1997, respectively............................................... 63 63
Additional paid-in capital.......................................... 67,386 67,176
Retained earnings................................................... 10,182 16,048
Accumulated other comprehensive income (loss):
Net unrealized gain (loss) on investments........................ (382) 1,533
------------ ------------
77,249 84,820
Less:
Treasury stock, at cost (409,800 shares at December 31, 1998).... (3,213) -
------------ ------------
Net stockholders' equity....................................... 74,036 84,820
Commitments and contingencies
------------ ------------
$254,948 $188,264
------------ ------------
------------ ------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Income:
Net premiums earned:
Workers' compensation........................ $127,997 $91,957 $54,563
Group medical and life....................... 773 878 941
Commissions..................................... 3,234 3,434 4,213
Net investment income........................... 9,540 5,582 4,701
Net realized investment gains................... 1,706 172 444
Other........................................... 842 1,047 896
------------- ------------ -----------
$144,092 $103,070 $65,758
------------- ------------ -----------
Expenses:
Losses and loss adjustment expenses incurred.... 114,483 68,107 33,900
Dividends provided for policyholders............ 677 (2,713) 1,628
Operating....................................... 37,636 30,741 25,480
------------- ------------ -----------
$152,796 $96,135 $61,008
------------- ------------ -----------
Income (loss) before income tax
expense (benefit).............................. (8,704) 6,935 4,750
Income tax expense (benefit)....................... (3,827) 1,776 827
------------- ------------ -----------
Net income (loss)....................... ($4,877) $5,159 $3,923
------------- ------------ -----------
------------- ------------ -----------
Earning per share:
Earnings (loss) per share...................... ($0.78) $1.88 $2.07
Earnings (loss) per share - assuming dilution.. ($0.78) $1.11 $1.00
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Net income (loss) ($4,877) $5,159 $3,923
Other comprehensive income (loss), net of tax:
Unrealized holding gains (losses) arising during
period (tax impact: 1998:$517, 1997:
$413, 1996: $197)........................... (1,003) 803 (384)
Reclassifications adjustment for realized gains
(losses) included in net income (loss) (tax
impact: 1998: $470, 1997: $24,
1996: $189)............................... (912) (48) (366)
------------ ---------- ----------
($1,915) $755 ($750)
------------ ---------- ----------
Comprehensive income (loss) ($6,792) $5,914 $3,173
------------ ---------- ----------
------------ ---------- ----------
</TABLE>
See accompanying notes to consolidated financial statements.
F-6
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
NET
UNREALIZED OBLIGATION
ADDITIONAL GAIN (LOSS) ON
NUMBER OF BOOK PAID-IN RETAINED ON TREASURY STOCK HELD
SHARES VALUE CAPITAL EARNINGS INVESTMENTS STOCK BY ESOP
------ ----- ------- -------- ----------- ----- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December
31, 1995............ 2,266,390 $22 $1,414 $16,117 $1,528 ($4,458) ($8,200)
Net income............. - - - 3,923 - - -
Change in carrying value
of preferred stock.. - - - (1,901) - - -
Restricted stock grants 22,500 - 177 - - - -
Restricted stock
forfeitures......... (1,400) - (12) - - - -
Retirement of common
stock............... (132,098) - (10) (1,471) - 1,486 -
Issuance of common stock 12,064 - 179 - - - -
Net change in unrealized
gain on investments
(net of tax)........ - - - - (750) - -
Change in obligation of
stock held by ESOP.. - - - - - - (3,249)
Change in guarantee of
ESOP notes payable.. - - - - - - -
---------------------------------------------------------------------------------------------
Balance at
December 31, 1996.. 2,167,456 $22 $1,748 $16,668 $778 ($2,972) ($11,449)
---------------------------------------------------------------------------------------------
Net income............. - - - 5,159 - - -
Change in carrying value
of preferred stock.. - - - (2,261) - -
Conversion of preferred
stock............... 1,882,354 19 23,641 - - - -
Conversion of warrants. 139,481 1 1,481 (549) - - -
Common stock awards.... 3,256 - 46 - - - -
Restricted stock
forfeitures......... (1,150) - (10) - - - -
Retirement of common
stock............... (270,534) (3) (51) (2,969) - 2,972 -
Issuance of common stock 2,400,314 24 40,321 - - - -
Net change in unrealized
gain on investments
(net of tax)........ - - - - 755 - -
Elimination of
obligation of stock
held by ESOP - - - - - - 11,449
Change in guarantee of
ESOP notes payable.. - - - - - - -
---------------------------------------------------------------------------------------------
Balance at
December 31, 1997.. 6,321,177 $63 $67,176 $16,048 $1,533 $ - $ -
---------------------------------------------------------------------------------------------
<CAPTION>
GUARANTEE OF
NOTES NET
PAYABLE STOCKHOLDERS'
OF ESOP EQUITY
------- ------
<S> <C> <C>
Balance at December
31, 1995............ ($319) $6,104
Net income............. - 3,923
Change in carrying value
of preferred stock.. - (1,901)
Restricted stock grants - 177
Restricted stock
forfeitures......... - (12)
Retirement of common
stock............... - 5
Issuance of common stock - 179
Net change in unrealized
gain on investments
(net of tax)........ - (750)
Change in obligation of
stock held by ESOP.. - (3,249)
Change in guarantee of
ESOP notes payable.. 98 98
-----------------------------
Balance at
December 31, 1996.. ($221) $4,574
-----------------------------
Net income............. - 5,159
Change in carrying value
of preferred stock.. - (2,261)
Conversion of preferred
stock............... - 23,660
Conversion of warrants. - 933
Common stock awards.... - 46
Restricted stock
forfeitures......... - (10)
Retirement of common
stock............... - (51)
Issuance of common stock - 40,345
Net change in unrealized
gain on investments
(net of tax)........ - 755
Elimination of
obligation of stock
held by ESOP - 11,449
Change in guarantee of
ESOP notes payable.. 221 221
-----------------------------
Balance at
December 31, 1997.. $ - $84,820
-----------------------------
</TABLE>
(Continued)
F-7
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY, CONTINUED
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
NET
UNREALIZED OBLIGATION
ADDITIONAL GAIN (LOSS) ON
NUMBER OF BOOK PAID-IN RETAINED ON TREASURY STOCK HELD
SHARES VALUE CAPITAL EARNINGS INVESTMENTS STOCK BY ESOP
------ ----- ------- -------- ----------- ----- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31, 1997.. 6,321,177 $63 $67,176 $16,048 $1,533 $ - $ -
Net loss............... - - - (4,877) - - -
Dividends paid ($0.16
per share).......... - - - (989) - - -
Options exercised,
including tax impact. 16,638 - 202 - - - -
Common stock awards.... 1,000 - 8 - - - -
Repurchase of common
stock............... (409,800) - - - - (3,213) -
Net change in unrealized
gain on investments
(net of tax)........ - - - - (1,915) - -
--------------------------------------------------------------------------------------------
Balance at
December 31, 1998.. 5,929,015 $63 $ 67,386 $10,182 ($382) ($3,213) $ -
--------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------
<CAPTION>
GUARANTEE OF
NOTES NET
PAYABLE STOCKHOLDERS'
OF ESOP EQUITY
------- ------
<S> <C> <C>
Balance at
December 31, 1997.. $ - $84,820
Net loss............... - (4,877)
Dividends paid ($0.16
per share).......... - (989)
Options exercised,
including tax impact. - 202
Common stock awards.... - 8
Repurchase of common
stock............... - (3,213)
Net change in unrealized
gain on investments
(net of tax)........ - (1,915)
-----------------------------
Balance at
December 31, 1998.. $ - $74,036
-----------------------------
-----------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-8
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)................................. ($4,877) $5,159 $3,923
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization.................. 1,522 1,370 1,509
Amortization of fixed maturity premium, net 705 623 797
(Gain) loss on sale of property and equipment.. 27 16 (12)
Gain on sales and calls of equity and fixed
maturities................................... (1,706) (172) (444)
(Increase) decrease in receivables............. (23,574) (14,032) 946
(Increase) decrease in deferred income taxes (2,072) 1,193 (282)
Increase (decrease) in unpaid losses and loss
adjustment expenses.......................... 58,532 22,064 (1,328)
Increase (decrease) in accrued policyholder
dividends.................................... 335 (3,981) (1,027)
Increase (decrease) in accounts payable and
accrued expenses............................. 11,546 3,747 (1,544)
Increase in unearned premiums.................. 4,844 4,735 6,046
Other, net..................................... (226) (861) 80
------------- ------------ ------------
Net cash provided by operating activities. $ 45,056 $19,861 $8,664
------------- ------------ ------------
Cash flows from investing activities:
Proceeds from sale of available for sale fixed
maturities..................................... 81,687 - 17,236
Proceeds from maturities and calls of available for
sale fixed maturities.......................... 8,947 14,840 7,930
Proceeds from sale of preferred stock............. 6,423 - -
Proceeds from sale of common stock................ 2,516 499 -
Proceeds from sale of property and equipment...... 27 1 146
Purchase of common stock.......................... - (5,138) -
Purchase of preferred stock....................... (4,231) (2,013) (1,014)
Purchase of available for sale fixed maturities... (149,112) (47,606) (26,456)
Purchase of property and equipment................ (1,871) (1,126) (1,029)
Purchase of other assets.......................... - (1,189) (703)
Purchase of insurance agency...................... (388) - (38)
------------- ------------ ------------
Net cash used in investing activities..... ($56,002) ($41,732) ($3,928)
------------- ------------ ------------
</TABLE>
(Continued)
F-9
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from financing activities:
Borrowings (repayments) under line of credit
agreement, net................................. $2,600 ($7,490) $1,968
Payments on notes payable......................... (389) (3,350) (1,782)
Issuance of notes payable......................... - 238 269
Dividends paid.................................... (989) - -
Exercise of stock options......................... 202 - -
Sale of common stock.............................. - 41,278 343
Repurchase of common stock........................ (3,213) - -
Retirement of common stock........................ - (60) (1,486)
------------- ------------ ------------
Net cash provided by (used in) financing
activities............................. ($1,789) $30,616 ($688)
------------- ------------ ------------
Net increase (decrease) in cash and
invested cash.......................... (12,735) 8,745 4,048
Cash and invested cash at beginning of period........ 19,452 10,707 6,659
------------- ------------ ------------
Cash and invested cash at end of period.............. $ 6,717 $19,452 $10,707
------------- ------------ ------------
------------- ------------ ------------
</TABLE>
Supplemental schedule of noncash financing activities:
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-10
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER 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, 1998,
California accounted for 72% 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.
In 1998, the Company adopted the provisions of Financial Accounting
Standards Board ("FASB") Statement No. 131, "Disclosures about Segments of an
Enterprise and Related Information ("SFAS 131"). Based on guidance included in
SFAS 131, the Company has determined that it operates in a single segment: the
production, underwriting and servicing of workers' compensation and accident and
health insurance.
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 1998 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, 1998 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
interest 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.
F-11
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER 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.
Certain direct costs associated with the development of software for
internal use are capitalized. Amortization on such amounts is provided on a
straight-line basis over the estimated useful life of the software, generally
five to seven years. Amortization begins when the related project is
substantially complete.
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 $1,286 and
$1,140 at December 31, 1998 and 1997, respectively.
F-12
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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.
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 28%, 46%, and 64% of net written premium for the years
ended December 31, 1998, 1997 and 1996, 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.
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.
F-13
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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.
COMPREHENSIVE INCOME (Loss)
In 1998, the Company adopted the provisions of FASB Statement No. 130,
"Reporting Comprehensive Income" ("SFAS 130"). 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's
only component of other comprehensive income relates to unrealized gains and
losses on investments. In accordance with the provisions of SFAS 130, the
Company has included consolidated statements of comprehensive income (loss) in
the accompanying consolidated financial statements.
EARNINGS PER SHARE ("EPS")
The EPS calculations for the years ended December 31, 1998, 1997 and 1996
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 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,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Shares used in EPS calculation.................. 6,228,479 2,737,065 1,896,464
Convertible preferred stock..................... - 1,526,512 1,882,354
Warrants........................................ - 48,804 40,114
Options......................................... - 352,130 91,783
------------------------------------------
Shares used in EPS - assuming dilution
calculation................................ 6,228,479 4,664,511 3,910,715
------------------------------------------
------------------------------------------
</TABLE>
In loss periods options are excluded from the calculation of EPS-assuming
dilution as the inclusion of such options would have an antidilutive effect.
F-14
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(2) INVESTMENTS
Investments in fixed maturities are substantially all held in investment
grade securities. Fair values were obtained from published securities quotation
services or from asset management professionals retained by the Company.
FIXED MATURITIES
The amortized cost and estimated fair value of investments in fixed
maturities classified as available for sale at December 31, 1998 and 1997 are as
follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
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........................................ $13,445 $321 $- $13,766
Obligations of states and political subdivisions.................... 24,082 337 73 24,346
Corporate securities................................................ 79,927 1,221 1,523 79,625
Collateralized mortgage obligations and other asset
backed securities............................................... 53,925 282 1,152 53,055
--------------------------------------------------------
Total......................................................... $171,379 $2,161 $2,748 $170,792
--------------------------------------------------------
--------------------------------------------------------
</TABLE>
<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>
F-15
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The amortized cost and estimated fair value of fixed maturities classified
as available for sale at December 31, 1998 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...................................................... $7,486 $7,541
Due after one year through five years........................................ 56,024 56,205
Due after five years through ten years....................................... 48,664 48,590
Due after ten years.......................................................... 5,280 5,401
Collateralized mortgage obligations and other asset backed
securities............................................................... 53,925 53,055
------------------------
$171,379 $170,792
------------------------
------------------------
</TABLE>
Fixed maturities with a book value of $83,995 were on deposit with various
regulatory authorities as of December 31, 1998 as required.
PREFERRED STOCK
Unrealized investment gains (losses) on preferred stock at December 31,
1998 and 1997 are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1998 1997
---- ----
<S> <C> <C>
Gross unrealized gains....................................................... $41 $93
Gross unrealized losses...................................................... - -
-----------------
$41 $93
-----------------
-----------------
</TABLE>
COMMON STOCK
Unrealized investment gains (losses) on common stock at December 31, 1998
and 1997 are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1998 1997
---- ----
<S> <C> <C>
Gross unrealized gains....................................................... $38 $-
Gross unrealized losses...................................................... (71) (1)
-----------------
($33) ($1)
-----------------
-----------------
</TABLE>
F-16
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NET INVESTMENT INCOME
Net investment income is summarized as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Interest........................................ $9,396 $5,665 $4,839
Dividends....................................... 500 121 62
----------------------------------
9,896 5,786 4,901
Less investment expenses........................ (356) (204) (200)
----------------------------------
$9,540 $5,582 $4,701
----------------------------------
----------------------------------
</TABLE>
An affiliate of a significant holder of the Company's stock also acts as
one of the Company's investment advisors. Fees paid for such investment services
totaled $244, $160 and $146 in 1998, 1997 and 1996, respectively.
NET REALIZED INVESTMENT GAINS (LOSSES)
Net realized investment gains (losses) are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Fixed maturities:
Gross realized gains......................... $1,863 $ - $449
Gross realized losses........................ (379) (1) (5)
Common stock:
Gross realized gains......................... 222 173 -
Gross realized losses........................ - - -
------------------------------
$1,706 $172 $444
------------------------------
------------------------------
</TABLE>
F-17
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER 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,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Balance at beginning of period.......... $77,784 $55,720 $57,049
Less reinsurance recoverable on
unpaid losses and loss adjustment
expenses............................ 6,394 6,427 6,775
---------------------------------------
Net balance at beginning of period...... $71,390 $49,293 $50,274
---------------------------------------
Incurred related to:
Current period....................... 108,454 66,840 36,554
Prior periods........................ 6,029 1,267 (2,654)
---------------------------------------
Total incurred.................... $114,483 $68,107 $33,900
---------------------------------------
Paid related to:
Current period....................... 34,674 20,809 13,143
Prior periods........................ 40,020 25,201 21,738
---------------------------------------
Total paid........................ $74,694 $46,010 $34,881
---------------------------------------
Net balance at end of period............ 111,179 71,390 49,293
Plus reinsurance recoverable on
unpaid losses and loss adjustment
expenses............................ 25,137 6,394 6,427
---------------------------------------
Balance at end of period................ $136,316 $77,784 $55,720
---------------------------------------
</TABLE>
The unfavorable incurred development for prior periods in 1998 in the
liability for unpaid losses and loss adjustment expenses is due to reserve
development on the 1997 accident year for the California book of business in
excess of what was anticipated given prior year reserving trends.
The favorable incurred development for prior periods in 1996 in the
liability for unpaid losses and loss adjustment expenses relates principally to
reduced claim frequency and stable severity.
F-18
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(4) NOTES PAYABLE
A summary of notes payable at December 31, 1998 and 1997 is as follows:
<TABLE>
<CAPTION>
DECEMBER 31
-----------
1998 1997
---- ----
<S> <C> <C>
Note payable (interest at 8.25% at December 31, 1997, due 1998), unsecured........... $- $50
Note payable (interest at 0.0% at December 31, 1998 and 1997, due 1999),
unsecured.......................................................................... 67 168
Note payable (interest at 0.0% at December 31, 1997, due 1998), secured by common
stock of borrower................................................................. - 238
----------------
$67 $456
----------------
----------------
Aggregate annual commitments under notes payable are as follows at
December 31, 1998:
1999........................................................................ $67
</TABLE>
Total interest paid by the Company on all notes during the years ended
December 31, 1998, 1997 and 1996 was $61, $1,014 and $1,300, respectively.
(5) NOTE PAYABLE TO BANK
On March 31, 1997, the Company entered into a $15,000 unsecured line of
credit with a 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 weighted average interest rate on balances
outstanding at December 31, 1998 was 6.5%. The line of credit imposes certain
financial covenants. At December 31, 1998, the Company's available line of
credit was $12,400.
F-19
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER 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, 1998, 1997
and 1996 is shown as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, FEDERAL STATE TOTAL
------------------------ ------- ----- -----
<S> <C> <C> <C>
1998:
Current............................................................ ($1,771) $16 ($1,755)
Deferred........................................................... (2,072) - (2,072)
--------------------------------------
($3,843) $16 ($3,827)
--------------------------------------
--------------------------------------
1997:
Current............................................................ $503 $80 $583
Deferred........................................................... 1,193 - 1,193
--------------------------------------
$1,696 $80 $1,776
--------------------------------------
--------------------------------------
1996:
Current............................................................ $1,079 $30 $1,109
Deferred........................................................... (282) - (282)
--------------------------------------
$797 $30 $827
--------------------------------------
--------------------------------------
</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,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Expected tax expense (benefit).......................................... ($2,959) $2,358 $1,615
Tax-exempt investment income............................................ (924) (715) (787)
Nondeductible expenses.................................................. 61 80 55
State income taxes, net of Federal benefit.............................. (5) 53 20
Other, net.............................................................. - - (76)
--------------------------------
($3,827) $1,776 $827
--------------------------------
--------------------------------
</TABLE>
F-20
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Temporary differences which give rise to a significant portion of deferred
tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
DECEMBER 31
-----------
1998 1997
---- ----
<S> <C> <C>
Deferred tax assets:
Loss reserve discounting........................................................... $4,461 $4,948
Unearned premiums.................................................................. 1,376 1,046
Net operating loss carry forward................................................... 2,564 -
Tax on net unrealized loss on securities carried at market value................... 197 -
Other.............................................................................. 1,644 1,002
--------------------------
Gross deferred tax assets..................................................... $10,242 $6,996
--------------------------
Deferred tax liabilities:
Unbilled premiums.................................................................. (3,076) (2,215)
Tax on net unrealized gain on securities carried at market value................... - (790)
Other.............................................................................. (860) (744)
--------------------------
Gross deferred tax liabilities................................................ ($3,936) ($3,749)
--------------------------
Net deferred tax asset........................................................ $6,306 $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 received Federal income tax refunds of $1,552 and made Federal
income tax payments of $65 during the year ended December 31, 1998 and paid
$2,300 and $1,400 of Federal income taxes during the years ended December 31,
1997 and 1996, respectively.
At December 31, 1998, the Company had a tax net operating loss carry
forward of $2,564 that expires in 2018.
(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.
F-21
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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. Additionally, PICO has also chosen
to quota-share a portion of its retained claims exposure. In a quota share
reinsurance contract, the company and the reinsurer share premiums, losses and
loss adjustment expenses on a proportional basis based on each parties interest
in the quota-shared risk.
The maximum retention for each loss occurrence on workers' compensation
policies has been $250 since July 1996 and was $200 in the first half of 1996.
In July 1998, PICO modified its prior existing excess of loss reinsurance treaty
on the $250 excess $250 layer to retain the first $2,000 in annual aggregate
losses, with a corresponding reduction in the reinsurance rate. In the fourth
quarter of 1998 PICO entered into a two year excess of loss reinsurance
arrangement with a retention of $50. Concurrent with this agreement, PICO
entered into an excess of loss agreement which covers a portion of the losses in
the $40 excess of $10 layer and a quota-share agreement which covers a portion
of losses below $10.
The following amounts have been deducted in the accompanying consolidated
financial statements as a result of reinsurance ceded:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Premiums earned............................................... $18,834 $3,226 $2,056
Losses and loss expenses incurred............................. $22,554 $ 573 $ 940
Operating expenses............................................ $ 3,024 $ - $ -
</TABLE>
In July 1998, the Company entered into an assumption agreement with the New
Mexico Retail Association Self-Insured Group ("the SIG"). The agreement
provides for the complete assumption by PICO of the SIG reserves outstanding as
of July 1, 1998 as well as a 100% quota-share participation on policies in-force
as of that date. The prospective piece of the treaty has been accounted for as
reinsurance in the accompanying consolidated financial statements. Premiums
assumed under the prospective piece of this agreement were $1,647 while loss
incurred were $1,031 for the year ended December 31, 1998. The portion of the
contract related to the loss portfolio transfer does not meet risk transfer
requirements and has therefore been accounted for using the deposit method of
accounting. At December 31, 1998, the related liability of $1,962 is included
in accounts payable and accrued expenses in the accompanying consolidated
financial statements.
(8) STOCKHOLDERS' EQUITY
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.
F-22
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER 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.
PAULA Financial is dependent on the transfer of funds from its
subsidiaries. Dividends and advances from PICO and PAULA Assurance Company
("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 $62,378
and $55,497 at December 31, 1998 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 827,223 and 1,094,126 shares of the
Company's common stock at December 31, 1998 and 1997, respectively. 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 $125
and $150 in the years ended December 31, 1997 and 1996, respectively. No
contributions were made in 1998.
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 $252, $224 and $208 for
the years ended December 31, 1998, 1997 and 1996, respectively.
Employees of the Company receive an annual year-end bonus based upon the
results of the Company. Amounts expensed under bonus programs were $641, $1,068
and $1,053 for the years ended December 31, 1998, 1997 and 1996, respectively.
In 1998, the Company implemented a key employee/consultant loan program
which provides funds exclusively for the borrowers' purchase of Company stock.
The Company has authorized loans of up to $1,000. The loans are full recourse,
bear interest at the rate of 8.5% per annum, payable quarterly, have a three
year maturity and are secured by the stock purchased. The loan program was
reviewed and approved by the Compensation Committee of the Board of Directors.
As of December 31, 1998, the Company had extended loans in the amount of
$505,000. Such amounts are included in other receivables in the accompanying
consolidated financial statements.
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
F-23
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
determined by the Executive Compensation Committee of the Board of Directors. At
December 31, 1998, 1,250 shares of common stock were available for issuance
under the 1994 plan.
In 1997, the Company adopted its 1997 Stock Incentive Plan, reserving
200,000 shares of common stock. Stock awards totaling 1,000 shares were granted
in 1998 and at December 31, 1998, 199,000 shares of common stock were available
for issuance under the 1997 plan. 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 generally exercisable for a ten-year term.
Changes in the status of options granted under the 1994 plan are summarized
as follows:
<TABLE>
<CAPTION>
1998
------
WEIGHTED
EXERCISE AVERAGE
SHARES PRICE EXERCISE PRICE
------------ -------------- ----------------
<S> <C> <C> <C>
Beginning of year.................................... 402,850 $ 7.88-12.50 $ 8.78
Granted........................................ 27,000 $13.50-23.13 $19.56
Canceled....................................... (200) $9.50 $ 9.50
Exercised or redeemed.......................... (10,150) $ 7.88-9.50 $ 8.44
-------------------------------------------------------
End of year.......................................... 419,500 $ 7.88-23.13 $ 9.48
-------------------------------------------------------
-------------------------------------------------------
Exercisable.......................................... 365,525 $ 7.88-23.13 $ 9.02
-------------------------------------------------------
-------------------------------------------------------
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
-------------------------------------------------------
-------------------------------------------------------
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
-------------------------------------------------------
-------------------------------------------------------
</TABLE>
F-24
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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,
1998, the restrictions on an aggregate of 13,900 shares of restricted stock have
lapsed; 450, 1,150 and 1,400 shares in 1998, 1997, and 1996, respectively, were
forfeited based upon voluntary termination. No restricted stock was granted in
the years ended December 31, 1998 and 1997.
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 plans. Options to purchase 84,000
shares of common stock were immediately exercisable with the remaining options
vesting over a period of three years. In 1998 options to purchase 8,000 shares
at $9.50 per share were exercised. Options to purchase 368,000 shares of common
stock issued outside the plans remain outstanding as of December 31, 1998.
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" ("SFAS 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 SFAS 123, the
Company's net income would have been reduced to the pro forma amounts indicated
below:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Net income (loss):
As reported ($4,877) $5,159 $3,923
Pro forma ($5,366) 4,730 3,326
Earnings (loss) per share:
As reported ($0.78) $1.88 $2.07
Pro forma ($0.86) 1.73 1.75
Earnings (loss) per share
assuming dilution:
As reported ($0.78) $1.11 $1.00
Pro forma ($0.86) 1.01 0.85
</TABLE>
F-25
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The fair value for options granted in 1998 was estimated at the date of
grant using a Black-Scholes option pricing model with the following assumptions:
risk free interest rate of 5.3%, average option exercise period of seven years,
and a volatility factor of 50%. The fair value for options granted prior to
1998 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
(loss) does not reflect options granted prior to 1995. During the initial
phase-in period of SFAS 123, the full impact of calculating compensation cost
for stock options is not reflected in the pro forma net income (loss) 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, 1998, 1997 and 1996 follow:
<TABLE>
<CAPTION>
AS INCLUDED
IN THE
ACCOMPANYING
CONSOLIDATED AS REPORTED
FINANCIAL TO REGULATORY
STATEMENTS AUTHORITIES
------------- -------------
<S> <C> <C>
Years ended December 31, 1998:
Net loss......................................................... ($5,519) ($6,955)
------------- -----------
------------- -----------
Stockholders' equity............................................. $67,793 $54,504
------------- -----------
------------- -----------
1997:
Net earnings..................................................... $6,017 $6,439
------------- -----------
------------- -----------
Stockholders' equity............................................. $61,974 $50,230
------------- -----------
------------- -----------
1996:
Net earnings..................................................... $5,770 $5,080
------------- -----------
------------- -----------
Stockholders' equity............................................. $45,202 $35,144
------------- -----------
------------- -----------
</TABLE>
F-26
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Statutory accounting practices for the insurance subsidiaries are
prescribed or permitted by the Department of Insurance of the State of
California ("California DOI"). 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 NAIC's project to codify statutory 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 California DOI has indicated that
codification will become effective on January 1, 2001. The Company has not
determined how implementation will affect its insurance subsidiaries' statutory
financial statements.
Insurance regulatory authorities impose various restrictions on the payment
of dividends and advances by insurance companies. As of December 31, 1998, the
maximum dividend and advance payments that may be made during 1999 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 $5,415.
(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. In 1997 and 1996 certain of these
leases are with related parties. Rent expense was $1,719, $1,613 and $1,657 for
the years ended December 31, 1998, 1997 and 1996, respectively. Included in rent
expense is rent paid to related parties of the Company totaling $52 and $149 for
the years ended December 31, 1997 and 1996, respectively.
Approximate aggregate minimum rental commitments under operating leases at
December 31, 1998 are as follows:
<TABLE>
<S> <C>
1999..................................................................... $1,565
2000..................................................................... 659
2001..................................................................... 261
2002..................................................................... 97
</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.
F-27
<PAGE>
PAULA FINANCIAL AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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, 1998, both PICO and PACO's adjusted capital and surplus exceeded
their respective risk-based capital requirements.
(12) ACQUISITIONS
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
In early 1999, the Company made an investment in the recently formed Altus
Insurance Holdings, LLC, the parent company of Altus Casualty Company Ltd.
("Altus"), a specialty workers' compensation insurance company. The Company
made a capital contribution of $5,500 and has the option to acquire additional
equity and provide quota-share reinsurance to Altus through PICO. The Company
will use the equity method to account for its investment in Altus.
In March 1999, the Company announced that it had agreed to purchase the
insurance agency assets of the Sacramento and Stockton, California offices of
CAPAX Management & Insurance Services ("CAPAX") for approximately $3,200. The
Company will fund the transaction with $2,100 in cash plus $1,100 in CAPAX
securities currently held by the Company. The transaction is expected to close
in April, subject to certain conditions. The acquisition will be accounted for
as an asset purchase.
F-28
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
F-29
<PAGE>
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 DESCRIPTION
- -------- -----------
NO.
---
<S> <C>
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>
CHEDULE DESCRIPTION
- -------- -----------
NO.
---
<S> <C>
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).*
2.6 Letter Agreement, dated March 12, 1999 by and among Registrant, PAU and CAPAX.
3.1 Certificate of Incorporation of Registrant.**
3.2 Certificate of Designations of Series B Junior Participating Cumulative Preferred Stock of Registrant***
3.3 Bylaws of Registrant.*
4.1 Reserved.
4.2 Specimen certificate of Common Stock, including legend evidencing attached Stock Purchase Rights.***
</TABLE>
IV-1
<PAGE>
<TABLE>
<S> <C>
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 Sixth Amendment, dated May 11, 1998, and Seventh Amendment dated September 17, 1998, to the Registrant's Lease for its
Pasadena, California office dated January 1, 1989, as amended and as assigned to date, between LACERA Gateway Property,
Inc., as lessor and PICO, as lessee. ***
10.19 Endorsement 8, dated March 9, 1998, and Endorsement 9, dated August 28, 1998, to Agreement of Reinsurance No. 7448 dated
February 16, 1990, as amended and endorsed to date, between General Reinsurance Corporation and PICO. ***
10.20 Limited Liability Company Operating Agreement of Altus Insurance Holdings, LLC dated as of March 12, 1999 among the
several members and Registrant.
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.*
</TABLE>
IV-2
<PAGE>
<TABLE>
<S> <C>
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.*
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).**
10.32 Paula Insurance Company Workers Compensation Quota Share Reinsurance Agreement
1998 Placement Slip effective October 1, 1998 between PICO and Reliance Insurance
Company
10.33 Paula Insurance Company Workers Compensation First and Second Excess of Loss Reinsurance
Agreement 1998 Placement Slip effective October 1, 1998 between PICO and
Reliance Insurance Company
10.34 Change of Control Agreement dated as of November 1, 1998 between
the Registrant and Jeffrey A. Snider.
11 Statement re computation of per share earnings.
21 List of subsidiaries of PAULA Financial.*
23 Consent of KPMG LLP.
27 Financial Data Schedule - Year Ended December 31, 1998.
</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.
*** Incorporated by reference from the exhibit of the same number filed as an
exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ending
September 30, 1998.
(b) REPORTS ON FORM 8-K.
The Company filed no reports on Form 8-K during the fourth quarter of 1998.
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.
PAUL FINANCIAL
By: /s/ James A. Nicholoson
------------------------------
SENIOR VICE PRESIDENT, CFO
MARCH 30, 1999
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, 1999
--------------------- Chief Executive Officer
Jeffrey A. Snider (Principal Executive Officer)
/s/ James A. Nicholson Senior Vice President and Chief March 30, 1999
---------------------- Financial Officer (Principal Financial
James A. Nicholson and Principal Accounting Officer)
/s/ John B. Clinton Director March 30, 1999
-------------------
John B. Clinton
/s/ Jerry M. Miller Director March 30, 1999
-------------------
Jerry M. Miller
/s/ Robert Puccinelli Director March 30, 1999
---------------------
Robert Puccinelli
/s/ Bradley K. Serwin Director March 30, 1999
---------------------
Bradley K. Serwin
/s/ Andrew M. Slavitt Director March 30, 1999
---------------------
Andrew M. Slavitt
/s/ Gerard Vecchio Director March 30, 1999
----------------------
Gerard Vecchio
/s/ Ronald W. Waisner Director March 30, 1999
---------------------
Ronald W. Waisner
</TABLE>
IV-4
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<S> <C>
2.6 Letter Agreement, dated March 8, 1999 by and among Registrant, PAU and CAPAX.
10.20 Limited Liability Company Operating Agreement of Altus Insurance Holdings, LLC dated as of March 12, 1999 among
the several members and Registrant.
10.32 Paula Insaurance Company Workers Compensation Quota Share Reinsurance Agreement
1998 Placement Slip effective October 1, 1998 between PICO and Reliance
Insurance Company
10.33 Paula Insurance Company Workers Compensation First and Second Excess of Loss
Reinsurance Agreement 1998 Placement Slip effective October 1, 1998 between PICO
and Reliance Insurance Company
10.34 Change of Control Agreement dated as of November 1, 1998
between the Registrant and Mr. Jeffrey A. Snider
11 Statement re computation of per share earnings.
23 Consent of KPMG LLP.
27 Financial Data Schedule - Year Ended December 31, 1998.
</TABLE>
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
PAULA Financial:
Under date of March 2, 1999, we reported on the consolidated
balance sheets of PAULA Financial and subsidiaries as of December 31, 1998 and
1997, and the related consolidated statements of operations, comprehensive
income (loss), stockholders' equity and cash flows for each of the years in the
three-year period ended December 31, 1998 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 LLP
Los Angeles, California
March 2, 1999
S-1
<PAGE>
SCHEDULE I
PAULA FINANCIAL AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1998
------------------------
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............. $ 13,445 $ 13,766 $ 13,766
States, municipalities and political subdivisions.. 24,082 24,346 24,346
Corporate securities............................... 79,927 79,625 79,625
Collateralized mortgage obligations and other
asset backed securities.......................... 53,925 53,055 53,055
---------------- -------------- --------------
Total fixed maturities........................ 171,379 170,792 170,792
Equity securities:
Common stock....................................... 3,252 3,219 3,219
Nonredeemable preferred stock...................... 999 1,040 1,040
---------------- -------------- --------------
Total equity securities....................... 4,251 4,259 4,259
Short-term investments................................ 2,572 2,572 2,572
---------------- -------------- --------------
Total investments............................. $178,202 $177,623 $177,623
---------------- -------------- --------------
---------------- -------------- --------------
</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,
--------------
1998 1997
--------------- ----------------
<S> <C> <C>
ASSETS
Common stock, at market (cost $1,018 and $5,138 in 1998 and 1997).......... $ 1,057 $ 5,138
Cash and invested cash...................................................... 1,624 13,647
Property and equipment, net................................................. 3 43
Investment in subsidiaries.................................................. 71,731 65,137
Deferred income taxes....................................................... 1,627 11
Other assets................................................................ 1,072 1,885
--------------- ----------------
--------------- ----------------
$77,114 $85,861
--------------- ----------------
--------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable............................................................... $ 2,667 $ 406
Accounts payable and other liabilities...................................... 411 635
---------------- -----------------
3,078 1,041
Stockholders' equity:
Preferred stock, $0.01 par value; Authorized 4,058,823 shares:
none issued and outstanding............................................. $ - $ -
Common stock, $0.01 par value; Authorized 15,000,000 shares:
issued, 6,338,815 shares in 1998 and 6,321,177 shares in 1997........... 63 63
Additional paid-in capital.................................................. 67,386 67,176
Retained earnings........................................................... 10,182 16,048
Accumulated other comprehensive income:
Net unrealized gain on investments....................................... (382) 1,533
---------------- -----------------
77,249 84,820
Treasury stock (409,800 shares in 1998)..................................... (3,213) -
---------------- -----------------
Net stockholders' equity.............................................. 74,036 84,820
--------------- ----------------
--------------- ----------------
$77,114 $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 OPERATIONS
(DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1998 1997 1996
----------- ---------- ----------
<S> <C> <C> <C>
Income:
Net investment income...................................... $ 858 $ 169 $ 31
Service fees............................................... 1,403 977 871
Other...................................................... 20 293 112
---------------- -------------- --------------
2,281 1,439 1,014
Expenses:
Interest expense........................................... 35 747 635
Service fees............................................... 668 910 865
Operating.................................................. 1,716 721 1,649
---------------- -------------- --------------
2,419 2,378 3,149
Loss from operations before income tax benefit and equity in
net income of subsidiaries................................. (138) (939) (2,135)
Income tax benefit......................................... (6) (309) (727)
---------------- -------------- --------------
Loss from operations before equity in net income of subsidiaries
(132) (630) (1,408)
Equity in net income of subsidiaries.......................... (4,745) 5,789 5,331
---------------- -------------- --------------
---------------- -------------- --------------
Net income (loss)..................................... ($4,877) $ 5,159 $ 3,923
---------------- -------------- --------------
---------------- -------------- --------------
Earnings (loss) per share..................................... ($0.78) $1.88 $ 2.07
Weighted average shares outstanding........................... 6,228,479 2,737,065 1,896,464
Earnings (loss) per share - assuming dilution................. ($0.78) $ 1.11 $ 1.00
Weighted average shares outstanding - assuming dilution....... 6,228,479 4,664,511 3,910,715
</TABLE>
See notes to condensed financial information
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,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)............................................... ($4,877) $5,159 $3,923
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Depreciation and amortization................................. 12 31 45
(Income) loss from subsidiaries............................... 4,745 (5,789) (5,331)
Dividends received from subsidiaries.......................... - - 820
Loss on sales of securities................................... 212 - -
Loss on sale of fixed assets.................................. - 6 5
(Increase) decrease in other assets........................... 813 (1,703) (539)
Increase (decrease) in accounts payable and other liabilities. (224) (351) 536
Other, net.................................................... (937) (111) (195)
---------------- ---------------- ----------------
Net cash used in operating activities..................... ($256) ($2,758) ($736)
---------------- ---------------- ----------------
Cash flows from investing activities:
Purchase of common stock..................................... - (5,138) -
Proceeds from sale of common stock........................... 3,908 - -
Proceeds from sale of property and equipment................. 28 13 88
Purchase of property and equipment........................... - - (74)
Capital contribution to subsidiary........................... (13,964) (10,000) -
---------------- ---------------- ----------------
Net cash provided by (used in) investing activities........ ($10,028) ($15,125) $ 14
---------------- ---------------- ----------------
Cash flows from financing activities:
Borrowings (repayments) under line of credit agreement, net.. 2,600 (7,490) 2,268
Payments on notes payable.................................... (339) (2,975) (1,627)
Issuance of notes payable.................................... - 238 269
Dividends paid............................................... (989) -
Exercise of stock options.................................... 202 -
Sale of common stock......................................... - 41,278 343
Repurchase of common stock................................... (3,213)
Retirement of common stock................................... - (60) -
---------------- ---------------- ----------------
Net cash provided (used in) financing activities........... ($1,739) $ 30,991 $ 1,253
---------------- ---------------- ----------------
Net increase (decrease) in cash and invested cash............... (12,023) 13,108 531
Cash and invested cash at beginning of period................... 13,647 539 8
---------------- ---------------- ----------------
Cash and invested cash at end of period......................... $ 1,624 $ 13,647 $ 539
---------------- ---------------- ----------------
---------------- ---------------- ----------------
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes.................. $ 1 $ 1 $ 1
---------------- ---------------- ----------------
---------------- ---------------- ----------------
Cash paid during the period for interest...................... $ 35 $ 1,007 $ 557
---------------- ---------------- ----------------
---------------- ---------------- ----------------
</TABLE>
See notes to condensed financial information
S-3
<PAGE>
SCHEDULE II.4
PAULA FINANCIAL AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PAULA FINANCIAL
NOTES TO CONDENSED FINANCIAL INFORMATION
DECEMBER 31, 1998 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,
1998 1997
---- ----
<S> <C> <C>
Note payable to bank............................................. $2,600
$ -
Note payable..................................................... 67 406
------------ ------------
------------ ------------
Balance at end of period......................................... $2,667 $ 406
------------ ------------
------------ ------------
</TABLE>
Maturities of notes payable for the next five years are as follows:
<TABLE>
<CAPTION>
FISCAL YEAR DECEMBER 31, 1998
- ----------- -----------------
<S> <C>
1999................................................................. $67
</TABLE>
3. DIVIDENDS FROM SUBSIDIARIES
During 1998 and 1997, no cash dividends were paid to PAULA Financial by
its consolidated subsidiaries. During 1996, a cash dividend of $820 was 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
A B C D E F
- - - - - -
FUTURE
POLICY OTHER
BENEFITS, POLICY
DEFERRED LOSSES, CLAIMS
POLICY CLAIMS AND AND
ACQUISITION LOSS UNEARNED BENEFITS PREMIUM
COSTS EXPENSES PREMIUM PAYABLE REVENUE
------------ ----------- --------- ---------- -----------
<S> <C> <C> <C> <C> <C>
1998
Workers Compensation.... $2,533 $135,939 $20,234 $- $127,997
Group A&H............... - 278 - - 490
Group Life.............. - 99 - - 283
------------ ----------- --------- ---------- -----------
Total................ $2,533 $136,316 $20,234 $- $128,770
------------ ----------- --------- ---------- -----------
------------ ----------- --------- ---------- -----------
1997
Workers Compensation.... $2,191 $77,441 $15,390 $- $91,957
Group A&H............... - 242 - - 563
Group Life.............. - 101 - - 315
------------ ----------- --------- ---------- -----------
Total................ $2,191 $77,784 $15,390 $- $92,835
------------ ----------- --------- ---------- -----------
------------ ----------- --------- ---------- -----------
1996
Workers Compensation.... $1,330 $55,187 $10,655 $- $54,563
Group A&H............... - 400 - - 551
Group Life.............. - 133 - - 390
------------ ----------- --------- ---------- -----------
------------ ----------- --------- ---------- -----------
Total................ $1,330 $55,720 $10,655 $- $55,504
------------ ----------- --------- ---------- -----------
------------ ----------- --------- ---------- -----------
</TABLE>
<TABLE>
<CAPTION>
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN
A G H I J K
- - - - - -
BENEFITS, AMORTIZA-
CLAIMS, TION OF
LOSSES DEFERRED
NET AND POLICY OTHER
INVESTMENT SETTLEMENT ACQUISI- OPERATING PREMIUMS
INCOME EXPENSES TION COSTS EXPENSES WRITTEN
------------- ----------- ---------- ----------- ------------
<S> <C> <C> <C> <C> <C>
1998
Workers Compensation.... $8,156 $114,118 $18,909 $33,672 $151,675
Group A&H............... 144 235 - 229 490
Group Life.............. 136 130 - 112 283
------------- ---------- ----------- ----------- ------------
Total................ $8,436 $114,483 $18,909 $34,013 $152,448
------------- ---------- ----------- ----------- ------------
------------- ---------- ----------- ----------- ------------
1997
Workers Compensation.... $5,066 $ 67,915 $ 9,074 $24,544 $ 99,919
Group A&H............... 155 98 - 278 563
Group Life.............. 139 94 - 131 315
------------- ---------- ----------- ----------- ------------
Total................ $5,360 $ 68,107 $ 9,074 $24,953 $100,797
------------- ---------- ----------- ----------- ------------
------------- ---------- ----------- ----------- ------------
1996
Workers Compensation.... $4,288 $ 33,293 $ 2,421 $17,256 $ 60,609
Group A&H............... 152 407 - 338 551
Group Life.............. 145 200 - 234 390
------------- ---------- ----------- ----------- ------------
Total................ $4,585 $ 33,900 $ 2,421 $17,828 $ 61,550
------------- ---------- ----------- ----------- ------------
------------- ---------- ----------- ----------- ------------
</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
DESCRIPTION OTHER OTHER PERCENTAGE OF
GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT AMOUNT
------------- ----------- ------------ ----------- --------------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1998 Premiums:
Workers' compensation insurance............... $144,328 $18,834 $2,503 $127,997 2.0%
Group A&H..................................... 490 - - 490 0.0%
Group Life.................................... 283 - - 283 0.0%
--------------------------------------------------------------------------
Total Premiums................................ $145,101 $18,834 $2,503 $128,770 2.0%
--------------------------------------------------------------------------
--------------------------------------------------------------------------
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%
--------------------------------------------------------------------------
--------------------------------------------------------------------------
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%
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</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, 1998
Allowance for uncollectible accounts............. $600 $301 $ - $ - $901
---------- ---------- --------- --------- --------
---------- ---------- --------- --------- --------
YEAR ENDED DECEMBER 31, 1997
Allowance for uncollectible accounts............. $500 $100 $ - $ - $600
---------- ---------- --------- --------- --------
---------- ---------- --------- --------- --------
YEAR ENDED DECEMBER 31, 1996
Allowance for uncollectible accounts............. $358 $142 $ - $ - $500
---------- ---------- --------- --------- --------
---------- ---------- --------- --------- --------
</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
A B C D E F
- - - - - -
DISCOUNT
IF ANY,
DEDUCTED IN
RESERVES RESERVES
FOR UNPAID FOR UNPAID
DEFERRED CLAIMS AND CLAIMS AND
POLICY CLAIMS CLAIM
ACQUISITION ADJUSTMENT ADJUSTMENT UNEARNED EARNED
COSTS EXPENSE EXPENSES PREMIUM PREMIUM
------------ ------------- ------------- ---------- ----------
<S> <C> <C> <C> <C> <C>
1998
Workers Compensation... $2,533 $135,939 $- $20,234 $127,997
1997
Workers Compensation... $2,191 $ 77,441 $- $15,390 $91,957
1996
Workers Compensation... $1,330 $ 55,187 $- $10,655 $54,563
</TABLE>
<TABLE>
<CAPTION>
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN
A G H I J K
- - - - - -
CLAIMS AND CLAIM
ADJUSTMENT
EXPENSES INCURRED
RELATED TO:
-----------------
AMORTIZA-
TION OF PAID
DEFERRED CLAIMS &
NET POLICY CLAIM
NVESTMENT CURRENT PRIOR ACQUISI- ADJUSTMENT PREMIUMS
INCOME YEAR YEAR TION COSTS EXPENSES WRITTEN
----------- -------- ------- ------------ ----------- ----------
<S> <C> <C> <C> <C> <C> <C>
1998
Workers Compensation... $8,156 $107,850 $ 6,268 $18,909 $74,363 $151,675
1997
Workers Compensation... $5,066 $66,330 $ 1,586 $ 9,074 $45,629 $ 99,919
1996
Workers Compensation... $4,288 $35,938 $(2,646) $ 2,421 $34,514 $ 60,609
</TABLE>
S-10
<PAGE>
[Letterhead of Paula Financial]
March 12, 1999
Mr. Joel Geddes
Chairman
CAPAX Management and Insurance Services
Modesto, CA
VIA FAX
Re: Revised Offer to Purchase the Assets of CAPAX' Stockton and Sacramento
Offices
Dear Joel:
Pan American Underwriters, Inc. ("PAU") is pleased to offer to purchase all of
the respective interests of CAPAX Management and Insurance Services and its
subsidiaries (collectively, "CAPAX") in the book of business serviced from their
Stockton and Sacramento offices, other than those portions of the book
identified on Exhibit A hereto (the "Excluded Book") on the following terms:
1. PAU will purchase all interests of CAPAX (as well as the interest of its
employees, employed or directly contracted producers, officers, directors
and affiliates (collectively, the "Seller")) in the book of insurance
business (other than the Excluded Book) being produced and/or serviced by
the Seller from or through CAPAX' Stockton and Sacramento California
locations (the "Offices") as defined below (the "Book of Business"). The
Book of Business will include, without limitation, all policies with
respect to which the Seller is named as the broker or agent of record, all
such prospective policies which have been submitted to carriers for
quotation and all such prospective policies with respect to which the
Seller has actively solicited quotations in the past 12 months, other than
the Excluded Book.
The Book of Business will also include, without limitation, all of the
Seller's interest in those policies being produced and/or serviced from the
Offices actually produced by independent agents (the "Sub-Producers") and
brokered through the Seller (the "Sub-Produced Business"), other than the
Excluded Book. The following individuals are not considered Sub-Producers
and their business is not considered "Sub-Produced Business": Messrs.
Seawall, Van Noate and Duckworth and Ms. Michaels.
2. PAU will pay a combination of cash and other consideration for the Book of
Business in an amount equal to 1.335x (A) Seller's annual commission
revenues, and fee revenue received in lieu of commission, but excluding
contingent commissions and interest income, relating to the portion of the
Book of Business which is in-force on
1
<PAGE>
the closing and renews or is replaced and is in force at the end of the 24
month measurement period, less (B) the portion of that annual commission
revenue, and fee revenue received in lieu of commission, relating to the
Sub-Produced Business that is passed through to the Sub-Producers, less
$80,000.
3. The estimated purchase price will be 1.335x $2,426,240 = $3,239,030 -
$80,000 = $3,159,030. This estimate will be adjusted prior to closing if
the 1998 commission and fee revenue relating to the Book of Business (other
than the Excluded Book) differs from $2,426,240. Such adjustment will be
made at the completion of due diligence.
4. At closing, PAU will pay to CAPAX $2,008,141 (less any downward adjustment
required by paragraph 3 above and plus any upward adjustment required by
paragraph 3 above) in cash.
At closing, PAULA Financial will tender all of its Series A Preferred Stock
in CAPAX, duly endorsed for transfer, and CAPAX will redeem such stock for
the sum of $955,624 to be paid as part of the promissory note discussed
below from CAPAX to PAULA (the "CAPAX Note"). Incidental thereto, the
Series A Preferred Stock Purchase Agreement dated March 11, 1997 along with
all exhibits thereto will be canceled and terminated. Notwithstanding the
foregoing, CAPAX will remain a PAULA Trading Company founder entitled to
all related rights thereto and nothing herein is intended to alter the
existing working relationship among Jeff Snider, Jim Parker and Joel
Geddes.
At closing PAULA Financial will exchange the outstanding term loan due from
Giddings, Corby, Hynes, Inc. to PAULA in the principal amount of $195,265,
plus accrued, but unpaid, interest to date, for a like interest in the
CAPAX Note. All existing collateral for the Giddings term loan shall be
released upon the execution of the new CAPAX Note.
5. At closing CAPAX will execute the CAPAX Note in favor of PAULA Financial
with the following terms:
A. Principal balance will be the sum of the amounts due above from CAPAX
and Giddings to PAULA ($955,624 + $195,265 + accrued but unpaid
interest on the old note);
B. Interest will accrue from the closing to maturity at 7.5% per year
payable at maturity; provided however that if maturity is extended as
discussed below, the CAPAX Note will continue to bear interest at 7.5%
on the unpaid balance;
C. Maturity will be coincidental with the final payment of the purchase
price for the Book of Business by PAU (24 months after closing);
2
<PAGE>
D. Note will be repaid, to the extent possible, by offset against the
final payment of the purchase price for the Book of Business by PAU;
provided that in the event the final payment by PAU is less than the
principal and interest due under the CAPAX Note, such excess shall be
payable over the succeeding 36 months in 36 equal monthly payments
which will fully amortize the principal and interest remaining due
under the CAPAX Note;
E. In the event that the CAPAX Note becomes payable in 36 equal monthly
payments, PAULA Financial will have the option to convert the
outstanding balance of the CAPAX Note into CAPAX voting common stock at
a price of $20 per share at any time until the CAPAX Note is paid in
full. If PAULA converts any portion of the balance into CAPAX stock,
such stock will be governed by the applicable provisions of the then
existing CAPAX Shareholders' Agreement; and
F. The CAPAX Note will be secured by a perfected senior security interest
in all of the assets of CAPAX and its subsidiaries; provided that PAULA
will permit CAPAX and its subsidiaries, in the aggregate, to borrow up
to $300,000 in debt which will have a senior call on the following
categories of secured assets: accounts receivables and property, plant
and equipment; provided further, that CAPAX can incur additional
indebtedness on an unsecured or secured but subordinated (to PAULA's
interests) basis without restriction.
G. The CAPAX Note will provide for cross-defaults in the event CAPAX or
its subsidiaries has a payment or any other default under any other
debt instrument and the other lender begins to foreclose on any CAPAX
assets.
6. The total purchase price will be adjusted at the end of 24 months from
closing based on the actual amount of commissions invoiced by PAU on the
Book of Business (which is still in force) (other than the Excluded Book)
during the 12 months beginning with the 10th full month after closing and
ending with the 21st full month after closing, plus the actual annual
amount of new commissions invoiced by PAU generated from the former CAPAX
producers during such 12 month period, less the amount passed through to
Sub-Producers during such 12 month period. In the event that payment of any
measured commissions is not received by the end of the 24 month period, the
commissions not paid will not be considered "invoiced" for this purpose. In
no event will new production by CAPAX producers increase the purchase price
above the adjusted estimated purchase price defined in Paragraph 3 above.
PAU will pay the difference between the total adjusted purchase price and
the initial cash payment at the end of such 24 month period. PAU will pay
interest on the actual amount of the final payment calculated at the rate
of 7 1/2% per year from the closing to the payment date. Interest will be
payable at the same time that the final payment is paid.
PAU will grant CAPAX a first priority security interest in the Book of
Business and
3
<PAGE>
related files as security for its obligation to make the foregoing payment.
7. In the event that PAU sells or otherwise disposes of any portion of the
Book of Business prior to the end of the 24 month period, for purposes of
calculating the adjusted purchase price, the said portion of the Book of
Business will be treated as if it was still in force and held by PAU and
that PAU received during the 12 month measurement period an amount of
commissions and fees equal to the amount of commissions and fees received
by PAU and/or CAPAX for the twelve months immediately prior to the sale of
such accounts by PAU.
8. In the event that PAU negligently fails to maintain the Book of Business
after the closing due to a change of control of PAU and/or PAULA and CAPAX
is damaged by such failure, CAPAX shall be entitled to recover its damages
caused by such negligence upon presentation of proof of such negligence and
such damages. This right of recovery will not prejudice any other right to
recovery that CAPAX may have in law or equity.
9. The parties agree that the Seller will be entitled to retain any and all
commissions and fees relating to the Book of Business invoiced prior to the
closing of the transaction in the ordinary course for items having an
inception date before closing, whether agency bill or direct bill. PAU will
be entitled to retain any and all commissions and fees relating to the Book
of Business invoiced after the closing of the transaction in the ordinary
course for items having an inception date before or after closing, whether
agency bill or direct bill. The Seller will pay over to PAU any and all
commissions and fees received by the Seller relating to commissions and
fees relating to the Book of Business invoiced after the closing of the
transaction in the ordinary course for items having an inception date
before or after the closing, whether agency bill or direct bill.
Notwithstanding the foregoing PAU does not agree to the foregoing
formulation unless during PAU's due diligence, PAU determines that its
estimated 1999 GAAP revenue from the Book of Business will at least equal
its estimated 1999 GAAP expenses from the Book of Business. In the event
due diligence cannot confirm this, the parties will work in good faith to
determine an alternative method of sharing commissions and fees which is
acceptable to all parties.
10. The Seller will remain obligated for all liabilities relating to the Book
of Business for the period ending on the closing date, including without
limitation, carrier payables, client payables, errors and omissions
liabilities and obligations to service the policies with respect to those
changes, additions and deletions requested/required as of, or prior to the
closing date. PAU will assume all such responsibilities on the day after
the closing date.
Each of the parties agrees to purchase E&O cover for its retained
liabilities in amounts and with deductibles reasonably acceptable to the
other party. Each party agrees to provide evidence of such cover prior to
closing and to maintain such cover
4
<PAGE>
in PAU's case until PAU's purchase price final payment is made and in
CAPAX' case until the CAPAX Note is paid in full.
11. The Seller will provide PAU with a blanket broker of record letter
addressed to all markets with which the Seller has placed a portion of the
Book of Business. Seller does not represent that such markets will accept
the Broker of Record letter, but Seller will use its best efforts to
accomplish such objective. In the event any such letter is rejected, the
Seller will allow PAU to broker the applicable portion of the Book of
Business through the Seller to such market without additional compensation,
for a period of 24 months.
12. The Seller will transfer to PAU all files and other records of the Seller
relating to the Book of Business which are necessary or helpful to PAU's
obligation to service the Book of Business going forward. Seller shall have
unlimited access to such files for all valid purposes. The Seller can copy
any and all of such files prior to closing and the documented out-of-pocket
cost of such copying will be shared by PAU and CAPAX equally. PAU will
exercise the same degree of care with the transferred files as it uses with
respect to its own files.
13. PAU will hire only those producers and staff persons currently operating
from the Offices which PAU, in its sole discretion chooses to hire, and
agrees to review those existing consulting agreements with Seawell, Van
Noate, Duckworth and Michaels with a view to assuming them. PAU will notify
CAPAX of its decision in this regard at the completion of its due
diligence. CAPAX will retain all obligations to pay Buck and any other
person for the purchase of their interests in the Book of Business.
All retained producers and staff persons will be offered compensation
packages either equal to that set forth in Mr. Jaques Presentation Book or
the compensation packages they had with CAPAX at December 31, 1998, PAU's
choice, which will be made on an individual basis. CAPAX agrees to pay to
all former employees of the Offices all ESOP, vacation and other accrued
employee benefits due to them under CAPAX policies or applicable law
relating to their separation from CAPAX, if any. Such persons will be
treated as new hires by PAU for all purposes except that PAU will provide
to those persons hired credit for service in the minimum amount necessary
to provide such persons with eligibility for PAU's normal medical, dental,
life and disability insurance benefits and PAU's 401(k) plan.
In the event PAU terminates any producer formerly working in the Offices
for any reason prior to the end of the measurement period set forth in
Section 6 above, any portion of the Book of Business being serviced by such
terminated producer at the time of termination will be "frozen" for
purposes of valuing the commissions and fees from that portion of the Book
of Business for purposes of Section 6. The value of the frozen portion will
equal the invoiced commissions and fees for the 12 months immediately prior
to the producer's termination which are actually paid. Voluntary
terminations will not result in any freezing of the value of the Book of
Business serviced by the separating producer.
5
<PAGE>
14. PAU will assume CAPAX' leasehold obligations on the Offices and related
office equipment (except the Sacramento computers) as of the closing date.
PAU will receive, for no additional consideration, all office equipment and
furniture housed in the Offices at December 31, 1998 except for computers
and related accessories located in the Sacramento office at December 31,
1998. CAPAX will deliver all transferred personal property free from all
liens and encumbrances other than leasehold obligations. In the event such
leases are not assumable, PAU will reimburse CAPAX for all continuing lease
obligations for the transferred items.
15. The Seller will pay all fees due to John H. Jaques, Inc. as finder. Each
party shall pay their own professional fees and other expenses related to
this transaction.
16. The Seller will transfer all rights to the name "Sacramento Valley
Insurance" at closing as part of the transaction. The Seller will cause its
existing corporate subsidiary to change its name to something which does
not conflict with the sold name prior to closing, will cease operating
under the sold name upon closing and will cooperate with PAU to allow PAU
to become licensed to sell insurance under the sold name as a "dba." PAU
agrees to broker any of Seller's retained insurance business through PAU
for no cost to the extent that such business must be brokered due to PAU's
use of the sold name as a dba for a period of 24 months after closing.
17. Closing is contingent upon the following:
A. Completion of PAU's due diligence on the Book of Business to
PAU's satisfaction;
B. Receipt of applicable consents to the transaction, including, but
not limited to, Boards, shareholders and landlords, as required
by any participating entity;
C. Release of all liens and other interests on or in the Book of
Business held by CAPAX' banks, shareholders, producers and any
other persons;
D. Execution of a definitive agreement in form and substance
satisfactory to all parties which will include, among other
things, standard representations and warranties for transactions
of this type;
E. Delivery of an opinion of counsel reasonably satisfactory to PAU
as to the authority of CAPAX to consummate the sale of the Book
of Business, the release of liens and security interests in and
on the Book of Business, CAPAX' right to redeem the Series A
Preferred Stock under the California general corporation law and
the due authorization of the consummation of the transactions by
CAPAX, its subsidiaries and shareholders.
F. Execution of a producer and severance agreement between PAU and
Jim Chenu in form and substance mutually acceptable to both
parties no later than the end of the due diligence period
discussed below. In the event such
6
<PAGE>
execution does not occur, any party may terminate its
participation in this transaction without liability to any
other party.
18. PAU agrees to conclude its due diligence within 15 working days from the
date this term sheet is executed by the Seller. In the event that PAU has
not satisfied all of its due diligence issues by such date, any party can
terminate its participation in the transaction without any obligation to
the other parties. Assuming that no party terminates after the end of the
due diligence period, the transaction will close within two weeks of the
end of the due diligence period. In the event that the transaction does not
close by such date, any party may terminate its participation in the
transaction without any obligation to the other parties. The parties also
agree to finalize the material provisions of the definitive agreement by
the end of the due diligence period. In the event that this has not been
done by that time, any party can terminate its participation in the
transaction without obligation to any other party.
19. The definitive document will contain a provision stating that disputes will
be settled by binding arbitration before a panel of arbitrators, all of
whom will meet minimum qualifications regarding their insurance industry
experience, and will be in form and substance mutually acceptable to the
parties.
In the event the foregoing is agreeable to you, with the intent to be bound
hereby, subject to the foregoing conditions, please signify agreement by causing
an authorized representative of the Seller to execute a duplicate of this letter
in the space below and returning it to me. This document will not be binding on
any party until executed by all parties.
PAN AMERICAN UNDERWRITERS, INC. PAULA FINANCIAL
By: /s/ James A. Nicholson By: /s/ James A. Nicholson
--------------------------- --------------------------
CAPAX MANAGEMENT AND
INSURANCE SERVICES, on behalf
of itself and its affiliates
By: /s/ Joel W. Geddes
----------------------------
7
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Exhibit 10.20
LIMITED LIABILITY COMPANY
OPERATING AGREEMENT
OF
ALTUS INSURANCE HOLDINGS, LLC
<PAGE>
TABLE OF CONTENTS
<TABLE>
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<S> <C>
ARTICLE 1 DEFINITIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . .4
ARTICLE 2 THE COMPANY. . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1. Formation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.2. Name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.3. Purpose; Powers. . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4. Principal Place of Business. . . . . . . . . . . . . . . . . . . . 14
2.5. Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.6. Filings; Agent for Service of Process. . . . . . . . . . . . . . . 14
2.7. Title to Property. . . . . . . . . . . . . . . . . . . . . . . . . 15
2.8. Payments of Individual Obligations . . . . . . . . . . . . . . . . 15
ARTICLE 3 MEMBERS' CAPITAL CONTRIBUTIONS . . . . . . . . . . . . . . . . . . 15
3.1. Original Capital Contributions . . . . . . . . . . . . . . . . . . 15
3.2. Interest on Capital Contributions. . . . . . . . . . . . . . . . . 15
3.3. Optional Additional Capital Contributions. . . . . . . . . . . . . 15
3.4. Withdrawal of Capital. . . . . . . . . . . . . . . . . . . . . . . 16
3.5. Loans by Members . . . . . . . . . . . . . . . . . . . . . . . . . 17
ARTICLE 4 ALLOCATIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.1. Profits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.2. Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.3 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
ARTICLE 5 DISTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.1. Net Cash Flow. . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.2. Minimum Distributions. . . . . . . . . . . . . . . . . . . . . . . 19
5.3. Amounts Withheld . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.4. Limitations on Distributions . . . . . . . . . . . . . . . . . . . 20
ARTICLE 6 MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
6.1. Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
6.2. Powers of Board of Managers. . . . . . . . . . . . . . . . . . . . 22
6.3. Duties and Obligations of the Managers . . . . . . . . . . . . . . 22
6.4. Reimbursements . . . . . . . . . . . . . . . . . . . . . . . . . . 23
6.5. Indemnification of the Managers. . . . . . . . . . . . . . . . . . 23
6.6. Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
6.7. Miscellaneous. . . . . . . . . . . . . . . . . . . . . . . . . . . 25
ARTICLE 7 ROLE OF MEMBERS. . . . . . . . . . . . . . . . . . . . . . . . . . 26
7.1. Rights or Powers . . . . . . . . . . . . . . . . . . . . . . . . . 26
</TABLE>
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<TABLE>
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7.2. Voting Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . 26
7.3. Meetings of the Members. . . . . . . . . . . . . . . . . . . . . . 26
7.4. Required Member Consents . . . . . . . . . . . . . . . . . . . . . 27
7.5. Withdrawal/Resignation . . . . . . . . . . . . . . . . . . . . . . 28
7.6. Member Compensation. . . . . . . . . . . . . . . . . . . . . . . . 28
7.7. Members Liability. . . . . . . . . . . . . . . . . . . . . . . . . 28
7.8. Partition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.9. Confidentiality. . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.10. Transactions Between a Member and the Company . . . . . . . . . . 29
7.11. Other Instruments . . . . . . . . . . . . . . . . . . . . . . . . 29
7.12. Guarantee of Company Indebtedness . . . . . . . . . . . . . . . . 29
7.13 Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
ARTICLE 8 REPRESENTATIONS AND WARRANTIES . . . . . . . . . . . . . . . . . . 30
8.1. In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
8.2. Representations and Warranties . . . . . . . . . . . . . . . . . . 30
ARTICLE 9 ACCOUNTING, BOOKS AND RECORDS. . . . . . . . . . . . . . . . . . . 31
9.1. Accounting, Books, and Records . . . . . . . . . . . . . . . . . . 31
9.2. Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
9.3. Accountants. . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
9.4. Tax Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
ARTICLE 10 AMENDMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
10.1. Amendments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
ARTICLE 11 TRANSFERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
11.1. Restrictions on Transfers . . . . . . . . . . . . . . . . . . . . 34
11.2. Permitted Transfers . . . . . . . . . . . . . . . . . . . . . . . 34
11.3. Conditions to Permitted Transfers . . . . . . . . . . . . . . . . 34
11.4. Right of First Refusal. . . . . . . . . . . . . . . . . . . . . . 35
11.5. PAULA Change of Control . . . . . . . . . . . . . . . . . . . . . 37
11.6 Prohibited Transfers . . . . . . . . . . . . . . . . . . . . . . . 37
11.7 Rights of Unadmitted Assignees . . . . . . . . . . . . . . . . . . 38
11.8 Admission of Substituted Members . . . . . . . . . . . . . . . . . 38
11.9 Representations Regarding Transfers; Legend. . . . . . . . . . . . 39
11.10 Distributions and Allocations in Respect of Transferred
Membership Interest . . . . . . . . . . . . . . . . . . . . . . . 39
11.11 Membership Interest . . . . . . . . . . . . . . . . . . . . . . . 40
ARTICLE 12 ADVERSE ACT . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
12.1. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
12.2. Adverse Act Purchase. . . . . . . . . . . . . . . . . . . . . . . 41
12.3. Net Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
12.4. Gross Appraised Value . . . . . . . . . . . . . . . . . . . . . . 43
</TABLE>
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12.5. Extension of Time . . . . . . . . . . . . . . . . . . . . . . . . 43
ARTICLE 13 DISSOLUTION AND WINDING UP. . . . . . . . . . . . . . . . . . . . 44
13.1. Dissolution Events. . . . . . . . . . . . . . . . . . . . . . . . 44
13.2. Winding Up. . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
13.3. Compliance With Certain Requirements of Regulations;
Deficit Capital Accounts. . . . . . . . . . . . . . . . . . . . . 46
13.4. Rights of Members . . . . . . . . . . . . . . . . . . . . . . . . 46
13.5. Notice of Dissolution/Termination . . . . . . . . . . . . . . . . 46
13.6. Allocations During Period of Liquidation. . . . . . . . . . . . . 47
13.7. Character of Liquidating Distributions. . . . . . . . . . . . . . 47
13.8. The Liquidator. . . . . . . . . . . . . . . . . . . . . . . . . . 47
13.9. Form of Liquidating Distributions . . . . . . . . . . . . . . . . 47
ARTICLE 14 POWER OF ATTORNEY . . . . . . . . . . . . . . . . . . . . . . . . 48
14.1. Managers as Attorneys-In-Fact . . . . . . . . . . . . . . . . . . 48
14.2. Nature of Special Power . . . . . . . . . . . . . . . . . . . . . 48
ARTICLE 15 MISCELLANEOUS . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.1. Notices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.2. Binding Effect. . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.3. Construction. . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.4. Time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.5. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.6. Severability. . . . . . . . . . . . . . . . . . . . . . . . . . . 49
15.7. Incorporation by Reference. . . . . . . . . . . . . . . . . . . . 49
15.8. Variation of Terms. . . . . . . . . . . . . . . . . . . . . . . . 50
15.9. Governing Law . . . . . . . . . . . . . . . . . . . . . . . . . . 50
15.10. Payment of Fees and Expenses . . . . . . . . . . . . . . . . . . 50
15.11. Waiver of Jury Trial . . . . . . . . . . . . . . . . . . . . . . 50
15.12. Counterpart Execution. . . . . . . . . . . . . . . . . . . . . . 50
15.13. Specific Performance . . . . . . . . . . . . . . . . . . . . . . 50
EXHIBIT A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
EXHIBIT B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
EXHIBIT C. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
EXHIBIT D. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
</TABLE>
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<PAGE>
LIMITED LIABILITY COMPANY
OPERATING AGREEMENT
OF
ALTUS INSURANCE HOLDINGS, LLC
This OPERATING AGREEMENT is entered into as of March 12, 1999, by and
between PAULA Financial, a Delaware corporation, R. Steven Clark, an individual
resident in the State of Washington, Edward A. Lopit, an individual resident in
the State of Washington, Lawrence A. Riggs, an individual resident in the State
of Washington and John R. Snyder, an individual resident in the State of
Washington, as Members pursuant to the provisions of the Act, on the following
terms and conditions:
ARTICLE 1
DEFINITIONS
1.1 Capitalized words and phrases used in this Agreement have the following
meanings:
"ACCEPTING OFFEREES" shall have the meaning set forth in Section 11.4(d)
hereof.
"ACT" means the Delaware Limited Liability Company Act, 6 Del. C. Section
18-101, ET SEQ., as amended from time to time (or any corresponding provisions
of succeeding law).
"ADDITIONAL CAPITAL CONTRIBUTIONS" means, with respect to each Member, the
Capital Contributions made by such Member pursuant to Section 3.1 and
Section 3.3 hereof.
"ADVERSE ACT" means, with respect to any Member, any of the following:
(i) a failure by such Member to make any Capital Contribution
required pursuant to any provision of the Agreement;
(ii) A determination that such Member has committed a material
breach of any material covenant contained in this Agreement or materially
defaulted on any material obligation provided for in this Agreement and such
breach or default continues for thirty (30) days after the date written notice
thereof has been given to such Member by any other Member, PROVIDED that, if
such breach or default is not a failure to pay money and is of such a nature
that it cannot reasonably be cured within such thirty (30) day period, but is
curable and such Member in good faith begins efforts to cure it within such
thirty (30) day period and continues diligently to do so, such Member shall have
a reasonable additional period thereafter to effect the cure (which shall not
exceed an additional ninety (90) days unless otherwise approved by the Board of
Managers), and PROVIDED FURTHER THAT, if within thirty (30) days after written
notice of such breach or default has been given to such Member, such Member
delivers written notice (the "CONTEST NOTICE") to each other Member and each
Manager that it contests such notice of breach or default, such breach or
default shall not constitute an Adverse Act unless and until (and assuming that
such breach or default has not theretofore been cured in full and that any
applicable grace period has expired) there is a Final Determination that such
Member's actions or failures to act constituted such a breach or default;
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(iii) A Transfer of all or any portion of such Member's Interest
except as expressly permitted or required by this Agreement; or
(iv) The Bankruptcy of such Member or the occurrence of any other
event which would permit a trustee or receiver to acquire control of the affairs
or assets of such Member.
"ADVERSE MEMBER" is any Member with respect to whom an Adverse Act has
occurred.
"AFFILIATE" means, with respect to any Person (i) any Person directly or
indirectly controlling, controlled by, or under common control with such Person
(ii) any officer, director, partner, member, or trustee of such Person or
(iii) any Person who is an officer, director, partner, member, or trustee of any
Person described in clauses (i) or (ii) of this sentence. For purposes of this
definition, the terms "controlling," "controlled by" or "under common control
with" shall mean the possession, direct or indirect, of the power to direct or
cause the direction of the management and policies of a Person or entity,
whether through the ownership of voting securities, by contract or otherwise, or
the power to elect at least 50% of the directors, managers, or persons
exercising similar authority with respect to such Person or entities.
"AGREEMENT" means this Limited Liability Company Operating Agreement of
Altus Insurance Holdings, LLC, including all Exhibits attached hereto, as
amended from time to time. Words such as "herein," "hereinafter," "hereof,"
"hereto" and "hereunder" refer to this Agreement as a whole, unless the context
otherwise requires.
"APPROVAL OF THE MEMBERS" means the approval of a majority in interest of
the Management Members and the approval of PAULA; provided that at such time as
PAULA becomes entitled to be allocated seventy five percent (75%) of the Profits
pursuant to Article 4, Approval of the Members shall mean the approval of
Members entitled to be allocated a majority of the Profits pursuant to Article
4.
"BANKRUPTCY" means, with respect to any Person, a "Voluntary Bankruptcy" or
an "Involuntary Bankruptcy." A "VOLUNTARY BANKRUPTCY" means, with respect to
any Person (i) the inability of such Person generally to pay its debts as such
debts become due, or an admission in writing by such Person of its inability to
pay its debts generally or a general assignment by such Person for the benefit
of creditors, or (ii) the filing of any petition or answer by such Person
seeking to adjudicate itself as bankrupt or insolvent, or seeking for itself any
liquidation, winding up, reorganization, arrangement, adjustment, protection,
relief, or composition of such Person or its debts under any law relating to
bankruptcy, insolvency or reorganization or relief of debtors, or seeking,
consenting to, or acquiescing in the entry of an order for relief or the
appointment of a receiver, trustee, custodian or other similar official for such
Person or for any substantial part of its Property. An "INVOLUNTARY BANKRUPTCY"
means, with respect to any Person, without the consent or acquiescence of such
Person, the entering of an order for relief or approving a petition for relief
or reorganization or any other petition seeking any reorganization, arrangement,
composition, readjustment, liquidation, dissolution or other similar relief
under any present or future bankruptcy, insolvency or similar statute, law or
5
<PAGE>
regulation, or the filing of any such petition against such Person which
petition shall not be dismissed within ninety (90) days, or without the consent
or acquiescence of such Person, the entering of an order appointing a trustee,
custodian, receiver or liquidator of such Person or of all or any substantial
part of the Property of such Person which order shall not be dismissed within
ninety (90) days.
"BOARD OF MANAGERS" means the Board of Managers referred to in
Section 6.1(a).
"BUSINESS" means the business of managing the business of the Subsidiary
holding all of the capital stock of the Subsidiary and matters incidental
thereto.
"BUSINESS DAY" means a day of the year other than a Saturday, a Sunday, or
a banking holiday in the State of Washington or in Bermuda.
"BUY-SELL NOTICE" shall have the meaning set forth in Section 11.5(b).
"BUY-SELL PRICE" shall have the meaning set forth in Section 12.2(a)
hereof.
"CALENDAR QUARTER" means (i) the period commencing on the Effective Date
and ending on March 31, 1999, (ii) any subsequent three-month period commencing
on each of April 1, July 1, October 1 and January 1 and ending on the last date
before the next such date, and (iii) the period commencing on the immediately
preceding January 1, April 1, July 1, or October 1, as the case may be, and
ending on the date on which all Property is distributed to the Members pursuant
to Section 13 hereof.
"CALENDAR YEAR" means (i) the period commencing on the Effective Date and
ending on December 31, 1999, (ii) any subsequent twelve (12) month period
commencing on January 1 and ending on December 31, (iii) any portion of the
period described in clauses (i) or (ii) for which the Company is required to
allocate Profits, Losses, and other items of Company income, gain, loss or
deduction pursuant to Section 4 hereof or (iv) the period commencing on the
immediately preceding January 1 and ending on the date on which all Property is
distributed to the Members pursuant to Section 13 hereof.
"CAPITAL ACCOUNT" means, with respect to any Member, the Capital Account
maintained for such Member in accordance with the following provisions:
(i) To each Member's Capital Account there shall be credited (A)
such Member's Capital Contributions, (B) such Member's distributive share of
Profits as provided for in Sections 4.1 and 4.3, and (C) the amount of any
Company liabilities assumed by such Member or which are secured by any Property
distributed to such Member;
(ii) To each Member's Capital Account there shall be debited (A)
the amount of money and the Gross Asset Value of any Property distributed to
such Member pursuant to any provision of this Agreement, (B) such Member's
distributive share of Losses as provided for in Section 4.2, and (C) the amount
of any liabilities of such Member assumed by the Company or which are secured by
any Property contributed by such Member to the Company;
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(iii) In the event a Membership Interest is Transferred in
accordance with the terms of this Agreement, the transferee shall succeed to the
Capital Account of the transferor to the extent it relates to the Transferred
Membership Interest; and
(iv) In determining the amount of any liability for purposes of
subparagraphs (i) and (ii) above there shall be taken into account Code Section
752(c) and any other applicable provisions of the Code and Regulations.
The foregoing provisions and the other provisions of this Agreement
relating to the maintenance of Capital Accounts are intended to comply with
Regulations Section 1.704-1(b), and shall be interpreted and applied in a manner
consistent with such Regulations. In the event the Members shall determine that
it is prudent to modify the manner in which the Capital Accounts, or any debits
or credits thereto (including, without limitation, debits or credits relating to
liabilities which are secured by contributed or distributed property or which
are assumed by the Company or any Members), are computed in order to comply with
such Regulations, the Members may make such modification, PROVIDED that it is
not likely to have a material effect on the amounts distributed to any Person
pursuant to Section 13 hereof upon the dissolution of the Company. The Members
also shall (i) make any adjustments that are necessary or appropriate to
maintain equality between the Capital Accounts of the Members and the amount of
capital reflected on the Company's balance sheet, as computed for book purposes,
in accordance with Regulations Section 1.704-1(b)(2)(iv)(G), and (ii) make any
appropriate modifications in the event unanticipated events might otherwise
cause this Agreement not to comply with Regulations Section 1.704-1(b).
"CAPITAL CONTRIBUTIONS" means, with respect to any Member, the amount of
money contributed to the Company with respect to the Membership Interest in the
Company held or purchased by such Member, including ADDITIONAL CAPITAL
CONTRIBUTIONS.
"CAUSE" means the occurrence or existence of any of the following with
respect to an officer of the Company as determined by the Board of Managers: (i)
a material breach by the officer of any of his obligations under the then
effective employment agreement, if any, between the officer and the Company or,
in the event that there is no employment agreement, a material breach of any
duties and responsibilities assigned to the officer, PROVIDED, HOWEVER, that in
each case Cause shall not be deemed to exist until the Company shall have given
written notice specifying the claimed material breach and the officer fails to
correct the claimed breach within thirty (30) days after the receipt of the
applicable notice, PROVIDED, HOWEVER, that the failure by the Company to achieve
performance targets shall not, in and of itself, constitute Cause; (ii) any
misappropriation, embezzlement, intentional fraud or similar conduct involving
the Company; (iii) the conviction or the plea of nolo contendere or the
equivalent in respect of a felony or a crime involving moral turpitude; or (iv)
the repeated non-prescription use of any controlled substance or the repeated
use of alcohol or any other non-controlled substance which, in any case
described in this clause (iv), the Board of Managers reasonably determines
renders the officer unfit to serve in his capacity as an officer of the Company,
except to the extent such determination would be reasonably related to illness,
disability or medical emergency affecting the officer or a member of their
immediate family.
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"CERTIFICATE" means the certificate of formation filed with the Secretary
of State of the State of Delaware pursuant to the Act to form the Company, as
originally executed and amended, modified, supplemented or restated from time to
time, as the context requires.
"CERTIFICATE OF CANCELLATION" means a certificate filed in accordance with
6 Del. C. Section 18-203.
"CHIEF EXECUTIVE OFFICER" means the Chief Executive Officer of the Company,
including any interim Chief Executive Officer.
"CLARK" means R. Steven Clark, an individual resident in the State of
Washington.
"CODE" means the United States Internal Revenue Code of 1986, as amended
from time to time.
"COMPANY" means the limited liability company formed pursuant to this
Agreement and the Certificate and the limited liability company continuing the
business of this Company in the event of dissolution of the Company as herein
provided.
"DEPARTING MEMBERS" shall have the meaning set forth in Section 6.6(f)
hereof.
"DEPRECIATION" means, for each Calendar Year, an amount equal to the
depreciation, amortization, or other cost recovery deduction allowable with
respect to an asset for such Calendar Year, except that if the Gross Asset Value
of an asset differs from its adjusted basis for federal income tax purposes at
the beginning of such Calendar Year, Depreciation shall be an amount which bears
the same ratio to such beginning Gross Asset Value as the federal income tax
depreciation, amortization, or other cost recovery deduction for such Calendar
Year bears to such beginning adjusted tax basis; PROVIDED, HOWEVER, that if the
adjusted basis for federal income tax purposes of an asset at the beginning of
such Calendar Year is zero, Depreciation shall be determined with reference to
such beginning Gross Asset Value using any reasonable method selected by the
Members.
"DISSOLUTION EVENT" shall have the meaning set forth in Section 13.1(a)
hereof.
"EFFECTIVE DATE" shall have the meaning set forth in Section 2.5 hereof.
"ELECTION NOTICE" shall have the meaning set forth in Section 12.2(a)
hereof.
"EXECUTIVE COMMITTEE" means the Executive Committee of the Board of
Managers.
"FINAL DETERMINATION" means (i) a determination set forth in a binding
settlement agreement between the Company and the Member alleged to have
committed an ADVERSE ACT, which settlement agreement has been approved by the
Board of Managers, or (ii) a final judicial determination, not subject to
further appeal, by a court of competent jurisdiction.
"FIRM OFFER" shall have the meaning set forth in Section 11.4(b) hereof.
8
<PAGE>
"GAAP" means generally accepted accounting principles in effect in the
United States of America from time to time.
"GROSS APPRAISED VALUE" shall have the meaning set forth in Section 12.4(a)
hereof.
"GROSS ASSET VALUE" means with respect to any asset, the asset's adjusted
basis for federal income tax purposes, except as follows:
(i) The Gross Asset Values of all Company assets shall be
adjusted to equal their respective gross fair market values (taking Code Section
7701(g) into account), as determined by the Board of Managers as of the
following times: (A) the acquisition of a Membership Interest in the Company by
any new or existing Member in exchange for more than a DE MINIMIS Capital
Contribution; (B) the distribution by the Company to a Member of more than a DE
MINIMIS amount of Company property as consideration for Membership Interest; (C)
the liquidation of the Company within the meaning of Regulations Section
1.704-1(b)(2)(ii)(g)[; and (D) the happening of a Valuation Event,] PROVIDED
that an adjustment described in clauses (A) and (B) of this paragraph shall be
made only if the Board of Managers reasonably determines that such adjustment is
necessary to reflect the relative economic interests of the Members in the
Company;
(ii) The Gross Asset Value of any item of Company assets
distributed to any Member shall be adjusted to equal the gross fair market value
(taking Code Section 7701(g) into account) of such asset on the date of
distribution as determined by the Board of Managers; and
(iii) The Gross Asset Values of Company assets shall be increased
(or decreased) to reflect any adjustments to the adjusted basis of such assets
pursuant to Code Section 734(b) or Code Section 743(b), but only to the extent
that such adjustments are taken into account in determining Capital Accounts
pursuant to Regulations Section 1.704-1(b)(2)(iv)(m) and subparagraph (vi) of
the definition of "PROFITS" and "LOSSES"; PROVIDED, HOWEVER, that Gross Asset
Values shall not be adjusted pursuant to this subparagraph (iii) to the extent
that an adjustment pursuant to subparagraph (ii) is required in connection with
a transaction that would otherwise result in an adjustment pursuant to this
subparagraph (iii).
If the Gross Asset Value of an asset has been determined or adjusted
pursuant to subparagraph (ii) or (iii), such Gross Asset Value shall thereafter
be adjusted by the Depreciation taken into account with respect to such asset,
for purposes of computing Profits and Losses.
"INVESTED CAPITAL" means with respect to each Member the Capital
Contributions made by such Member, net of any liabilities assumed by the Company
as a result of such Capital Contribution or to which any contributed Property is
subject.
"INVOLUNTARY BANKRUPTCY" has the meaning set forth in the definition of
Bankruptcy.
"LIQUIDATION PERIOD" has the meaning set forth in Section 13.6 hereof.
"LIQUIDATOR" has the meaning set forth in Section 13.8(a) hereof.
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<PAGE>
"LOPIT" means Edward A. Lopit, an individual resident in the State of
Washington.
"LOSSES" has the meaning set forth in the definition of "Profits" and
"Losses."
"MANAGEMENT MEMBERS" means Clark, Lopit, Riggs and Snyder.
"MANAGEMENTS' INCENTIVE INTEREST" shall be expressed as a percentage and
calculated as set forth on EXHIBIT A and is intended to represent Management's
interest in the Company derived from the performance of the Company and to be
independent of Management's interest in the Company derived from its Proportion
of Capital.
"MANAGEMENTS' INITIAL INTEREST" shall be calculated as set forth on
EXHIBIT A.
"MANAGEMENTS' TOTAL INTEREST" has the meaning set forth in Section 4.3(b).
"MANAGER" means any of the individuals elected to serve as a Manager
pursuant to the terms of this Agreement and "MANAGERS" means all of such
individuals.
"MEMBER" means any Person (i) who is referred to as such on EXHIBIT B to
this Agreement, or who has become a substituted Member pursuant to the terms of
this Agreement and (ii) who has not ceased to be a Member.
"MEMBERS" means all such Persons.
"MEMBERSHIP INTEREST" means an ownership interest in the Company by a
Member as reflected on EXHIBIT B, including any and all benefits to which the
holder of such Membership Interest may be entitled as provided in this
Agreement, together with all obligations of such Person to comply with the terms
and provisions of this Agreement.
"NET CASH FLOW" means the gross cash proceeds of the Company less the
portion thereof used to pay or establish reserves for all Company expenses, debt
payments, capital improvements, replacements, and contingencies, all as
determined by the Board of Managers. "Net Cash Flow" shall not be reduced by
depreciation, amortization, cost recovery deductions, or similar allowances, but
shall be increased by any reductions of reserves previously established pursuant
to the first sentence of this definition.
"NET EQUITY" shall have the meaning set forth in Section 12.3 hereof.
"NET EQUITY NOTICE" shall have the meaning set forth in Section 12.3
hereof.
"OFFER NOTICE" shall have the meaning set forth in Section 11.4(b) hereof.
"OFFER PERIOD" shall have the meaning set forth in Section 11.4(c) hereof.
"OFFER PRICE" shall have the meaning set forth in Section 11.4(a) hereof.
"OFFERED INTEREST" shall have the meaning set forth in Section 11.4 hereof.
10
<PAGE>
"OFFEREES" shall have the meaning set forth in Section 11.4(b) hereof.
"PAULA" means PAULA Financial, a Delaware corporation.
"PAULA CHANGE OF CONTROL" means with respect to PAULA (i) any sale,
transfer, or other conveyance, whether direct or indirect, of all or
substantially all of the assets of PAULA, on a consolidated basis, in one
transaction or a series of related transactions, (ii) any transaction as a
result of which any "Person" or "group" (as such terms are used for the purposes
of Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, whether or
not applicable) obtains possession of fifty percent (50%) of the voting
securities of PAULA by contract, family relationship, or otherwise, (iii) a
reorganization, merger (not including a merger to effectuate a reincorporation
of PAULA) or consolidation of PAULA as a result of which all the outstanding
voting securities of PAULA are exchanged for or converted into cash, property
and/or securities not issued by PAULA, or (iv) a point in time at which Jeffrey
A. Snider and any one of James A. Nicholson, Andrew M. Slavitt or Bradley K.
Serwin are no longer members of the PAULA Board of Directors; and the date of
any such PAULA Change of Control shall be the closing date of the transaction(s)
that constitute the PAULA Change of Control.
"PERMITTED TRANSFER" has the meaning set forth in Section 11.2 hereof.
"PERSON" means any individual, partnership, limited liability company,
corporation, trust, estate, association, nominee, or other entity.
"PROFITS" and "LOSSES" mean, for each Calendar Year, an amount equal to the
Company's taxable income or loss for such Calendar Year, determined in
accordance with Code Section 703(a) (for this purpose, all items of income,
gain, loss, or deduction required to be stated separately pursuant to Code
Section 703(a)(1) shall be included in taxable income or loss), with the
following adjustments (without duplication):
(i) Any income of the Company that is exempt from federal income
tax and not otherwise taken into account in computing Profits or Losses pursuant
to this definition of "Profits" and "Losses" shall be added to such taxable
income or loss;
(ii) Any expenditures of the Company described in Code Section
705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures pursuant to
Regulations Section 1.704-1(b)(2)(iv)(i), and not otherwise taken into account
in computing Profits or Losses pursuant to this definition of "Profits" and
"Losses" shall be subtracted from such taxable income or loss;
(iii) In the event the Gross Asset Value of any Company asset is
adjusted pursuant to subparagraphs (i) or (ii) of the definition of Gross Asset
Value, the amount of such adjustment shall be treated as an item of gain (if the
adjustment increases the Gross Asset Value of the asset) or an item of loss (if
the adjustment decreases the Gross Asset Value of the asset) from the
disposition of such asset and shall be taken into account for purposes of
computing Profits or Losses;
11
<PAGE>
(iv) Gain or loss resulting from any disposition of Property with
respect to which gain or loss is recognized for federal income tax purposes
shall be computed by reference to the Gross Asset Value of the Property disposed
of, notwithstanding that the adjusted tax basis of such Property differs from
its Gross Asset Value;
(v) In lieu of the depreciation, amortization, and other cost
recovery deductions taken into account in computing such taxable income or loss,
there shall be taken into account Depreciation for such Calendar Year, computed
in accordance with the definition of Depreciation; and
(vi) To the extent an adjustment to the adjusted tax basis of any
Company asset pursuant to Code Section 734(b) is required, pursuant to
Regulations Section 1.704-(b)(2)(iv)(m)(4), to be taken into account in
determining Capital Accounts as a result of a distribution other than in
liquidation of a Member's interest in the Company, the amount of such adjustment
shall be treated as an item of gain (if the adjustment increases the basis of
the asset) or loss (if the adjustment decreases such basis) from the disposition
of such asset and shall be taken into account for purposes of computing Profits
or Losses.
"PROPERTY" means all real and personal property acquired by the Company,
including cash, and any improvements thereto, and shall include both tangible
and intangible property.
"PROPORTION OF CAPITAL" means for each Member the ratio the numerator of
which is such Member's Invested Capital and the denominator of which is the
Invested Capital of all Members.
"PURCHASE NOTICE" shall have the meaning set forth in Section 12.2(b)
hereof.
"PURCHASE OFFER" shall have the meaning set forth in Section 11.4(a)
hereof.
"PURCHASER" shall have the meaning set forth in Section 11.4(a) hereof.
"PURCHASING MEMBERS" shall have the meaning set forth in Section 12.2(b)
hereof.
"RECIPIENT" shall have the meaning set forth in Section 11.5(c).
"RECONSTITUTION PERIOD" has the meaning set forth in Section 13.1(b)
hereof.
"REGULATIONS" means the Income Tax Regulations, including temporary
regulations, promulgated under the Code, as such regulations are amended from
time to time.
"RELATIONSHIP" has the meaning set forth in Section 6.6(f) hereof.
"RIGGS" means Lawrence A. Riggs, an individual resident in the State of
Washington.
"SELLER" shall have the meaning set forth in Section 11.4 hereof.
"SENDER" shall have the meaning set forth in Section 11.5(c) hereof.
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<PAGE>
"SECURITIES ACT" means the Securities Act of 1933, as amended.
"SNYDER" means John R. Snyder, an individual resident in the State of
Washington
"SUBSIDIARY" means Altus Casualty Company Ltd., a Bermuda company.
"TAX MATTERS MEMBER" has the meaning set forth in Section 9.4(a) hereof.
"TRANSFER" means, as a noun, any voluntary or involuntary transfer, sale,
pledge or hypothecation or other disposition and, as a verb, voluntarily or
involuntarily to transfer, sell, pledge or hypothecate or otherwise dispose of.
"VALUATION EVENT" means (i) any Dissolution Event; (ii) the sale of all or
substantially all the assets of the Company; or (iii) any other event determined
to be a Valuation Event by the Board of Managers.
"VOLUNTARY BANKRUPTCY" has the meaning set forth in the definition of
"Bankruptcy."
"WHOLLY OWNED AFFILIATE" of any Person means an Affiliate of such Person
(i) one hundred percent (100%) of the voting stock or beneficial ownership of
which is owned directly by such Person, or by any Person who, directly or
indirectly, owns one hundred percent (100%) of the voting stock or beneficial
ownership of such Person, (ii) an Affiliate to such Person who, directly or
indirectly, owns one hundred percent (100%) of the voting stock or beneficial
ownership of such Person, and (iii) any Wholly Owned Affiliate of any Affiliate
described in clause (i) or clause (ii).
ARTICLE 2
THE COMPANY
2.1 FORMATION. The Members hereby agree to form the Company as a
limited liability company under and pursuant to the provisions of the Act and
upon the terms and conditions set forth in this Agreement. The fact that the
Certificate is on file in the office of the Secretary of State, State of
Delaware, shall constitute notice that the Company is a limited liability
company. Simultaneously with the execution of this Agreement and the formation
of the Company, each of the Members shall be admitted as members of the Company.
The rights and liabilities of the Members shall be as provided under the Act,
the Certificate and this Agreement.
2.2 NAME. The name of the Company shall be Altus Insurance Holdings,
LLC and all business of the Company shall be conducted in such name. The
Managers may change the name of the Company upon ten (10) Business Days notice
to the Members.
2.3 PURPOSE; POWERS.
(a) The purposes of the Company are (i) to operate the Business, (ii) to
engage in any and all activities related or incidental to the purposes set forth
in clause (i). The purposes of the Company may be supplemented or changed by
Approval of the Members.
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<PAGE>
(b) The Company has the power to do any and all acts necessary,
appropriate, proper, advisable, incidental or convenient to or in furtherance of
the purposes of the Company set forth in Section 2.3 hereof and has, without
limitation, any and all powers that may be exercised on behalf of the Company by
the Managers pursuant to Article 6 hereof.
2.4 PRINCIPAL PLACE OF BUSINESS. The principal place of business of the
Company shall be at Bellevue, Washington or at such other location determined by
the Board of Managers. The Board of Managers may change the principal place of
business of the Company to any other place within or without the State of
Delaware upon ten (10) Business Days notice to the Members. The registered
office of the Company in the State of Delaware initially is located at National
Registered Agents, Inc., 9 East Loockerman Street, Dover, County of Kent, DE
19901.
2.5 TERM. The term of the Company shall commence from the date of
filing the Certificate in the office of the Secretary of State of the State of
Delaware in accordance with the Act (the "EFFECTIVE DATE") and shall continue
until the winding up and liquidation of the Company and its business is
completed following a Dissolution Event, as provided in Section 13 hereof.
2.6 FILINGS; AGENT FOR SERVICE OF PROCESS.
(a) The Board of Managers are hereby authorized to and shall cause the
Certificate to be filed in the office of the Secretary of State of the State of
Delaware in accordance with the Act. The Managers shall take any and all other
actions reasonably necessary to perfect and maintain the status of the Company
as a limited liability company under the laws of the State of Delaware,
including the preparation and filing of such amendments to the Certificate and
such other assumed name certificates, documents, instruments and publications as
may be required by law, including, without limitation, action to reflect:
(i) a change in the Company name;
(ii) a correction of false or erroneous statements in the
Certificate or the desire of the Members to make a change in any statement
therein in order that it shall accurately represent the agreement among the
Members; or
(iii) a change in the time for dissolution of the Company as stated
in the Certificate and in this Agreement.
(b) The Members and the Board of Managers shall execute and cause to be
filed original or amended certificates and shall take any and all other actions
as may be reasonably necessary to perfect and maintain the status of the Company
as a limited liability company or similar type of entity under the laws of any
other jurisdictions in which the Company engages in business.
14
<PAGE>
(c) The registered agent for service of process on the Company in the
State of Delaware shall be National Registered Agents, Inc. or any successor as
appointed by the Members in accordance with the Act.
(d) Upon the dissolution and completion of the winding up and
liquidation of the Company in accordance with Section 13, the Board of Managers
shall promptly cause to be executed and cause to be filed a certificate of
cancellation in accordance with the Act and the laws of any other jurisdictions
in which the Board of Managers deem such filing necessary or advisable.
2.7 TITLE TO PROPERTY. All Property owned by the Company shall be owned
by the Company as an entity and no Member shall have any ownership interest in
such Property in such Member's individual name, and each Member's interest in
the Company shall be personal property for all purposes. At all times after the
Effective Date, the Company shall hold title to all of its Property in the name
of the Company and not in the name of any Member.
2.8 PAYMENTS OF INDIVIDUAL OBLIGATIONS. The Company's credit and assets
shall be used solely for the benefit of the Company, and no asset of the Company
shall be Transferred or encumbered for, or in payment of, any individual
obligation of any Member.
ARTICLE 3
MEMBERS' CAPITAL CONTRIBUTIONS
3.1 ORIGINAL CAPITAL CONTRIBUTIONS. Each Member shall forthwith deliver
to the Company the money, set forth beside such Member's name on EXHIBIT B.
3.2 INTEREST ON CAPITAL CONTRIBUTIONS. No Member shall be entitled to
receive any interest on such Member's Capital Contribution.
3.3 OPTIONAL ADDITIONAL CAPITAL CONTRIBUTIONS.
(a) PAULA shall have the option to make each of the following additional
capital contributions:
(i) $2 million at any time between January 1, 2000 and
December 31, 2000;
(ii) $5 million at any time between January 1, 2001 and
December 31, 2001;
(iii) $5 million at any time between January 1, 2002 and
December 31, 2002;
(iv) $5 million at any time between January 1, 2003 and
December 31, 2003;
(v) $2.5 million at any time between January 1, 2004 and
December 31, 2004;
and each such option shall be distinct and may be exercised at any time prior to
the expiration time noted by delivering a certified check for its Additional
Capital Contribution and a written notice of exercise to the principal place of
business of the Company. The Members acknowledge their intent that during the
course of the year during which a foregoing option may be exercised, PAULA will
not be expected to consider exercising such option unless and until the
Company's operating needs indicate that the Additional Capital Contribution is
required by the Company.
15
<PAGE>
If agreed by PAULA and the Company, the exercise dates of the foregoing options
may be accelerated so that PAULA may provide the Company with an Additional
Capital Contribution on an as needed basis. In the event that PAULA does not
exercise a particular option at a time that the Board of Managers determines
that the Company needs to raise the additional funds which would have been
provided by PAULA's exercise of such option, the Members each agree to cooperate
fully with the Company's efforts to raise such funds from other sources.
Further, the Members acknowledge that in such event no Member has any right of
first refusal to match any third party investment proposal.
(b) Each of Clark, Lopit, Riggs and Snyder shall have the option to make
an Additional Capital Contribution of $10,000 for each $1 million Capital
Contribution that PAULA makes pursuant to an option referred to in Section
3.3(a). The Company shall provide each of Clark, Lopit, Riggs and Snyder with
notice of any Capital Contribution made by PAULA pursuant to Section 3.3(a) and
they shall each have a period of 30 days from the date such notice is sent to
them to exercise the option granted to each of them pursuant to this Section
3.3(b) by delivering a certified check for their Additional Capital Contribution
and a written notice of exercise to the principal place of business of the
Company. In the event that any or all of Clark, Lopit, Riggs or Snyder do not
exercise a particular option at a time that the Board of Managers determines
that the Company needs to raise the additional funds which would have been
provided by the exercise of such respective options, the Members each agree to
cooperate fully with the Company's efforts to raise such funds from other
sources. Further, the Members acknowledge that in such event no Member has any
right of first refusal to match any third party investment proposal.
(c) Provided that the Management Member in question is not in default of
any terms or conditions of this Agreement, PAULA agrees to loan to each
Management Member a sum equal to 80% of any amount that the Management Member
agrees to contribute pursuant to Section 3.3(b). Such loan shall (i) have a
ten-year term with no principal payments due until maturity; (ii) shall provide
for the acceleration of the maturity of the principal amount thereof to the
earlier of (A) the closing date of any Dissolution Event or (B) the closing of
any sale of the Membership Interest purchased by the Management Member borrower
in part with the funds provided by the applicable loan; (iii) bear market rates
of interest for corporate ten-year term loans which interest shall be payable
quarterly in arrears; (iv) secured by the Membership Interest held by the Member
in form and substance satisfactory to PAULA; (v) be a personal obligation of the
Member with full recourse to other assets of the Member; (vi) be documented and
executed in form and substance satisfactory to PAULA; (vii) be subject to the
irrevocable exercise by such Management Member of the option in Section 3.3(b)
of this Agreement to which the loan relates; and (viii) be available to a
Management Member on written notice on the business day following satisfaction
of the foregoing terms and conditions:
3.4 WITHDRAWAL OF CAPITAL. Except in connection with proceedings to
dissolve the Company in accordance with the procedures set forth in Section 13
of this Agreement, no Member may withdraw any portion of such Member's Capital
Contribution, or any portion of such Member's Capital Account, from the Company
without the approval of the Board of Managers.
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<PAGE>
3.5 LOANS BY MEMBERS. A Member may take a loan or advance money or
property to or on behalf of the Company, only upon such terms that have received
the Approval of the Members. Such loan or advance shall not increase the
lending Member's Capital Account, entitle the lending Member to any greater
share of Company distributions or entitle or subject such lending Member to any
greater proportion of Company Profits or Losses. The amount of such loans or
advances shall be a debt owed by the Company to the lending Member, and any
interest paid to the lending Member shall be charged as any other expense
against income of the Company.
ARTICLE 4
ALLOCATIONS
4.1 PROFITS. Subject to adjustment pursuant to Section 4.3, Profits for
any Calendar Year shall be allocated to the Members as follows:
(i) first, to the Members up to and in proportion to Losses
allocated to the Members pursuant to clause 4.2(ii) for all prior periods; and
(ii) second, to the Members as set out on EXHIBIT B.
4.2 LOSSES. Losses for any Calendar Year shall be allocated to the
Members as follows:
(i) first, to the Members up to and in proportion to Profits
allocated to the Members pursuant to clause 4.1(ii) for all prior periods; and
(ii) second, to the Members in proportion to their Capital Account
balances in effect immediately before any allocations under this clause 4.2(ii).
4.3 ADJUSTMENTS.
(a) For each $960,000 Additional Capital Contribution that PAULA makes
pursuant to the exercise of the options granted in Section 3.3(a) of this
Agreement in excess of any Additional Capital Contributions made by the
Management Members pursuant to Section 3.3(b), the allocation of Profits set out
on EXHIBIT B shall be adjusted such that PAULA's allocation of Profits shall be
increased by an aggregate of 3.104% and each Management Member's allocation of
Profits shall be decreased by 0.776%. In the case of Additional Capital
Contributions by PAULA in an amount in excess of that made by the Management
Members that is less than or greater than $960,000 the adjustments referred to
in this Section 4.3(a) shall be decreased or increased proportionally. The
Members acknowledge that the following example represents the intended operation
of the foregoing adjustment provision: if PAULA exercises the option referred
to in Section 3.3(a)(i) and makes an additional capital contribution of $2
million and each of the Management Members exercise their corresponding option
in Section 3.3(b) and the Management Members collectively make an aggregate
Additional Capital Contribution of $80,000, PAULA's allocation of Profits shall
each be increased by 6.208% to a total of 27.416%
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<PAGE>
and each Management Member's allocation of Profits shall be decreased by 1.552%
to a total of 18.146%.
(b) Upon the happening of a Valuation Event, the Profits for the current
Calendar Year shall be allocated as follows:
(i) First, the Management Members shall be allocated an amount of
Profit equal to: (A) the product of aggregate Net Equity, measured as of the
date of the Valuation Event, and Management's Incentive Interest, plus
(B) Losses allocated to the Management Members pursuant to clause 4.2(ii) for
all prior Calendar Years, minus (C) Profits allocated to the Management Members
pursuant to clause 4.1(ii) for all prior Calendar Years (this aggregate amount
of Profit to be allocated among the Management Members equally); and
(ii) Second, any remaining Profits shall be allocated to the
Members on the basis of each Member's Proportion of Capital.
The ratio, the numerator of which is the sum of each Management Members
Capital Account following the allocations provided for in this Section 4.3(b),
and the denominator of which is the sum of each Members Capital Account
following the allocations provided for in this Section 4.3(b) is hereinafter
referred to as "MANAGEMENTS' TOTAL INTEREST."
(c) Following the happening of a Valuation Event, the allocation of
Profits shall henceforth be adjusted such that: (i) PAULA's allocation shall be
equal to the percentage equal to one hundred percent (100%) minus Managements'
Total Interest; and (ii) each Management Member's allocation shall be equal to
the percentage equal to the product of (A) .25 and (B) Managements' Total
Interest.
(d) In the event that an officer who was a Management Member was
terminated for Cause or voluntarily terminated his employment with the Company
during the periods set out below, such Member's allocation of Profits,
determined following the application of the adjustments provided for in this
Section 4.3 shall be reduced by the following proportion of the amounts
allocated to such Member in relation to such Members share of Managements'
Incentive Interest pursuant to clause 4.3(b)(i).
<TABLE>
<CAPTION>
Reduction of Member's Managements'
Date of Termination Incentive Interest
------------------- ----------------------------------
<S> <C>
(i) Prior to January 1, 2000 100%
(ii) After December 31, 1999 and 80%
prior to January 1, 2001
(iii) After December 31, 2000 and 60%
prior to January 1, 2002
(iv) After December 31, 2001 and 40%
</TABLE>
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<PAGE>
<TABLE>
<S> <C>
prior to January 1, 2003
(v) After December 31, 2002 and 20%
prior to January 1, 2004
(vi) After January 1, 2004 No adjustment
</TABLE>
provided that no adjustments shall be made pursuant to this Section 4.3(d) in
the event that the officer in question was terminated without Cause, died, was
permanently disabled or retired at the Company's regular retirement age. The
unallocated proportion of Profits resulting from the operation of the
adjustments provided for in this Section 4.3(d) shall be allocated to the
Members not subject to the adjustments provided for in this Section 4.3(d) on a
basis proportional to the then existing allocation of Profits specified in
Section 4.3(c).
(e) In the event that any Dissolution Event referred in Section
13.1(a)(iv) occurs, each Management Members allocation of Profits shall be
reduced to such Member's Proportion of Capital and PAULA's allocation of Profits
shall be increased by the same aggregate amount.
(f) The adjustments provided for in this Section 4.3 are to be
cumulative and shall apply to successive events resulting in any adjustment
pursuant to this Section 4.3.
(g) The examples set out on EXHIBIT C represent the intended operation
of the adjustments provided for by Section 4.3(b) and Section 4.3(d).
ARTICLE 5
DISTRIBUTIONS
5.1 NET CASH FLOW. Except as otherwise provided in Article 13 hereof,
Net Cash Flow, if any, shall be distributed to the Members in the proportions
that Profits are allocated to Members pursuant to Article 4 at such times as
approved by the Board of Managers.
5.2 MINIMUM DISTRIBUTIONS. Notwithstanding Section 5.1 hereof, prior to
April 15th (or March 15th in the case of a Member that is a Subchapter C
Corporation) following the Calendar Year to which the taxes contemplated by this
Section 5.2 relate, the Company shall distribute to each Member an amount of Net
Cash Flow equal to the product of the highest United States federal tax rate for
individuals and the Profits and other items of Company income and gains
allocated to such Member for the Calendar Year pursuant to Section 4 hereof.
The aggregate amounts distributed to a Member under this Section 5.2 will reduce
the amounts otherwise distributable to the Member under Section 5.1.
5.3 AMOUNTS WITHHELD. All amounts withheld pursuant to the Code or any
provision of any state, local, or foreign tax law with respect to any payment,
distribution, or allocation to the Company or the Members shall be treated as
amounts paid or distributed, as the case may be, to the Members with respect to
which such amount was withheld pursuant to this Section 5.3 for all purposes
under this Agreement. The Company is authorized to withhold from payments and
distributions, or with respect to allocations to the Members, and to pay over to
any federal,
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state and local government or any foreign government, any amounts required to be
so withheld pursuant to the Code or any provisions of any other federal, state
or local law or any foreign law, and shall allocate any such amounts to the
Members with respect to which such amount was withheld.
5.4 LIMITATIONS ON DISTRIBUTIONS.
(a) The Company shall make no distributions to the Members except as
provided in this Section 5 and Article 13 hereof.
(b) A Member may not receive a distribution from the Company to the
extent that, after giving effect to the distribution, all liabilities of the
Company, other than liabilities to Members on account of their Capital
Contributions, would exceed the lower of the book value or the fair value of the
Company's assets.
ARTICLE 6
MANAGEMENT
6.1 MANAGERS.
(a) The management of the Company shall be vested in a Board of eight
Managers, seven of whom will be voting and one of whom will be non-voting.
Managers may, but need not be, Members of the Company. The Management Members
shall have the right to appoint four voting Managers. PAULA shall have the
right to appoint three voting Managers and one non-voting Manager. The
non-voting Manager shall have all of the rights and responsibilities of a voting
Manager except that the non-voting Manager shall not be entitled to vote at
meetings of or proceedings of the Board of Managers.
(b) The initial Managers of the Company shall be Clark, Lopit, Riggs,
Snyder, Jeffrey A. Snider, Andrew M. Slavitt, James A. Nicholson and Bradley K.
Serwin. Bradley K. Serwin shall serve as the non-voting Manager. Clark, Lopit,
Riggs and Snyder shall be considered nominees of the Management Members on the
board of Managers. Jeffrey A. Snider, Andrew M. Slavitt, James A. Nicholson and
Bradley K. Serwin shall be considered nominees of PAULA on the Board of
Managers. In the event that the Management Members cease to hold the right to
be allocated a majority of Profits pursuant to Article 4, then: (i) the
Management Members shall then be entitled to appoint three voting Managers and
one non-voting Manager, (ii) PAULA shall be entitled to appoint four voting
Managers, and (iii) the non-voting Manager appointed by PAULA shall be entitled
to voting rights as a Manager without the need for any further action on the
seventh day following such event; and (iv) the Management Members shall notify
the Company and PAULA in writing within seven days of such event which of their
nominees to the Board of Managers will serve as a non-voting Manager and failing
which the nominee Manager of the Management Members that is youngest in age
shall become the non-voting Manager.
(c) The Board of Managers shall have the following Committees and the
initial members of such committees shall be as follows:
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<TABLE>
<CAPTION>
Committee Members
------------------------- ---------------------------------------
<S> <C>
(i) Executive: Clark and Jeffrey A. Snider;
(ii) Audit: Snyder and James A. Nicholson;
(iii) Compensation: Jeffrey A. Snider, Andrew M. Slavitt and
Clark (ex officio basis); and
(iv) Investment/M&A/Capital Riggs, Snyder, Jeffrey A. Snider and
Planning: James A. Nicholson;
</TABLE>
and such Committees will continue to exist and perform the delegated functions
so long as this Agreement continues in force or until they are changed in
accordance with the terms hereof.
(d) Committees of the Board of Managers shall have the responsibilities
set out below and such other responsibilities as may be determined by the Board
of Managers from time to time:
(i) the Audit Committee shall recommend to the Board of Managers
whether the financial statements of the Company and the
Subsidiary are to be reviewed or audited and which firm of
accountants is to be engaged as the Company's auditor or
accounting advisors and shall monitor compliance with
relevant standards and policies;
(ii) The Investment/M&A/Capital Planning Committee will recommend
standards to the Board of Managers to be utilized by the
Company's management to evaluate potential transactions prior
to bringing any such transactions forward to the Board of
Managers for approval and;
(iii) the Compensation Committee will review and recommend to the
Board of Managers compensation packages for the officers of
the Company;
(e) A Manager shall serve as such until the earliest of (i) the
resignation of such Manager for any reason, or (ii) the removal of such Manager
from that position by the Members so entitled.
(f) Each Manager shall perform his duties as a Manager in good faith, in
a manner that is in the best interests of the Company and the Members, and with
such care as an ordinarily prudent person in a like position would use under
similar circumstances. A Manager shall not be liable to the Company or the
Members for monetary damages for breach of any duty as a Manager unless it is
demonstrated by way of a final judicial determination, not subject to further
appeal, by a court of competent jurisdiction that such breach of duty involved
fraud, intentional misconduct, gross negligence or a knowing violation of any
law or regulation material to the breach of duty.
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(g) A Manager shall not be liable under a judgment, decree or order of
court, or in any other manner, for a debt, obligation or liability of the
Company.
6.2 POWERS OF BOARD OF MANAGERS.
(a) Except as otherwise provided in this Agreement, the Board of
Managers shall have the powers to control and manage the Business and affairs of
the Company and may exercise all powers of the Company and take all actions
that the Board of Managers deem necessary, useful, or appropriate for the
management and conduct of the Business, provided that the power of the Board of
Managers shall in all cases be subject to approval by the Members as required by
statute, the Certificate or this Agreement.
(b) The Board of Managers shall act by majority consent, and no
individual Manager may act on behalf of the Company without the approval of the
Board of Managers by majority consent.
(c) The Board of Managers shall have the power to delegate authority to
officers, employees, agents, and representatives of the Company as they may from
time to time deem appropriate. Any delegation of authority to take any action
must be approved in the same manner as would be required for the Board of
Managers to approve such action directly.
(d) The Board of Managers may establish policies and guidelines for the
hiring of employees to permit the Company to act as an operating company with
respect to its Business. The Board of Managers may adopt appropriate management
incentive plans and employee benefit plans.
(e) The Board of Managers shall have the power to approve any
non-typical excess of loss reinsurance treaty arrangements.
6.3 DUTIES AND OBLIGATIONS OF THE MANAGERS.
(a) The Board of Managers shall cause the Company to conduct its
Business and operations separate and apart from that of any Member, Manager, or
any Affiliate of any Member or Manager, including, without limitation,
(i) segregating Company assets and not allowing funds or other assets of the
Company to be commingled with the funds or other assets of, held by, or
registered in the name of, any Member, Manager, or any Affiliate of any Member
or Manager, (ii) maintaining books and financial records of the Company separate
from the books and financial records of any Member, Manager, or any Affiliate of
any Member or Manager, and observing all Company procedures and formalities,
including, without limitation, maintaining minutes of Company meetings and
acting on behalf of the Company when required only pursuant to due authorization
of the Members, (iii) causing the Company to pay its liabilities from assets of
the Company, and (iv) causing the Company to conduct its dealings with third
parties in its own name and as a separate and independent entity.
(b) The Board of Managers shall take all actions that may be necessary
or appropriate (i) for the continuation of the Company's valid existence as a
limited liability company under the
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laws of the State of Delaware and of each other jurisdiction in which such
existence is necessary to protect the limited liability of the Members or to
enable the Company to conduct the Business and (ii) for the accomplishment of
the Company's purposes, including the acquisition, development, maintenance,
preservation, and operation of the Business or Property in accordance with the
provisions of this Agreement and applicable laws and regulations.
6.4 REIMBURSEMENTS. The Company shall reimburse the Members and
Managers for all reasonable expenses incurred and paid by any of them in the
organization of the Company and in the conduct of the Company's business. Such
expenses shall not include any expenses incurred in connection with a Member's
or Manager's exercise of its rights as a Member or a Manager apart from the
authorized conduct of the Company's business. Such reimbursement shall be
treated as expenses of the Company and shall not be deemed to constitute
distributions to any Member of Profit, Loss or capital of the Company.
6.5 INDEMNIFICATION.
(a) Unless otherwise provided in Section 6.5(d) hereof, the Company, its
receiver, or its trustee (in the case of its receiver or trustee, to the extent
of Company Property) shall indemnify, save harmless, and pay all judgments and
claims against any Manager or officer of the Company relating to any liability
or damage incurred by such Manager or officer by reason of any act performed or
omitted to be performed by any Manager or officer of the Company in connection
with the Business, including reasonable attorneys' fees incurred by the Manager
or officer in connection with the defense of any action based on any such act or
omission, which attorneys' fees may be paid as incurred.
(b) Unless otherwise provided in Section 6.5(d) hereof, in the event of
any action by a Member against any Manager or officer of the Company, including
a Company derivative suit, the Company shall indemnify, save harmless, and pay
all expenses of such Manager or officer, including reasonable attorneys' fees
incurred in the defense of such action.
(c) Unless otherwise provided in Section 6.5(d) hereof, the Company
shall indemnify, save harmless, and pay all expenses, costs, or liabilities of
any Manager or officer of the Company, if for the benefit of the Company and in
accordance with this Agreement said Manager or officer makes any deposit or
makes any other similar payment of personal funds or assumes any personal
obligation in connection with any Property proposed to be acquired by the
Company and suffers any personal financial loss as the result of such action.
(d) Notwithstanding the provisions of Sections 6.5(a), 6.5(b) and 6.5(c)
above, no Manager or officer of the Company shall be indemnified or held
harmless pursuant to this Section 6.5 if it is demonstrated by way of a final
judicial determination, not subject to further appeal, by a court of competent
jurisdiction that the fraud, intentional misconduct, gross negligence or knowing
violation of any law or regulation by such Manager or officer of the Company
contributed materially to such liability or claim. Any reduction in the
indemnification otherwise provided for in this Section 6.5 by virtue of the
operation of this Section 6.5(d) shall be
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made in proportion to the contribution of the fraud, intentional misconduct,
gross misconduct or knowing violation of law or regulation to the aggregate
liability or damage in question.
6.6 OFFICERS.
(a) The officers of the Company, the holders of such offices and the
duties associated with such offices shall be determined by the Board of Managers
of the Company from time to time. Until the Board of Managers of the Company
otherwise determines the offices of the Company, the holders of such offices and
the duties associated with such offices shall be as provided in this Section
6.6.
(b) The initial offices of the Company shall include a Chief Executive
Officer, President, Executive Vice President, Senior Vice President -
Operations, Chief Financial Officer, Treasurer and Corporate Secretary. Clark
shall be the initial President and Chief Executive Officer of the Company.
Snyder shall be the initial Chief Financial Officer and Treasurer of the
Company. Riggs shall be the initial Executive Vice President of the Company.
Lopit shall be the initial Senior Vice President - Operations of the Company.
Bradley K. Serwin shall be the initial Secretary of the Company. Only the Board
of Managers can remove or otherwise change such officers.
(c) The officers of the Company shall be responsible for the day-to-day
operations of the Company including without limitation matters related to:
(i) underwriting, (ii) claims, (iii) distribution force, (iv) investments within
investment guidelines approved by the Board of Managers, (v) hiring and
termination of employees subject to any guidelines approved by the Board of
Managers; (vi) reinsurance arrangements within guidelines approved by the Board
of Managers; (vii) quota-share reinsurance arrangements with PAULA; (viii) the
submission of a monthly financial report to the Board of Managers consisting of
a statement of profit and loss, balance sheet and managements' discussion and
analysis; and (ix) the preparation and submission to the Board of Managers for
approval of an annual business plan relating to the budget, planned acquisitions
and capital expenditures.
(d) The Company will purchase life insurance in respect of each of the
officers of the Company on terms determined by the Executive Committee of the
Board of Managers. Each Management Member represents and warrants that to the
best of their knowledge any such life insurance can be obtained by the Company
on commercially reasonable terms.
(e) At such time as PAULA acquires the right to be allocated a majority
of the Profits pursuant to Article 4, PAULA and each Management Member who is an
officer of the Company shall commence good faith negotiations related to a
separation agreement that will govern the relationship between such officer and
the Company in the event that such officer ceases to be an employee of the
Company. Subject to the terms of any such separation agreement, in the event
that a Dissolution Event specified in Section 13.1(a)(iv)(A) of this Agreement
takes place, the Company shall pay each Management Member who ceases to be an
officer of the Company severance of not less than an amount equal to ninety days
pay. In the event that a Dissolution Event specified in Section 13.1(a)(iv)(B)
or (C) of this Agreement takes place, the Company
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<PAGE>
may, but shall not be obligated to, pay to each Management Member who ceases to
be an officer of the Company severance equal to ninety days pay.
(f) In the event that:
(i) a majority of the Management Members ("DEPARTING MEMBERS")
cease to be officers of the Company and become employees of,
consultants to or enter into a similar relationship
(collectively a "RELATIONSHIP") with any entity or entities
engaged in the casualty insurance business; and
(ii) customers of the Company who were customers of the Company
when any such Departing Members were officers of the Company
do not renew any insurance policies with the Company and
place such insurance with an entity that a Departing Member
has a Relationship with within thirteen months of the date
that the Departing Member in question ceased to be an officer
of the Company,
then the Departing Members on a joint and several basis shall pay to the Company
compensation for the lost business determined through a procedure to be agreed
upon within 90 days of the date that the Department Members ceased to be
officers of the Company. Such procedure will be agreed upon by one
representative of the Departing Members and one representative of the Company.
In the event that such persons cannot agree on a procedure during the 90 day
period, they must agree on a third person or entity which will make the
procedural determination on behalf of the parties within the 90 day period. The
Departing Members on the one hand and the Company on the other will split the
cost of any such necessary third party. Such third party will be asked to
render its determination within 30 days after his, her or its appointment.
6.7. MISCELLANEOUS.
(a) The parties acknowledge that they each contemplate and expect that:
(i) the Subsidiary and PAULA Insurance Company, an Affiliate of PAULA, will
enter into a quota - share reinsurance agreement following the Effective Date on
commercially reasonable terms for the purpose of providing underwriting capacity
and surplus to the Subsidiary, and (ii) the Subsidiary will operate at
approximately a 2.5:1 net writings to surplus ratio. Any such agreement
approved by the Board of Managers shall be deemed to have received the Approval
of the Members.
(b) Each of the Management Members and PAULA shall have the right to
request that the Executive Committee of the Board of Managers review any of the
terms of this Agreement if such Member believes that such term(s) are materially
unfair to the requesting Member. In order to exercise such right a Member shall
submit a written request for review to each member of the Executive Committee
specifying the terms that such Member believes to be unfair and the reasons
related thereto. The Executive Committee shall respond in writing to all
Members and to the Board of Managers within 30 days of receipt of such written
request. The response of the Executive Committee shall be non-binding but all
Members and the Board of
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<PAGE>
Managers shall make reasonable best efforts to consider such response including
the commencement of good faith negotiations to implement the recommendations
contained in such response.
(c) It is the intention of the Members that the Subsidiary will be
continued or reincorporated in a United States jurisdiction as soon as
practicable following the Effective Date.
(d) To the extent practicable, the board of directors of the Subsidiary
shall be organized in the same fashion as the Board of Managers, including
without limitation the membership thereof.
ARTICLE 7
ROLE OF MEMBERS
7.1 RIGHTS OR POWERS. Except as specifically set forth herein, the
Members as such shall not have any right or power to take part in the management
or control of the Company or its business and affairs or to act for or bind the
Company in any way. Notwithstanding the foregoing, the Members have all the
rights and powers specifically set forth in this Agreement and, to the extent
not inconsistent with this Agreement, in the Act.
7.2 VOTING RIGHTS.
(a) No Member has any voting right except with respect to those matters
specifically reserved for a Member vote which are set forth in this Agreement
and as required in the Act.
(b) Unless a provision of this Agreement specifically provides
otherwise, matters that may or must be approved by the Members pursuant to this
Agreement will be approved upon a vote in favor that constitutes the Approval of
the Members.
7.3 MEETINGS OF THE MEMBERS.
(a) Meetings of the Members may be called upon the written request of
any Member. The call shall state the location of the meeting and the nature of
the business to be transacted. Notice of any such meeting shall be given to all
Members not less than seven (7) Business Days nor more than thirty (30) days
prior to the date of such meeting. Members may vote in person, by proxy or by
telephone at such meeting and may waive advance notice of such meeting.
Whenever the vote or consent of Members (whether Extraordinary or otherwise) is
permitted or required under the Agreement, such vote or consent may be given at
a meeting of the Members or may be given in accordance with the procedure
prescribed in this Section 7.3.
(b) Each Member may authorize any Person or Persons to act for it by
proxy on all matters in which a Member is entitled to participate, including
waiving notice of any meeting, or voting or participating at a meeting. Every
proxy must be signed by the Member or its attorney-in-fact. No proxy shall be
valid after the expiration of eleven (11) months from the date thereof unless
otherwise provided in the proxy. Every proxy shall be revocable at the pleasure
of the Member executing it.
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(c) Notwithstanding this Section 7.3, the Company may take any action
contemplated under this Agreement as approved by the Members in writing, or by
telephone or facsimile, if such telephone conversation or facsimile is followed
by a written summary of the telephone conversation or facsimile communication
sent by registered or certified mail, postage and charges prepaid, addressed as
described in Section 15.1 hereof, or to such other address as such Person may
from time to time specify by notice to the Members and Managers.
7.4 REQUIRED MEMBER CONSENTS.
(a) Notwithstanding any other provision of this Agreement, no action may
be taken by the Company (whether by the Board of Managers, or otherwise) in
connection with any of the following matters without the Approval of the
Members:
(i) Any activity that is not consistent with the purposes of the
Company as set forth in Section 2.3 hereof;
(ii) Any act in contravention of this Agreement;
(iii) Confession of a judgment against the Company (other than in
the ordinary course of business);
(iv) A material change in the nature of the Business;
(v) a material change in the manner in which the Business is
conducted, including without limitation any amendment to the Memorandum of
Association or By-Laws of the Subsidiary or any change in the composition of the
Board of Directors of the Subsidiary;
(vi) Any sale of assets of the Company not in the ordinary course
of business or involving total consideration in excess of $100,000;
(vii) Issuance of additional Membership Interests or any other
equity or any equity-based security by the Company other than any adjustment to
Capital Accounts and allocations of Profits, Losses or Net Cash Flow contained
in this Agreement;
(viii) Any capital expenditures in excess of $250,000;
(ix) Any transaction in excess of $10,000 between the Company and
any Member, Manager, or Affiliate thereof; or
(x) Any acquisition by the Company not in the ordinary course of
business or involving total consideration in excess of $500,000.
(xi) Any transaction by the Company involving the incurrence of
any indebtedness for borrowed money not in the ordinary course of business or in
excess of $250,000 or any guaranty or other contingent liability of the Company
in respect of any obligation of any third party (other than in the ordinary
course of business);
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(xii) the payment of any distribution to the Members;
(xiii) Dissolution, liquidation, or winding up of the Company; or
(xiv) Merger or consolidation of the Company, or sale of the
Company or all or substantially of all of its assets; provided however that such
transaction will not be consummated until after the expiration of the Management
Members' rights under Section 11.4(g) below.
7.5 WITHDRAWAL/RESIGNATION. Except as otherwise provided in Articles 5
and 13 hereof, no Member shall demand or receive a return on or of such Member's
Capital Contributions or withdraw from the Company without the consent of all
Members. Under circumstances requiring a return of any Capital Contributions,
no Member has the right to receive Property other than cash except as may be
specifically provided herein.
7.6 MEMBER COMPENSATION. No Member shall receive any interest, salary,
or drawing with respect to its Capital Contributions or its Capital Account or
for services rendered on behalf of the Company, or otherwise, in its capacity as
a Member, except as otherwise provided in this Agreement.
7.7 MEMBERS LIABILITY. No Member shall be liable under a judgment,
decree or order of a court, or in any other manner for the debts or any other
obligations or liabilities of the Company. A Member shall be liable only to
make its Capital Contributions and shall not be required to restore a deficit
balance in its Capital Account or to lend any funds to the Company or, after its
Capital Contributions have been made, to make any additional contributions,
assessments, or payments to the Company, provided that a Member may be required
to repay distributions made to it as provided in Section 18-607 of the Act. The
Managers shall not have any personal liability for the repayment of any Capital
Contributions of any Member.
7.8 PARTITION. While the Company remains in effect or is continued,
each Member agrees and waives its rights to have any Company Property
partitioned, or to file a complaint or to institute any suit, action or
proceeding at law or in equity to have any Company Property partitioned, and
each Member, on behalf of itself, its successors and its assigns hereby waives
any such right.
7.9 CONFIDENTIALITY. Except as contemplated hereby or required by a
court of competent authority, each Member shall keep confidential and shall not
disclose to others and shall use its reasonable efforts to prevent such Member's
Affiliates, and any present or former employees, agents, and representatives of
such Member or such Member's Affiliates from disclosing to others without the
prior written consent of all Members any information that (i) pertains to this
Agreement, any negotiations pertaining thereto, any of the transactions
contemplated hereby,
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or the Business of the Company, or (ii) pertains to confidential or proprietary
information of any Member or the Company or that any Member has labeled in
writing as confidential or proprietary. No Member shall use, and each Member
shall use its best efforts to prevent any Affiliate of such Member from using,
any information that (i) pertains to this Agreement, any negotiations pertaining
hereto, any of the transactions contemplated hereby, or the Business of the
Company, or (ii) pertains to the confidential or proprietary information of any
Member or the Company or which any Member has labeled in writing as confidential
or proprietary, except in connection with the transactions contemplated hereby.
The term "confidential information" is used in this Section 7.9 to describe
information that is confidential, non-public, or proprietary in nature, was
provided to such Member or its representatives by the Company, any other Member,
or such Persons' agents, representatives and employees, and relates either
directly, or indirectly to the Company or the Business. Information which (i) is
available, or becomes available, to the public through no fault or action by
such Member, its agents, representatives or employees or (ii) becomes available
on non-confidential basis from any source other than the Company, any other
Member, or such Persons' agents, representatives or employees and such source is
not prohibited from disclosing such information, shall not be deemed
confidential information.
7.10 TRANSACTIONS BETWEEN A MEMBER AND THE COMPANY. Except as otherwise
provided by applicable law and as otherwise provided herein, any Member may upon
the approval of the Members, but shall not be obligated to, lend money to the
Company, act as surety for the Company, and transact other business with the
Company. A Member has the same rights and obligations when transacting business
with the Company as a Person or entity who is not a Member. A Member, any
Affiliate thereof, or an employee, stockholder, agent, director or officer of a
Member or any Affiliate thereof, may also be an employee or be retained as an
agent of the Company. The existence of these relationships and acting in such
capacities will not result in the Member being deemed to be participating in the
control of the business of the Company or otherwise affect the limited liability
of the Member.
7.11 OTHER INSTRUMENTS. Each Member hereby agrees to execute and deliver
to the Company within five (5) days after receipt of a written request therefor,
such other and further documents and instruments, statements of interest and
holdings, designations, powers of attorney and other instruments and to take
such other action as may be necessary, useful or appropriate to comply with any
laws, rules or regulations as may be necessary to enable the Company to fulfill
its responsibilities under this Agreement.
7.12 GUARANTEE OF COMPANY INDEBTEDNESS. Except for arrangements
expressly described in this Agreement, no Member shall enter into (or permit any
Person related to the Member to enter into) any arrangement with respect to any
liability of the Company that would result in such Member (or a Person related
to such Member under Regulations Section 1.752-4(b)) bearing the economic risk
of loss (within the meaning of Regulations Section 1.752-2) with respect to such
liability unless such arrangement has received the Approval of the Members. To
the extent a Member is permitted to guarantee the repayment of any Company
indebtedness under this Agreement, each of the other Members shall be afforded
the opportunity to guarantee such Members pro rata share of such indebtedness.
This Section 7.12 shall not prohibit a Member from making a loan described in
Section 3.5.
7.13 LITIGATION. If the Company and any Member are joint defendants in
litigation relating to the Company, the Company shall pay the legal fees and
expenses of one counsel for the Company and the Member or Members in question to
the extent that the claim asserted
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<PAGE>
against the Company is also asserted against the Member. To the extent that the
claim asserted against a Member is materially different from that asserted
against the Company and results from such Member's willful or grossly negligent
failure to act in conformity with Company policies or procedures, the Member
shall be responsible for retaining independent counsel and for paying the fees
and expenses of such counsel. In the event any Management Member recovers the
cost of counsel or judgments or settlements through indemnification from third
parties, such Management Member will share such recoveries with the Company to
offset the Company's defense costs on a proportionate basis.
ARTICLE 8
REPRESENTATIONS AND WARRANTIES
8.1 IN GENERAL. As of the date hereof, each Member hereby makes each of
the representations and warranties applicable to such Member as set forth in
Section 8.2 hereof, and such warranties and representations shall survive the
execution of this Agreement.
8.2 REPRESENTATIONS AND WARRANTIES. Each Member hereby represents and
warrants that:
(a) Such Member understands and acknowledges that such Member's
Membership Interest has not been registered under the Securities Act of 1933 or
any state securities laws.
(b) Such Member understands and acknowledges that Membership Interests
may not be sold unless they are registered under the Securities Act of 1933 and
applicable state securities laws, or pursuant to an exemption from such
registration requirements.
(c) The limitations on transfer contained in this Section 8.2 and in
Article 11 of this Agreement create an economic risk that such Member is capable
of bearing.
(d) Except for an action by Lumbermen's Mutual against the Company and
the Management Members in the Superior Court of Washington for King County,
there are no actions, suits, proceedings, or investigations pending or, to the
knowledge of such Member, threatened against or affecting such Member or any of
his properties, assets, or businesses in any court or before or by any
governmental department, board, agency, or instrumentality, domestic or foreign,
or any arbitrator which could, if adversely determined (or, in the case of an
investigation could lead to any action, suit, or proceeding, which if adversely
determined could) reasonably be expected to materially impair such Member's
ability to perform its obligations under this Agreement or to have a material
adverse effect on the financial condition of such Member.
(e) Such Member is acquiring its Membership Interest based upon its own
investigation, and the exercise by such Member of its rights and the performance
of its obligations under this Agreement will be based upon its own
investigation, analysis, and expertise. Such Member's acquisition of its
Membership Interest is being made for its own account for investment, and not
with a view to the sale or distribution thereof. Such Member is a
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sophisticated investor possessing an expertise in analyzing the benefits and
risks associated with acquiring investments that are similar to the acquisition
of its Membership Interest.
(f) Such Member understands that taxable income and gain allocated to
such Member by the Company under this Agreement and the tax on the portion
thereof allocated to such Member hereunder for any Calendar Year may exceed the
cash distributions from the Company to such Member and, that such Member may
have to look to sources other than distributions from the Company to pay such
tax.
ARTICLE 9
ACCOUNTING, BOOKS AND RECORDS
9.1 ACCOUNTING, BOOKS, AND RECORDS.
(a) The Company shall keep on site at its principal place of business
each of the following:
(i) Separate books of account for the Company which shall show a
true and accurate record of all costs and expenses incurred, all charges made,
all credits made and received, and all income derived in connection with the
conduct of the Company and the operation of the Business in accordance with this
Agreement.
(ii) A current list of the full name and last known business,
residence, or mailing address of each Member and Manager, both past and present;
(iii) A copy of the Certificate and all amendments thereto,
together with executed copies of any powers of attorney pursuant to which any
amendment has been executed;
(iv) Copies of the Company's federal, state, and local income tax
returns and reports, if any, for the three most recent years;
(v) Copies of this Agreement;
(vi) Copies of any writings permitted or required under Section
18-502 of the Act regarding the obligation of a Member to perform any
enforceable promise to contribute cash or property or to perform services as
consideration for such Member's Capital Contribution;
(vii) Unless contained in this Agreement, a statement prepared and
certified as accurate by the Managers of the Company which describes:
(A) The amount of cash and a description and statement of
the agreed value of the other property or services contributed by each Member
and which each Member has agreed to contribute in the future;
(B) The times at which or events on the happening of which
any Additional Capital Contributions agreed to be made by each Member are to be
made;
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(C) If agreed upon, the time at which or the events on the
happening of which a Member may terminate his Membership Interest in the Company
and the amount of, or the method of determining, the distribution to which he
may be entitled respecting his Membership Interest and the terms and conditions
of the termination and distribution;
(D) Any right of a Member to receive distributions, which
include a return of all or any part of a Member's contribution;
(viii) Any written consents obtained from Members pursuant to
Section 18-302 of the Act regarding action taken by Members without a meeting.
(b) The Company shall use the accrual method of accounting in
preparation of its financial reports and for tax purposes and shall keep its
books and records accordingly. Any Member or its designated representative has
the right to have reasonable access to and inspect and copy the contents of such
books or records and shall also have reasonable access during normal business
hours to such additional financial information, documents, books and records.
The rights granted to a Member pursuant to this Section 9.1 are expressly
subject to compliance by such Member with the safety, security, and
confidentiality procedures and guidelines of the Company, as such procedures and
guidelines may be established from time to time.
9.2 REPORTS.
(a) The chief financial officer (or other officer appointed by the
Managers) of the Company shall be responsible for causing the preparation of
financial reports of the Company and the coordination of financial matters of
the Company with the Company's accountants.
(b) The Company shall cause to be delivered to each Member the financial
statements listed in clauses (i) and (ii) below, prepared, in each case (other
than with respect to Member's Capital Accounts, which shall be prepared in
accordance with this Agreement) in accordance with GAAP consistently applied and
such other reports as any Member may reasonably request from time to time;
PROVIDED THAT, if the Board of Managers so determine within thirty (30) days
thereof, such other reports shall be provided at such requesting Member's sole
cost and expense. The quarterly financial statements referred to in clause (ii)
below may be subject to normal year-end audit adjustments.
(i) As soon as practicable following the end of each Calendar
Year (and in any event not later than sixty (60) days after the end of such
Calendar Year) and at such time as distributions are made to the Members
pursuant to Section 13 hereof following the occurrence of a Dissolution Event, a
balance sheet of the Company as of the end of such Calendar Year and the related
statements of operations, Members' Capital Accounts and changes therein, and
cash flows for such Calendar Year, together with appropriate notes to such
financial statements and supporting schedules, all of which shall be audited and
certified, or not audited but reviewed, by the Company's accountants, as
determined by the Board of Managers following receipt of the recommendation of
the Audit Committee, and in each case, to the extent the Company was in
existence, setting forth in comparative form the corresponding figures for the
immediately
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preceding Calendar Year end (in the case of the balance sheet) and the two (2)
immediately preceding Calendar Years (in the case of the statements).
(ii) As soon as practicable following the end of each of the first
three Calendar Quarters of each Calendar Year (and in any event not later than
thirty (30) days after the end of each such Calendar Quarter), a balance sheet
of the Company as of the end of such Calendar Quarter and the related statements
of operations and cash flows for such Calendar Quarter and for the Calendar Year
to date, in each case, to the extent the Company was in existence, setting forth
in comparative form the corresponding figures for the prior Calendar Year's
Calendar Quarter and the interim period corresponding to the Calendar Quarter
and the interim period just completed.
The quarterly statements described in clause (ii) above shall be
accompanied by a written certification of the chief financial officer (or other
officer appointed by the Managers)of the Company that such statements have been
prepared in accordance with GAAP consistently applied or this Agreement, as the
case may be.
9.3 ACCOUNTANTS. The Company's and the Subsidiary's accountants shall
be such accountants approved by the Board of Managers following receipt of a
recommendation of the Audit Committee of the Board of Managers.
9.4 TAX MATTERS.
(a) TAX ELECTIONS. The Board of Managers shall, without any further
consent of the Members being required (except as specifically required herein),
make or delegate responsibility to the officers of the Company to make any and
all elections for federal, state, local, and foreign tax purposes including,
without limitation, any election, if permitted by applicable law: (i) to adjust
the basis of Property pursuant to Code Sections 754, 734(b) and 743(b), or
comparable provisions of state, local or foreign law, in connection with
Transfers of Membership Interest and Company distributions; (ii) with the
consent of all of the Members, to extend the statute of limitations for
assessment of tax deficiencies against the Members with respect to adjustments
to the Company's federal, state, local or foreign tax returns; and (iii) to the
extent provided in Code Sections 6221 through 6231 and similar provisions of
federal, state, local, or foreign law, to represent the Company and the Members
before taxing authorities or courts of competent jurisdiction in tax matters
affecting the Company or the Members in their capacities as Members, and to file
any tax returns and execute any agreements or other documents relating to or
affecting such tax matters, including agreements or other documents that bind
the Members with respect to such tax matters or otherwise affect the rights of
the Company and the Members. Snyder is specifically authorized to act as the
"Tax Matters Member" under the Code and in any similar capacity under state or
local law until such time as PAULA is entitled to be allocated a majority of the
Profits pursuant to Article 4, and thereafter PAULA is specifically authorized
to act as the "Tax Matters Member" under the Code.
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(b) TAX INFORMATION. Necessary tax information shall be delivered to
each Member as soon as practicable after the end of each Calendar Year of the
Company but not later than two and one-half (21/2) months after the end of each
Calendar Year.
(c) PARTNERSHIP TREATMENT. It is the intention of the Members that the
Company shall be treated as a partnership for tax purposes.
ARTICLE 10
AMENDMENTS
10.1 AMENDMENTS.
(a) Amendments to this Agreement may be proposed by the Board Managers
or any Member. Following such proposal, the Board of Managers shall submit to
the Members a verbatim statement of any proposed amendment, providing that
counsel for the Company shall have approved of the same in writing as to form,
and the Board of Managers shall include in any such submission a recommendation
as to the proposed amendment. The Board of Managers shall seek the written vote
of the Members on the proposed amendment or shall call a meeting to vote thereon
and to transact any other business that it may deem appropriate. A proposed
amendment shall be adopted and be effective as an amendment hereto if it
receives the Approval of the Members.
(b) Notwithstanding Section 10.1(a) hereof, this Agreement shall not be
amended without the consent of each Member adversely affected if such amendment
would modify the limited liability of a Member, or (ii) alter the interest of a
Member in Profits, Losses, other items, or any Company distributions.
ARTICLE 11
TRANSFERS
11.1 RESTRICTIONS ON TRANSFERS. Except as otherwise permitted by this
Agreement, no Member shall Transfer all or any portion of such Member's
Membership Interest or any other interest in the Company.
11.2 PERMITTED TRANSFERS. Subject to the conditions and restrictions set
forth in Section 11.3 hereof, a Member may at any time Transfer all or any
portion of its Membership Interest to (a) any Wholly Owned Affiliate of the
transferor Member, (b) any Purchaser in accordance with Section 11.4 hereof, and
(c) as provided in Section 11.5 hereof (any such Transfer being referred to in
this Agreement as a "PERMITTED TRANSFER").
11.3 CONDITIONS TO PERMITTED TRANSFERS. A Transfer shall not be treated
as a Permitted Transfer under Section 11.2 hereof unless and until the following
conditions are satisfied:
(a) The transferor and transferee shall execute and deliver to the
Company (i) such documents and instruments of conveyance as may be necessary or
appropriate in the opinion of
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counsel to the Company to effect such Transfer. In all cases, the Company shall
be reimbursed by the transferor and/or transferee for all costs and expenses
that it reasonably incurs in connection with such Transfer.
(b) The transferor and transferee shall furnish the Company with the
transferee's taxpayer identification number, sufficient information to determine
the transferee's initial tax basis in the Membership Interest transferred, and
any other information reasonably necessary to permit the Company to file all
required federal and state tax returns and other legally required information
statements or returns. Without limiting the generality of the foregoing, the
Company shall not be required to make any distribution otherwise provided for in
this Agreement with respect to any transferred Membership Interest until it has
received such information.
(c) The Transfer would not cause the Company to be (i) treated as a
"publicly traded partnership" within the meaning of Code Section 7704 or
(ii) classified as a corporation for state income tax purposes within the
meaning of Code Section 7701(a) or any similar state tax provision.
(d) Unless otherwise approved by all the Members, no Transfer of a
Membership Interest shall be made except upon terms which would not, in the
opinion of counsel chosen by and mutually acceptable to all the Members, result
in the termination of the Company within the meaning of Section 708 of the Code
or cause the application of the rules of Sections 168(f)(5) and 168(i)(7) of the
Code or similar rules to apply to the Company.
(e) No notice or request initiating the procedures contemplated by
Section 11.4 may be given by any Member, while any notice, purchase or Transfer
is pending under Section 11.4 or Section 12, as the case may be, or after a
Dissolution Event has occurred. If any Member is an Adverse Member, the other
Members shall not be offered any portion of the Adverse Member's Membership
Interest pursuant to Section 11.4, during the period that the Company is
pursuing any remedy specified in Section 12.1 with respect to such Member's
status as an Adverse Member. No Member may sell any portion of its Membership
Interest pursuant to Section 11.4 during any period that, as provided above, it
may not give the notice initiating the procedures contemplated by such
Section or thereafter until it has given such notice and otherwise complied with
the provisions of such Section.
11.4 RIGHT OF FIRST REFUSAL. In addition to the other limitations and
restrictions set forth in this Section 11, except as permitted by Section 11.2
hereof, no Member shall Transfer all or any portion of its Membership Interest
(the "OFFERED INTEREST") unless such Member (the "SELLER") first offers to sell
the Offered Interest pursuant to the terms of this Section 11.4.
(a) LIMITATION ON TRANSFERS. No Transfer may be made under this Section
11.4 unless the Seller has received a bona fide written offer (the "PURCHASE
OFFER") from a Person (the "PURCHASER") to purchase the Offered Interest for a
purchase price (the "OFFER PRICE") denominated and payable in United States
dollars at closing or according to specified terms, with or without interest,
which offer shall be in writing signed by the Purchaser and shall be
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irrevocable for a period ending no sooner than the Business Day following the
end of the Offer Period, as hereinafter defined.
(b) OFFER NOTICE. Prior to making any Transfer that is subject to the
terms of this Section 11.4, the Seller shall, subject to the terms and
conditions of this Agreement, give to the Company and each other Member written
notice (the "OFFER NOTICE") which shall include a copy of the Purchase Offer and
an offer (the "FIRM OFFER") to sell the Offered Membership Interest to the other
Members (the "OFFEREES") for the Offer Price, payable according to the same
terms as (or more favorable terms than) those contained in the Purchase Offer,
PROVIDED that the Firm Offer shall be made without regard to the requirement of
any earnest money or similar deposit required of the Purchaser prior to closing,
and without regard to any security (other than the Offered Interest) to be
provided by the Purchaser for any deferred portion of the Offer Price.
(c) OFFER PERIOD. The Firm Offer shall be irrevocable for a period (the
"OFFER PERIOD") ending at 11:59 P.M., local time at the Company's principal
place of business, on the thirtieth (30th) day following the day of the Offer
Notice.
(d) ACCEPTANCE OF FIRM OFFER. At any time during the Offer Period, any
Offeree may accept the Firm Offer as to all or any portion of the Offered
Interest, by giving written notice of such acceptance to the Seller and each
other Offeree, which notice shall indicate the maximum proportion of the Offered
Interest that such Offeree is willing to purchase. If the Seller is a Management
Member, Members who are Management Members shall have a first priority on a pro
rata basis to purchase all of the Offered Interest, PROVIDED that if Management
Members do not agree to purchase all of the Offered Interest, the Company shall
have the right to purchase any of the Offered Interest that Management Members
have not agreed to purchase, and PROVIDED FURTHER that if Management Members and
the Company do not agree to purchase all of the Offered Interest, PAULA shall
have the right to purchase any of the Offered Interest that the Management and
the Company have not agreed to purchase. If the Seller is PAULA, the Management
Members shall have the right to purchase the Offered Interest on a pro rata
basis. In the event that Offerees ("ACCEPTING OFFEREES"), in the aggregate,
accept the Firm Offer with respect to all of the Offered Interest, the Firm
Offer shall be deemed to be accepted and each Accepting Offeree shall be deemed
to have accepted the Firm Offer to the extent set out above. If Offerees do not
accept the Firm Offer as to all of the Offered Interest during the Offer Period,
the Firm Offer shall be deemed to be rejected only with respect to the Offered
Interest that the Offerees have declined to purchase.
(e) CLOSING OF PURCHASE PURSUANT TO FIRM OFFER. In the event that any
portion of the Firm Offer is accepted, the closing of the sale of the Offered
Interest shall take place within thirty (30) days after the Firm Offer is
accepted or, if later, the date of closing set forth in the Purchase Offer. The
Seller and all Accepting Offerees shall execute such documents and instruments
as may be necessary or appropriate to effect the sale of the Offered Interest
pursuant to the terms of the Firm Offer and this Section 11.
(f) SALE PURSUANT TO PURCHASE OFFER IF FIRM OFFER REJECTED. If any
portion of the Firm Offer is not accepted in the manner hereinabove provided,
the Seller may sell the remaining
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Offered Interest to the Purchaser at any time within sixty (60) days after the
last day of the Offer Period, provided that such sale shall be made on terms no
more favorable to the Purchaser than the terms contained in the Purchase Offer
and provided further that such sale complies with other terms, conditions, and
restrictions of this Agreement that are not expressly made inapplicable to sales
occurring under this Section 11.4. In the event that the Offered Interest is not
sold in accordance with the terms of the preceding sentence, the Offered
Interest shall again become subject to all of the conditions and restrictions of
this Section 11.4.
(g) FIRST REFUSAL RIGHTS UPON MERGER PROPOSAL. In the event the Company
entertains a BONA FIDE offer to merge, consolidate, sell or sell substantially
all of the assets of, the Company in a transaction which will not trigger rights
under Section 11.5 below, the Management Members shall have a right of first
refusal to match such offer in accordance with the applicable notice and timing
provisions of this Section 11.4.
11.5 PAULA CHANGE OF CONTROL.
(a) In the event that a PAULA Change of Control occurs, PAULA shall
forthwith give notice of such occurrence to all the Management Members.
(b) At any time up to thirty days, following the occurrence of a PAULA
Change of Control, either PAULA or, the Management Members if the Management
Members unanimously agree, may deliver, in the case of PAULA to the Management
Members collectively, and in the case of the Management Members to PAULA, a
notice in writing ("BUY-SELL NOTICE") offering to purchase such Member or
Members Membership Interest at the purchase price and on the terms specified in
the Buy-Sell Notice.
(c) The recipient of the Buy-Sell Notice (the "RECIPIENT") may accept
the Buy-Sell Notice by delivering to the sender of the Buy-Sell Notice (the
"SENDER") written notice of acceptance. The Recipients may reject the Buy-Sell
Notice by delivering written notice of rejection to the Sender, whereupon the
Recipient shall be deemed to have agreed to purchase and the Sender shall be
deemed to have agreed to sell all of the Sender's Membership Interest based on
the terms specified in the Buy-Sell Notice. If the Management Members are
deemed to have agreed to purchase PAULA's Membership Interest pursuant to this
Section 11.5(c) they shall do so on a pro rata basis, unless a different
proportion is unanimously agreed upon by the Management Members and communicated
in writing to PAULA.
(d) If the Recipient fails to accept or reject the Buy-Sell Notice
within fifteen days of receipt of the Buy-Sell Notice, the Recipient shall be
deemed to have accepted the Buy-Sell Notice and the Recipient shall be deemed to
have agreed to sell and the Sender shall be deemed to have agreed to purchase
all of the Recipient's Membership Interest on the terms specified in the
Buy-Sell Notice.
(e) Unless otherwise agreed by the Sender and the Recipient, the
transaction related to the Buy-Sell Notice shall in all events be completed
within forty five (45) days of the date that the Buy-Sell Notice is accepted,
rejected or deemed accepted pursuant to this Section 11.5.
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11.6 PROHIBITED TRANSFERS. Any purported Transfer of Membership Interest
that is not a Permitted Transfer shall be null and void and of no force or
effect whatever; PROVIDED that, if the Company is required to recognize a
Transfer that is not a Permitted Transfer (or if all of the Managers, in their
sole discretion, elect to recognize a Transfer that is not a Permitted
Transfer), the Membership Interest Transferred shall be strictly limited to the
transferor's rights to allocations and distributions as provided by this
Agreement with respect to the transferred Membership Interest, which allocations
and distributions may be applied (without limiting any other legal or equitable
rights of the Company) to satisfy any debts, obligations, or liabilities for
damages that the transferor or transferee of such Membership Interest may have
to the Company.
In the case of a Transfer or attempted Transfer of Membership Interest that
is not a Permitted Transfer, the parties engaging or attempting to engage in
such Transfer shall be liable to indemnify and hold harmless the Company and the
other Members from all cost, liability, and damage that any of such indemnified
Members may incur (including, without limitation, incremental tax liabilities,
lawyers' fees, and expenses) as a result of such Transfer or attempted Transfer
and efforts to enforce the indemnity granted hereby.
11.7 RIGHTS OF UNADMITTED ASSIGNEES. A Person who acquires a Membership
Interest but who is not admitted as a substituted Member pursuant to Section
11.8 hereof shall be entitled only to allocations and distributions with respect
to such Membership Interest in accordance with this Agreement, and shall have no
right to any information or accounting of the affairs of the Company, shall not
be entitled to inspect the books or records of the Company, and shall not have
any of the rights of a Member under the Act or this Agreement.
11.8 ADMISSION OF SUBSTITUTED MEMBERS. Subject to the other provisions
of this Article 11, a transferee of a Membership Interest may be admitted to the
Company as a substituted Member only upon satisfaction of the conditions set
forth in this Section 11.8:
(a) The Membership Interest with respect to which the transferee is
being admitted was acquired by means of a Permitted Transfer;
(b) The transferee of the Membership Interest (other than, with respect
to clauses (i) and (ii) below, a transferee that was a Member prior to the
Transfer) shall, by written instrument in form and substance reasonably
satisfactory to the Board of Managers (and, in the case of clause (iii) below,
the transferor Member), (i) make representations and warranties to each
nontransferring Member equivalent to those set forth in Article 8, (ii) accept
and adopt the terms and provisions of this Agreement, including this Article 11,
and (iii) assume the obligations of the transferor Member under this Agreement
with respect to the transferred Membership Interest. The transferor Member
shall be released from all such assumed obligations except (x) those obligations
or liabilities of the transferor Member arising out of a breach of this
Agreement, (y) in the case of a Transfer to any Person other than a Member or
any of its Wholly Owned Affiliates, those obligations or liabilities of the
transferor Member based on events occurring, arising, or maturing prior to the
date of Transfer, and (z) in the case of a Transfer to any of its Wholly Owned
Affiliates, any Capital Contribution or other financing obligation of the
transferor Member under this Agreement;
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(c) The transferee pays or reimburses the Company for all reasonable
legal, filing, and publication costs that the Company incurs in connection with
the admission of the transferee as a Member with respect to the Transferred
Membership Interest; and
(d) If required by the Board of Managers, the transferee (other than a
transferee that was a Member prior to the Transfer) shall deliver to the Company
evidence of the authority of such Person to become a Member and to be bound by
all of the terms and conditions of this Agreement, and the transferee and
transferor shall each execute and deliver such other instruments as the Board of
Managers reasonably deems necessary or appropriate to effect, and as a condition
to, such Transfer, including amendments to the Certificate or any other
instrument filed with the State of Delaware or any other state or governmental
authority.
11.9 REPRESENTATIONS REGARDING TRANSFERS; LEGEND.
(a) Each Member hereby represents and warrants to the Company and the
Members that such Member's acquisition of a Membership Interest hereunder is
made as principal for such Member's own account and not for resale or
distribution of such Membership Interest. Each Member further hereby agrees
that the following legend may be placed upon any counterpart of this Agreement,
the Certificate, or any other document or instrument evidencing ownership of
Membership Interests:
The Company Membership Interests represented by this document have
not been registered under any securities laws and the transferability of such
Membership Interests are restricted. Such Membership Interests may not be sold,
assigned, or transferred, nor will any assignee, vendee, transferee, or endorsee
thereof be recognized as having acquired any such Membership Interest by the
Company for any purposes, unless (1) a registration statement under the
Securities Act of 1933, as amended, with respect to such Membership Interest
shall then be in effect and such transfer has been qualified under all
applicable state securities laws, or (2) the availability of an exemption from
such registration and qualification shall be established to the satisfaction of
counsel to the Company.
The Membership Interests represented by this document are subject to
further restriction as to their sale, transfer, hypothecation, or assignment as
set forth in this Agreement and agreed to by each Member. Said restriction
provides, among other things, that no Membership Interest may be transferred
without first offering such Membership Interest to the other Members.
11.10 DISTRIBUTIONS AND ALLOCATIONS IN RESPECT OF TRANSFERRED MEMBERSHIP
INTEREST. If any Membership Interest is Transferred during any Calendar Year in
compliance with the provisions of this Article 11, Profits, Losses, and all
other items attributable to the Transferred Membership Interest for such
Calendar Year shall be divided and allocated between the transferor and the
transferee by taking into account their varying Percentage Interests during the
Calendar Year in accordance with Code Section 706(d), using any conventions
permitted by law and selected by the Board of Managers. All distributions on or
before the date of such Transfer shall be made to the transferor, and all
distributions thereafter shall be made to the
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transferee. Solely for purposes of making such allocations and distributions,
the Company shall recognize such Transfer not later than the end of the calendar
month during which it is given notice of such Transfer, PROVIDED that, if the
Company is given notice of a Transfer at least ten (10) Business Days prior to
the Transfer, the Company shall recognize such Transfer as of the date of such
Transfer, and PROVIDED FURTHER that if the Company does not receive a notice
stating the date such Membership Interest were transferred and such other
information as the Managers may reasonably require within thirty (30) days after
the end of the Calendar Year during which the Transfer occurs, then all such
items shall be allocated, and all distributions shall be made, to the Person
who, according to the books and records of the Company, was the owner of the
Membership Interest on the last day of such Calendar Year. Neither the Company
nor any Member shall incur any liability for making allocations and
distributions in accordance with the provisions of this Section 11.10, whether
or not any Manager or the Company has knowledge of any Transfer of ownership of
any Membership Interest.
11.11 MEMBERSHIP INTEREST. Any sale, transfer or other disposition of a
Membership Interest pursuant to Article 11 and Article 12 must be with respect
to the same proportion of a Member's Capital Account and allocation of Profits.
ARTICLE 12
ADVERSE ACT
12.1 REMEDIES.
(a) If an Adverse Act has occurred or is continuing with respect to any
Member, any non-Adverse Member may elect:
(i) To cause the Company to commence the procedures specified in
Section 12.2 for the purchase of the Adverse Member's Membership Interest; or
(ii) To seek to enjoin such Adverse Act or to obtain specific
performance of the Adverse Member's obligations or Damages (as defined and
subject to the limitations specified below) in respect of such Adverse Act.
The foregoing remedies shall not be deemed to be mutually exclusive, and,
subject to the requirements of this Section 12.1(a) regarding the timing of the
election of such remedies, selection or resort to any thereof shall not
preclude selection or resort to the others.
Notwithstanding anything to the contrary contained in this Article 12, the
remedy specified in clause (i) above and the right to seek Damages under clause
(ii) above may not be pursued and Section 12.1(b) will not apply to an Adverse
Act specified in clause (ii) of the term "Adverse Act" in Section 1 until such
time as there is a Final Determination that the Member's actions or failure to
act constituted an Adverse Act, if the affected Member timely delivered a
Contest Notice.
The election of a remedy specified in clause (i) or (ii) above may be
exercised by notice given to the Adverse Member within ninety (90) days after
the Member making such election
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obtains actual knowledge of the occurrence of such Adverse Act, including, if
applicable, that any cure period has expired; PROVIDED that, if an election
pursuant to clause (ii) above is made to seek an injunction, specific
performance or other equitable relief and a final judgment in such action is
rendered denying such equitable remedy and no election was made pursuant to
clause (i) above, then, by notice given within ten (10) days after such final
judgment is rendered, the non-Adverse Member may elect to pursue the remedies
specified in clause (i) above unless (x) prior to the giving of such notice, the
Adverse Member has cured in full (or caused to be cured in full) the Adverse Act
in question and no other Adverse Act with respect to such Adverse Member has
occurred and is continuing or (y) the final judgment denying equitable relief
specifically held that there was no Adverse Act.
Except as provided in Section 12.1(b), the failure to elect a remedy with
respect to the subject Adverse Act within the time periods provided in the
preceding paragraph shall be conclusively presumed to be a waiver of the
remedies provided in this Section 12 with respect to the subject Adverse Act.
Unless resort to such remedy has been waived as set forth in the
immediately preceding paragraph, the Company shall be entitled to recover from
the Adverse Member in an appropriate proceeding any and all damages, losses and
expenses (including reasonable attorneys' fees and disbursements) (collectively,
"DAMAGES") suffered or incurred by the Company as a result of such Adverse Act;
PROVIDED that the Company shall not have or assert any claim against the Adverse
Member for punitive Damages or for indirect, special, or consequential Damages
suffered or incurred by the Company as a result of an Adverse Act; and PROVIDED
FURTHER that the amount the Company may recover in any action for Damages shall
be reduced by an amount equal to any positive difference between the Net Equity
of the Adverse Member's Membership Interest and the applicable Buy-Sell Price.
The resort to any remedy pursuant to this Section 12.1(a) shall not for any
purpose be deemed to be a waiver of any remedy not described in this Section
12.1(a) and otherwise available hereunder or under applicable law.
(b) If the Company is dissolved pursuant to Section 13.1(a) at any time
as a result of a Dissolution Event that occurs prior to a remedy having been
elected pursuant to Section 12.1(a) with respect to any Adverse Member, the time
periods for such election shall thereupon expire and the Liquidator shall deduct
from any amounts to be paid to such Adverse Member pursuant to Section 13.2 that
amount which it reasonably estimates to be sufficient to compensate the
non-Adverse Members for Damages incurred by them as a result of the Adverse Act
(subject to the limitations of Section 12.1(a)) and shall pay the same to the
non-Adverse Members on behalf of the Adverse Member.
12.2 ADVERSE ACT PURCHASE.
(a) DETERMINATION OF NET EQUITY OF ADVERSE MEMBER'S MEMBERSHIP INTEREST.
If any Member makes an election pursuant to Section 12.1(a)(i) to commence the
purchase procedures set forth in this Section 12.2, the Net Equity of the
Adverse Member's Membership Interest shall
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be determined in accordance with this Section 12.2 as of the last day of the
Calendar Quarter immediately preceding the Calendar Quarter in which notice of
such election (the "ELECTION NOTICE") was given to the Adverse Member, and the
Adverse Member shall be obligated to sell to the Members in the manner provided
herein all but not less than all of the Adverse Member's Membership Interest in
accordance with this Section 12.2 at a purchase price (the "BUY-SELL PRICE")
equal to (A) in the case of any Adverse Act other than an Adverse Act identified
in clause (iv) of the definition of "Adverse Act" in Section 1, ninety percent
(90%) of the Net Equity thereof as so determined, and (B) in the case of an
Adverse Act specified in clause (iv), the Net Equity thereof.
(b) ELECTION TO PURCHASE MEMBERSHIP INTEREST OF ADVERSE MEMBER. For a
period ending at 11:59 p.m. (local time at the Company's principal office) on
the thirtieth (30th) day following the day on which notice of the Adverse
Member's Net Equity is given pursuant to Section 12.3 (the "ELECTION PERIOD"),
each Member who is not an Adverse Member, may elect, by notice to the Adverse
Member (the "PURCHASE NOTICE"), to purchase, or designate a third party to
purchase, all or any portion of the Membership Interest of the Adverse Member,
which notice shall state the maximum Membership Interest that such non-Adverse
Member, or such designated third party (in each case, the "PURCHASING MEMBER"),
is willing to purchase (each a "PURCHASE COMMITMENT"). If the aggregate
Purchase Commitments made by the Purchasing Members are equal to at least one
hundred percent (100%) of the Adverse Member's Membership Interest, then subject
to Section 11.12 and the following sentence, each Purchasing Member shall be
obligated to purchase, and the Adverse Member shall be obligated to sell to such
Purchasing Member, that portion of the Adverse Member's Membership Interest that
corresponds to the ratio of the allocation of Profits to such Purchasing Member
to the aggregate allocation of Profits to all Purchasing Members; PROVIDED that,
if any Purchasing Member's Purchase Commitment was for an amount less than its
proportionate share of the Adverse Member's Membership Interest as so
determined, the portion of the Adverse Member's Membership Interest not so
committed to be purchased shall be allocated to the other Purchasing Members;
and PROVIDED FURTHER, that each other Purchasing Member shall not be obligated
to purchase in excess of the proportion of the Membership Interest set forth in
the Purchase Commitment delivered by such other Purchasing Member. If the other
Members do not elect to purchase the entire Membership Interest of the Adverse
Member, the Adverse Member shall be under no obligation to sell any portion of
its Membership Interest to any Member.
(c) TERMS OF PURCHASE; CLOSING. Unless the Purchasing Members and the
Adverse Member otherwise agree, the closing of the purchase and sale of the
Adverse Member's Membership Interest shall occur at the principal office of the
Company at 10:00 a.m. (local time at the place of the closing) on the first
Business Day occurring on or after the thirtieth (30th) day following the last
day of the Election Period (subject to Section 12.5). At the closing, the
Purchasing Members shall pay to the Adverse Member, by cash or other immediately
available funds, the purchase price for the Adverse Member's Membership Interest
and the Adverse Member shall deliver to the Purchasing Members good title, free
and clear of any liens or encumbrances (other than those created by this
Agreement) to the Adverse Member's Membership Interest thus purchased.
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At the closing, the Members shall execute such documents and instruments of
conveyance as may be necessary or appropriate to effectuate the transactions
contemplated hereby, including the Transfer of the Adverse Member's Membership
Interest to the Purchasing Members and the assumption by each Purchasing Member
of the Adverse Member's obligations with respect to the Adverse Member's
Membership Interest Transferred to such Purchasing Member. The Company and each
Member shall bear its own costs of such Transfer and closing, including
attorneys' fees and filing fees. The cost of determining Net Equity shall be
borne one-half by the Adverse Member and one-half by the Purchasing Member.
12.3 NET EQUITY. The "Net Equity" of a Member's Membership Interest, as
of any day, shall be the amount that would be distributed to such Member in
liquidation of the Company pursuant to Section 13.2 if (i) the Company's
business were sold substantially as an entirety for Gross Appraised Value,
(ii) the Company paid, or established reserves pursuant to Section 13.2 for the
payment of, all Company liabilities and (iii) the Company distributed the
remaining proceeds to the Members in liquidation, all as of such day.
The Net Equity of a Member's Membership Interest shall be determined,
without audit or certification, from the books and records of the Company by the
Company's accountants. The Net Equity of a Member's Membership Interest shall
be determined within thirty (30) days of the day upon which the accountants are
apprised in writing of the Gross Appraised Value of the Company's Property, and
the amount of such Net Equity shall be disclosed to the Company and each of the
Members by written notice ("NET EQUITY NOTICE"). The Net Equity determination
of the accountants shall be final and binding in the absence of a showing of
manifest error.
12.4 GROSS APPRAISED VALUE.
(a) "GROSS APPRAISED VALUE," as of any day, shall be equal to the fair
market value of Company Property as of such day. As used herein, as of any day,
"fair market value" of the Property means the price at which a willing seller
would sell, and a willing buyer would buy, the Property, free and clear of all
liens, security interests or other encumbrances, in an arm's length transaction
for cash, without time constraints and without being under any compulsion to buy
or sell.
(b) The Executive Committee shall retain a qualified and independent
valuer to make a determination of Gross Appraised Value when any such
determination is required hereunder and to report thereon to the Executive
Committee. Such report will not be binding on the Executive Committee who shall
make the final determination of the Gross Appraised Value within 30 days of
receipt of the report of the valuer. Notwithstanding, the foregoing provisions
of this Section 12.4(b), in the event that an independent transaction has taken
place within the previous twelve months which in the reasonable opinion of the
Executive Committee establishes a reasonable basis for the determination of the
Gross Appraised Value, the Executive Committee shall not be required to retain a
valuer and shall independently establish the Gross Appraised Value within 60
days of a request to do so hereunder. The Executive Committee shall apprise the
Company's accountants in writing of the Gross Appraised Value forthwith after it
is determined.
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12.5 EXTENSION OF TIME. If any Transfer of a Member's Membership
Interest in accordance with this Article 12 or Article 11 requires the consent,
approval, waiver, or authorization of any governmental authority or of the
stockholders of a Member or any of its Affiliates as a condition to the lawful
and valid Transfer of such Member's Membership Interest to the proposed
transferee thereof, then each of the time periods provided in this Article 12 or
Article 11, as applicable, for the closing of such Transfer shall be suspended
for the period of time during which any such consent, approval, waiver, or
authorization is being diligently pursued; PROVIDED HOWEVER, that in no event
shall the suspension of any time period pursuant to this Section 12.5 extend for
more than three hundred sixty-five (365) days other than in the case of a
purchase of an Adverse Member's Membership Interest. Each Member agrees to use
its diligent efforts to obtain, or to assist the affected Member or the Managers
in obtaining, any such consent, approval, waiver, or authorization and shall
cooperate and use its diligent efforts to respond as promptly as practicable to
all inquiries received by it, by the affected Member or by the Managers from any
governmental authority for initial or additional information or documentation in
connection therewith. Any extension of time pursuant to this Section 12.5 will
not otherwise effect the terms of the Transfer in question including without
limitation any determination of Gross Appraised Value or Net Equity in
connection therewith and any such determination shall remain in effect and will
be utilized in connection with the ultimate completion of the Transfer in
question.
ARTICLE 13
DISSOLUTION AND WINDING UP
13.1 DISSOLUTION EVENTS.
(a) DISSOLUTION. The Company shall dissolve and shall commence winding
up and liquidating upon the first to occur of any of the following (each a
"DISSOLUTION EVENT"):
(i) A judicial determination that an event has occurred that
makes it unlawful, impossible, or impractical to carry on the Business;
(ii) The Bankruptcy, dissolution, retirement, resignation, or
expulsion of any Member; PROVIDED that any such event will not be deemed a
Dissolution Event in the event that there are at least two remaining Members and
each remaining Member agrees to continue the business of the Company within
ninety (90) days after the occurrence of such an event.
(iii) The Approval of the Members; or
(iv) If the Subsidiary has not:
(A) recorded premium income in excess of $0.00 for the six
month period following the Effective Date;
(B) recorded premium income in excess of $5 million for
the twelve month period following the Effective Date; or
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(C) recorded premium income in excess of $10 million for
the eighteen month period following the Effective Date.
The Members hereby agree that, notwithstanding any provision of the Act,
the Company shall not dissolve prior to the occurrence of a Dissolution Event.
(b) RECONSTITUTION. If it is determined, by a court of competent
jurisdiction, that the Company has dissolved prior to the occurrence of a
Dissolution Event, then within an additional ninety (90) days after such
determination (the "RECONSTITUTION PERIOD"), all of the Members may elect to
reconstitute the Company and continue its business on the same terms and
conditions set forth in this Agreement by forming a new limited liability
company on terms identical to those set forth in this Agreement. Unless such an
election is made within the Reconstitution Period, the Company shall liquidate
and wind up its affairs in accordance with Section 13.2 hereof. If such an
election is made within the Reconstitution Period, then:
(i) The reconstituted limited liability company shall continue
until the occurrence of a Dissolution Event as provided in this Section 13.1(a);
(ii) Unless otherwise agreed by way of an Approval of the Members,
the Certificate and this Agreement shall automatically constitute the
Certificate and Agreement of such new Company. All of the assets and
liabilities of the dissolved Company shall be deemed to have been automatically
assigned, assumed, conveyed and transferred to the new Company. No bond,
collateral, assumption or release of any Member's or the Company's liabilities
shall be required; PROVIDED that the right of the Members to select successor
managers and to reconstitute and continue the Business shall not exist and may
not be exercised unless the Company has received an opinion of counsel that the
exercise of the right would not result in the loss of limited liability of any
Member and neither the Company nor the reconstituted limited liability company
would cease to be treated as a partnership for federal income tax purposes upon
the exercise of such right to continue.
13.2 WINDING UP. Upon the occurrence of (i) a Dissolution Event or
(ii) the determination by a court of competent jurisdiction that the Company has
dissolved prior to the occurrence of a Dissolution Event (unless the Company is
reconstituted pursuant to Section 13.1(b) hereof), the Company shall continue
solely for the purposes of winding up its affairs in an orderly manner,
liquidating its assets, and satisfying the claims of its creditors and Members,
and no Member shall take any action that is inconsistent with, or not necessary
to or appropriate for, the winding up of the Company's business and affairs,
PROVIDED that all covenants contained in this Agreement and obligations provided
for in this Agreement shall continue to be fully binding upon the Members until
such time as the Property has been distributed pursuant to this Section 13.2 and
the Certificate has been canceled pursuant to the Act. The Liquidator shall be
responsible for overseeing the winding up and dissolution of the Company, which
winding up and dissolution shall be completed as soon as practicable after the
occurrence of the applicable Dissolution Event. The Liquidator shall take full
account of the Company's liabilities and Property and shall cause the Property
or the proceeds from the sale
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thereof (as determined pursuant to Section 13.9 hereof), to the extent
sufficient therefor, to be applied and distributed, to the maximum extent
permitted by law, in the following order:
(a) First, to creditors (including Members and Managers who are
creditors, to the extent otherwise permitted by law) in satisfaction of all of
the Company's debts and other liabilities (whether by payment or the making of
reasonable provision for payment thereof), other than liabilities for which
reasonable provision for payment has been made and liabilities for distribution
to Members under Section 18-601 or 18-604 of the Act;
(b) Second, except as provided in this Agreement, to Members and former
Members of the Company in satisfaction of liabilities for distribution under
Sections 18-601 or 18-604 of the Act; and
(c) The balance, if any, to the Members in accordance with the positive
balance in their Capital Accounts, after giving effect to all contributions,
distributions, and allocations for all periods.
No Member or Manager shall receive additional compensation for any services
performed pursuant to this Section 13.
13.3 COMPLIANCE WITH CERTAIN REQUIREMENTS OF REGULATIONS; DEFICIT CAPITAL
ACCOUNTS. In the event the Company is "liquidated" within the meaning of
Regulations Section 1.704-1(b)(2)(ii)(g), distributions shall be made pursuant
to this Article 13 to the Members who have positive Capital Accounts, in
proportion to each Members Capital Account balance, in compliance with
Regulations Section 1.704-1(b)(2)(ii)(b)(2). If any Member has a deficit
balance in his Capital Account (after giving effect to all contributions,
distributions, and allocations for all Calendar Years, including the Calendar
Year during which such liquidation occurs), such Member shall have no obligation
to make any contribution to the capital of the Company with respect to such
deficit, and such deficit shall not be considered a debt owed to the Company or
to any other Person for any purpose whatsoever. In the discretion of the
Liquidator, a pro rata portion of the distributions that would otherwise be made
to the Members pursuant to this Article 13 may be:
(a) Distributed to a trust established for the benefit of the Members
for the purposes of liquidating Company assets, collecting amounts owed to the
Company, and paying any contingent or unforeseen liabilities or obligations of
the Company. The assets of any such trust shall be distributed to the Members
from time to time, in the reasonable discretion of the Liquidator, in the same
proportions as the amount distributed to such trust by the Company would
otherwise have been distributed to the Members pursuant to Section 13.2 hereof;
or
(b) Withheld to provide a reasonable reserve for Company liabilities
(contingent or otherwise) and to reflect the unrealized portion of any
installment obligations owed to the Company, PROVIDED that such withheld amounts
shall be distributed to the Members as soon as practicable.
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13.4 RIGHTS OF MEMBERS. Except as otherwise provided in this Agreement,
each Member shall look solely to the Property of the Company for the return of
its Capital Contribution and has no right or power to demand or receive Property
other than cash from the Company. If the assets of the Company remaining after
payment or discharge of the debts or liabilities of the Company are insufficient
to return such Capital Contribution, the Members shall have no recourse against
the Company or any other Member or Manager for the deficiency.
13.5 NOTICE OF DISSOLUTION/TERMINATION.
(a) In the event a Dissolution Event occurs or an event occurs that
would, but for provisions of Section 13.1, result in a dissolution of the
Company, the Managers shall, within thirty (30) days thereafter, provide written
notice thereof to each of the Members and to all other parties with whom the
Company regularly conducts business (as determined in the discretion of the
Managers) and shall publish notice thereof in a newspaper of general circulation
in each place in which the Company regularly conducts business (as determined in
the discretion of the Managers).
(b) Upon completion of the distribution of the Company's Property as
provided in this Article 13, the Company shall be terminated, and the Liquidator
shall cause the filing of the Certificate of Cancellation pursuant to Section
18-203 of the Act and shall take all such other actions as may be necessary to
terminate the Company.
13.6 ALLOCATIONS DURING PERIOD OF LIQUIDATION. During the period
commencing on the first day of the Calendar Year during which a Dissolution
Event occurs and ending on the date on which all of the assets of the Company
have been distributed to the Members pursuant to Section 13.2 hereof (the
"LIQUIDATION PERIOD"), the Members shall continue to share Profits, Losses,
gain, loss and other items of Company income, gain, loss or deduction in the
manner provided in Section 4 hereof.
13.7 CHARACTER OF LIQUIDATING DISTRIBUTIONS. All payments made in
liquidation of the interest of a Member in the Company shall be made in exchange
for the interest of such Member in Property pursuant to Section 736(b)(1) of the
Code, including the interest of such Member in Company goodwill.
13.8 THE LIQUIDATOR.
(a) DEFINITION. The "LIQUIDATOR" shall mean a Person appointed by the
Board of Managers to oversee the liquidation of the Company.
(b) FEES. The Company is authorized to pay a reasonable fee to the
Liquidator for its services performed pursuant to this Article 13 and to
reimburse the Liquidator for its reasonable costs and expenses incurred in
performing those services unless the liquidator is a Manager or a Member, in
which case such Manager or Member shall receive no fee.
(c) INDEMNIFICATION. The Company shall indemnify, save harmless, and
pay all judgments and claims against such Liquidator or any officers, directors,
agents or employees of
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the Liquidator relating to any liability or damage incurred by reason of any act
performed or omitted to be performed by the Liquidator, or any officers,
directors, agents or employees of the Liquidator in connection with the
liquidation of the Company, including reasonable attorneys' fees incurred by the
Liquidator, officer, director, agent or employee in connection with the defense
of any action based on any such act or omission, which attorneys' fees may be
paid as incurred, except to the extent such liability or damage is caused by the
fraud, intentional misconduct of, or a knowing violation by the Liquidator of
the applicable laws or regulations or terms of the Liquidation's engagement
which violation was material to the cause of action.
13.9 FORM OF LIQUIDATING DISTRIBUTIONS. For purposes of making
distributions required by Section 13.2 hereof, the Liquidator shall sell all of
the Property and distribute the proceeds therefrom unless the Liquidator and the
Managers agree on the distribution of any Property in-kind, in which case the
Liquidator shall proceed as agreed with the Managers in such regard.
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ARTICLE 14
POWER OF ATTORNEY
14.1 MANAGERS AS ATTORNEYS-IN-FACT. Each Member hereby makes,
constitutes, and appoints Bradley K. Serwin and R. Steven Clark, either of whom
may act alone, with full power of substitution and resubstitution, such Member's
true and lawful attorneys-in-fact for it and in its name, place, and stead and
for its use and benefit, to sign, execute, certify, acknowledge, swear to, file,
publish and record (i) all certificates of formation, amended name or similar
certificates, and other certificates and instruments (including counterparts of
this Agreement) which the Board Managers may deem necessary to be filed by the
Company under the laws of the State of Delaware or any other jurisdiction in
which the Company is doing or intends to do business; (ii) any and all
amendments, restatements or changes to this Agreement and the instruments
described in clause (i), as now or hereafter amended, which the Board Managers
may deem necessary to effect a change or modification of the Company in
accordance with the terms of this Agreement, including, without limitation,
amendments, restatements or changes to reflect (A) any amendments adopted by the
Members in accordance with the terms of this Agreement, (B) the admission of any
substituted Member and (C) the disposition by any Member of his interest in the
Company; (iii) all certificates of cancellation and other instruments which the
Board Managers deem necessary or appropriate to effect the dissolution and
termination of the Company pursuant to the terms of this Agreement and (iv) any
other instrument which is now or may hereafter be required by law to be filed on
behalf of the Company or is deemed necessary by the Board Managers to carry out
fully the provisions of this Agreement in accordance with its terms. Each
Member authorizes each such attorneys-in-fact to take any further action which
such attorneys-in-fact shall consider necessary in connection with any of the
foregoing, hereby giving such attorneys-in-fact full power and authority to do
and perform each and every act or thing whatsoever requisite to be done in
connection with the foregoing as fully as such Member might or could do
personally, and hereby ratify and confirm all that any such attorneys-in-fact
shall lawfully do, or cause to be done, by virtue thereof or hereof.
14.2 NATURE OF SPECIAL POWER. The power of attorney granted to Bradley
K. Serwin and R. Steven Clark pursuant to this Article 14:
(a) Is a special power of attorney coupled with an interest and is
irrevocable;
(b) May be exercised by any such attorneys-in-fact by listing the
Members executing any agreement, certificate, instrument, or other document with
the single signature of any such attorney-in-fact acting as attorney-in-fact for
such Members; and
(c) Shall survive and not be affected by the subsequent Bankruptcy,
insolvency, dissolution, or cessation of existence of a Member and shall survive
the delivery of an assignment by a Member of the whole or a portion of its
interest in the Company (except that where the assignment is of such Member's
entire interest in the Company and the assignee, with the consent of the other
Members as provided herein, is admitted as a substituted Member, the power of
attorney shall survive the delivery of such assignment for the sole purpose of
enabling
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any such attorney-in-fact to effect such substitution) and shall extend to such
Member's, or assignee's successors and assigns.
ARTICLE 15
MISCELLANEOUS
15.1 NOTICES. Any notice, payment, demand, or communication required or
permitted to be given by any provision of this Agreement shall be in writing and
shall be deemed to have been delivered, given, and received for all purposes
(i) if delivered personally to the Person or to an officer of the Person to whom
the same is directed, or (ii) when the same is actually received, if sent either
by registered or certified mail, postage and charges prepaid, or by facsimile,
if such facsimile is followed by a hard copy of the facsimile communication sent
promptly thereafter by registered or certified mail, postage and charges
prepaid, addressed as follows, or to such other address as such Person may from
time to time specify by notice to the Members and Managers:
(a) If to the Company, to the address determined pursuant to Section 2.4
hereof;
(b) If to the Managers, to the address set forth in EXHIBIT D hereto;
(c) If to a Member, to the address set forth in EXHIBIT B hereto.
15.2 BINDING EFFECT. Except as otherwise provided in this Agreement,
every covenant, term, and provision of this Agreement shall be binding upon and
inure to the benefit of the Members and their respective successors,
transferees, and assigns.
15.3 CONSTRUCTION. Every covenant, term, and provision of this Agreement
shall be construed simply according to its fair meaning and not strictly for or
against any Member.
15.4 TIME. In computing any period of time pursuant to this Agreement,
the day of the act, event or default from which the designated period of time
begins to run shall not be included, but the time shall begin to run on the next
succeeding day. The last day of the period so computed shall be included,
unless it is a Saturday, Sunday or legal holiday, in which event the period
shall run until the end of the next day which is not a Saturday, Sunday or legal
holiday.
15.5 HEADINGS. Section and other headings contained in this Agreement
are for reference purposes only and are not intended to describe, interpret,
define, or limit the scope, extent, or intent of this Agreement or any provision
hereof.
15.6 SEVERABILITY. Except as otherwise provided in the succeeding
sentence, every provision of this Agreement is intended to be severable, and, if
any term or provision of this Agreement is illegal or invalid for any reason
whatsoever, such illegality or invalidity shall not affect the validity or
legality of the remainder of this Agreement. The preceding sentence of this
Section 15.6 shall be of no force or effect if the consequence of enforcing the
remainder of this Agreement without such illegal or invalid term or provision
would be to cause any Member to lose the material benefit of its economic
bargain.
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15.7 INCORPORATION BY REFERENCE. Every exhibit, schedule, and other
appendix attached to this Agreement and referred to herein is not incorporated
in this Agreement by reference unless this Agreement expressly otherwise
provides.
15.8 VARIATION OF TERMS. All terms and any variations thereof shall be
deemed to refer to masculine, feminine, or neuter, singular or plural, as the
identity of the Person or Persons may require.
15.9 GOVERNING LAW. The laws of the State of Delaware shall govern the
validity of this Agreement, the construction of its terms, and the
interpretation of the rights and duties arising hereunder.
15.10 PAYMENT OF FEES AND EXPENSES. The Company shall pay all expenses
incurred with respect to this Agreement. If any remedy at law or in equity is
necessary to enforce the terms of this Agreement, the prevailing party shall be
entitled to reasonable attorney's fees, costs and necessary disbursements in
addition to any other relief to which such party may be entitled.
15.11 WAIVER OF JURY TRIAL. Each of the Members irrevocably waives to the
extent permitted by law, all rights to trial by jury and all rights to immunity
by sovereignty or otherwise in any action, proceeding or counterclaim arising
out of or relating to this Agreement.
15.12 COUNTERPART EXECUTION. This Agreement may be executed in any number
of counterparts with the same effect as if all of the Members had signed the
same document. All counterparts shall be construed together and shall
constitute one agreement.
15.13 SPECIFIC PERFORMANCE. Each Member agrees with the other Members
that the other Members would be irreparably damaged if any of the provisions of
this Agreement are not performed in accordance with their specific terms and
that monetary damages would not provide an adequate remedy in such event.
Accordingly, it is agreed that, in addition to any other remedy to which the
nonbreaching Members may be entitled, at law or in equity, the nonbreaching
Members shall be entitled to injunctive relief to prevent breaches of the
provisions of this Agreement and specifically to enforce the terms and
provisions hereof in any action instituted in any court of the United States or
any state thereof having subject matter jurisdiction thereof.
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IN WITNESS WHEREOF, the parties have executed and entered into this
Operating Agreement as of the day first above set forth.
/s/ R. Steven Clark
----------------------------------------
R. STEVEN CLARK
/s/ Edward A. Lopit
----------------------------------------
EDWARD A. LOPIT
/s/ Lawrence A.Riggs
----------------------------------------
LAWRENCE A. RIGGS
/s/ John R. Snyder
----------------------------------------
JOHN R. SNYDER
PAULA FINANCIAL, a Delaware corporation
By: /s/ Bradley K. Serwin
----------------------------------------
Name: Bradley K. Serwin
Title: Sr. V.P.
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PAULA INSURANCE COMPANY
WORKERS COMPENSATION QUOTA SHARE REINSURANCE AGREEMENT
FINAL PLACEMENT SLIP
COMPANY: PAULA Insurance Company
a California corporation
and/or any Company hereafter affiliated with
PAULA Insurance Company
EFFECTIVE: Losses occurring during the period beginning
12:01 a.m., Pacific Standard Time, October 1,
1998, and ending 12:01 a.m., Pacific Standard
Time, October 1, 2000, under policies in force at
12:01 a.m., Pacific Standard Time, October 1,
1998, and written and renewed with effective
dates during the term of this Agreement.
If, at any time, the Reinsurer ceases
underwriting operations or loses the whole or
part of its paid up capital, becomes insolvent,
or is placed in conservation, rehabilitation, or
liquidation, has a receiver appointed, or is
acquired, controlled by, merged with, or
reinsures its entire business with any other
company or corporation, the Company will have the
right to cancel this Agreement by giving 15 days
notice by certified or registered mail.
BUSINESS
COVERED: All business classified by the Company as Workers
Compensation and Employers Liability.
EXCLUSIONS: Per attached.
TERRITORY: Worldwide.
LIMIT: 25% Quota Share of the first $10,000 of ultimate net
loss, each and every occurrence, regardless of the
number of policies involved.
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"Occurrence" (except for losses arising from
Occupational Disease or Cumulative Trauma as
defined below) will mean any one accident,
disaster, casualty, or loss or series of
accidents, disasters, casualties, or losses
arising out of or caused by one event.
With respect to Occupational Disease or
Cumulative Trauma, all losses arising from each
employee will be deemed a separate "occurrence".
The date of loss for each occurrence will be the
date when the compensable disability of the
employee commences, or if there is no such
disability, when the medical treatment commences.
The terms "Occupation Disease" and "Cumulative
Trauma" as used in this Agreement will be as
defined by applicable state statutes,
regulations, or Federal Law.
LOSS EXPENSES: Loss expense included within the ultimate net loss in
satisfying Retention and Limit hereon.
"Loss expense" will mean expense assignable to
the investigation, defense, and settlement of
specific claims, including litigation expense,
interest on judgments, staff counsel expense, and
declaratory judgment expense, but not including
salaries and benefits of the Company's directors,
officers, and employees, nor the Company's office
expenses, overhead, and other fixed expenses of
the Company. Any expenses paid to a company that
is part of or affiliated with the Company, or to
an economically-related enterprise, or to any
enterprise which has common ownership with a
company or affiliate of the Company, will not be
included in loss expense. Any commission or other
compensation paid to the Company by a company
providing service on the business subject to this
Agreement will be deducted from the allowable
loss expense hereunder.
PREMIUM: Pro-Rata of GNEP, payable monthly as earned.
Gross Net Earned Premium is defined as the
Company's Premium for the business covered
hereunder less 28.7%.
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Monthly bordereaux within 45 days of the end of
each month of premiums and losses; loss
bordereaux to delineate claims for occupational
disease, cumulative trauma, employers liability,
extra contractual obligations, and excess limits
liability claims. Bordeaux to include GNEP
associated with class codes with a "D" or "E"
modifier. Settlement with bordereaux if balance
is due the Reinsurer; if balance is due the
Company, settlement due from the Reinsurer within
15 days after receipt of bordereaux.
CEDING
COMMISSION: Company allowed a ceding commission of [redacted]% on
GNEP ceded.
ESTIMATED
SUBJECT
PREMIUM: $162,500,000 - First twelve-months
$162,500,000 - Second twelve-months
ORIGINAL The liability of the Reinsurer will be subject in all
CONDITIONS: respects to the same interpretations, terms, rates,
conditions, waivers, modifications, and alterations as
the respective policies of the Company to which this
Agreement relates. However, in no event will this be
construed in any way to provide coverage outside
the terms and conditions set forth in this
Agreement.
The Company will be the sole judge as to what
will constitute a claim or loss covered under the
Company's policy and as to the Company's
liability thereunder and will, at its sole
discretion, adjust, settle, or compromise all
claims and losses. All such adjustments,
settlements, or compromises will be
unconditionally binding on the Reinsurer in
proportion to its participation, provided they
are within the terms and conditions of this
Agreement. The Company will, likewise, at its
sole discretion, commence, continue, defend, or
withdraw from actions, suits, or proceedings and
generally handle all matters related to all
claims and losses, and all payments made and
costs and expenses incurred in connection
therewith or taking legal advice therefor will be
shared by the Reinsurer.
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<PAGE>
When so requested, however, the Company will
afford the Reinsurer, at the Reinsurer's own
expense, an opportunity to be associated with the
Company in the defense of any claim, suit, or
proceeding involving this Agreement, and the
Company and the Reinsurer will cooperate in every
respect in such defense.
OTHER Access to Records Clause
PROVISIONS: Aon Re Inc. Intermediary Clause
Arbitration Clause
Currency (U.S. Dollars) Clause
Delays, Errors, or Omissions Clause
90%ECO/90% ELL (counsel and concur) - included
within ultimate net loss
Entire Agreement and Amendments Clause
Insolvency Clause
Settlements Clause
Salvage & Subrogation Clause
Net Retained Liability Clause
Offset Clause
Tax Clause
Ultimate Net Loss Clause -- UNL to include any
deductible under the insured's policy
* * * * *
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<PAGE>
We ask that you review the terms and conditions set forth hereon. Assuming that
you find everything in order, please indicate your acceptance and approval by
signing and returning one (1) copy of this Placement Slip to Aon Re Inc., 201
California Street, Suite 900, San Francisco, California 94111.
REINSURER: RELIANCE INSURANCE COMPANY_________________________________________
SIGNED LINE: 100% BEING $2,500________________________________________________
REFERENCE NO.:_________________________________________________________________
ACCEPTED AND
APPROVED BY: /s/ JAMES A. FOWLER__________________ DATED: January 11,1999____
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<PAGE>
EXCLUSIONS
No reinsurance indemnity will be afforded under this Agreement for:
A. Loss arising out of operations employing the process of
nuclear fission or fusion or handling radioactive material,
which operations include but are not limited to:
1. The use of nuclear reactors such as atomic piles,
particle accelerators, or generators, or
2. The use, handling, or transportation of radioactive
materials, or
3. The use, handling, or transportation of any weapon of
war or explosive device employing nuclear fission or
fusion.
Subsections 1., 2., and 3. above do not apply to:
a. The exclusive use of particle accelerators incidental
to ordinary industrial or educational research
pursuits, or
b. The exclusive use, handling, or transportation of
radioisotopes for medical or industrial use, or
c. Radium or radium compounds.
The term "any weapon of war or explosive device employing
nuclear fission or fusion" will not apply to a device not
equipped for intended explosive purposes, which employs
nuclear fission or fusion for propulsion only.
B. Class code with a "D" or "E" modifier (except on an incidental
basis, i.e., less than 20% of total book).
C. Class code nos. 1164 and 1165.
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<PAGE>
D. Second Injury Funds or Residual Market Assessments.
E. Jones Act.
F. Loss Portfolio Transfers.
G. Insolvency Funds.
H. Aggregate Workers' Compensation Policies.
I. Liability assumed by the Company under any form of treaty or
facultative reinsurance; however, this exclusion does not
apply to policies written by another carrier at the Company's
request and reinsured 100% by the Company.
The above Exclusions (other than Exclusion A, C, D, E, F, G, and H) will not
apply when they are merely incidental to the main operations of the insured
provided such main operations are covered by the Company and are not themselves
excluded from the scope of this Agreement. The Company will be the sole judge
(except as respects exclusion B) as to what constitutes "incidental."
Furthermore, should any judicial, regulatory, or legislative entity having
jurisdiction invalidate any exclusion of the Company's policy, any amount of
loss for which the Company would not be liable except for such invalidation will
not be subject to the Exclusions hereunder.
Should the Company, by reason of an inadvertent act, error, or omission, be
bound to afford coverage excluded hereunder or should an existing insured extend
its operations to include coverage excluded hereunder, the Reinsurer will waive
the exclusion(s) with the exception of Exclusion A, C, D, E, F, G, and H. The
duration of said waiver will not extend beyond the time that notice of such
coverage has been received by the responsible underwriting authority of the
Company plus the minimum time period required thereafter for the Company to
terminate such coverage.
The Company may submit in writing to the Reinsurer, for special acceptance
hereunder, business not covered by this Agreement. If said business is accepted
in writing by the Reinsurer, it will be subject to the terms of this Agreement,
except as such terms are modified by such acceptance. Any special acceptance
business covered under the reinsurance Agreement being replaced by this
Agreement will be automatically covered hereunder. Further, should Reinsurers
become a party to this Agreement subsequent to the acceptance of any business
not normally covered hereunder, they will automatically accept same as being a
part of this Agreement.
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<PAGE>
ACCESS TO RECORDS
The Reinsurer or its duly-accredited representatives will have the
right, upon prior notice to the Company, to inspect the books and records of the
Company relating to the subject matter of this Agreement at all reasonable times
while this Agreement is in force and subsequent to its termination so long as
any claim or premium matters remain outstanding.
The inspecting party will have the right, at its own expense, to make
copies of any relevant information in the Company's files. At the conclusion of
the inspection the inspecting party will meet with and discuss the review with
the Company and will provide a written report of its findings.
All non-public information provided in the course of the inspection
will be kept confidential by the Reinsurer as against third parties, except as
respects any obligation to do so by law or contract to retrocessionaires of the
Reinsurer, to counsel retained by the Reinsurer, or to external accounting or
compliance auditors.
DEFINITIONS
"Ultimate net loss" will mean the actual loss or losses paid or payable
by the Company under its policies, after deduction of all salvages and
recoveries that are actually received, and inuring reinsurance whether
recoverable or not. Ultimate net loss will be inclusive of loss expense, any
deductible under the insureds' policies, and 90% of any claims-related extra
contractual obligations and excess limits liability. All salvages, recoveries,
or reinsurance received subsequent to any loss settlement hereunder will be
applied as if received prior to the settlement, and all necessary adjustments
will be made by the parties hereto. Nothing in this definition, however, should
be construed to mean that losses under this Agreement are not recoverable until
the Company's ultimate net loss has been ascertained. In the event a verdict or
judgment is reduced by an appeal or a settlement, subsequent to the entry of the
judgment, however, resulting in an ultimate saving on such verdict or judgment,
or a judgment is reversed outright, the loss expense incurred in securing such
final reduction or reversal will be prorated between the Reinsurer and the
Company in the proportion that each benefits from such reduction or reversal.
"Declaratory judgment expense" will mean all expenses incurred by the
Company in connection with declaratory judgment actions brought to determine the
Company's defense and indemnification obligations that are allocable to specific
policies and claims subject to this Agreement. Declaratory judgment expense will
be deemed to have been fully incurred by the Company on the date of the actual
or alleged loss giving rise to the action under the Company's policy.
OFFSET
The Company and each Reinsurer hereunder may offset any paid claims
against ceded premiums due from one party to the other under this Agreement or
any other agreement entered into between them.
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<PAGE>
PAULA INSURANCE COMPANY
WORKERS COMPENSATION FIRST AND SECOND EXCESS OF LOSS
REINSURANCE AGREEMENT
FINAL PLACEMENT SLIP
COMPANY: PAULA Insurance Company
a California corporation and/or any Company
hereafter affiliated with PAULA Insurance
Company.
EFFECTIVE: Losses occurring during the period beginning
12:01 a.m., Pacific Standard Time, October 1,
1998, and ending 12:01 a.m., Pacific Standard
Time, October 1, 2000, under policies in force at
12:01 a.m., Pacific Standard Time, October 1,
1998, and written and renewed with effective
dates during the term of this Agreement.
If, at any time, the Reinsurer ceases
underwriting operations or loses the whole or
part of its paid up capital, becomes insolvent,
or is placed in conservation, rehabilitation, or
liquidation, has a receiver appointed, or is
acquired, controlled by, merged with, or
reinsures its entire business with any other
company or corporation, the Company will have the
right to cancel this Agreement by giving 15 days
notice by certified or registered mail.
BUSINESS
COVERED: All business classified by the Company as Workers
Compensation and Employers Liability.
EXCLUSIONS: Per attached.
TERRITORY: Worldwide.
RETENTION FIRST EXCESS
AND LIMIT:
$40,000 ultimate net loss each and every
occurrence, excess of $10,000 ultimate net loss
each and every occurrence, regardless of the
number of policies involved.
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<PAGE>
SECOND EXCESS
$200,000 ultimate net loss each and every
occurrence, excess of $50,000 ultimate net loss
each and every occurrence, regardless of the
number of policies involved.
"Occurrence" (except for losses arising from
Occupational Disease or Cumulative Trauma as
defined below) will mean any one accident,
disaster, casualty, or loss or series of
accidents, disasters, casualties, or losses
arising out of or caused by one event.
With respect to Occupational Disease or
Cumulative Trauma, all losses arising from each
employee will be deemed a separate "occurrence".
The date of loss for each occurrence will be the
date when the compensable disability of the
employee commences, or if there is no such
disability, when the medical treatment commences.
The terms "Occupation Disease" and "Cumulative
Trauma" as used in this Agreement will be as
defined by applicable state statutes,
regulations, or Federal Law.
LOSS Loss expense included within the ultimate net loss in
EXPENSES: satisfying Retention and Limit hereon.
"Loss expense" will mean expense assignable to
the investigation, defense, and settlement of
specific claims, including litigation expense,
interest on judgments, staff counsel expense, and
declaratory judgment expense, but not including
salaries and benefits of the Company's directors,
officers, and employees, nor the Company's office
expenses, overhead, and other fixed expenses of
the Company. Any expenses paid to a company that
is part of or affiliated with the Company, or to
an economically-related enterprise, or to any
enterprise which has common ownership with a
company or affiliate of the Company, will not be
included in loss expense. Any commission or other
compensation paid to the Company by a company
providing service on the business subject to this
Agreement will be deducted from the allowable
loss expense hereunder.
PREMIUM FIRST EXCESS
AND
REMITTANCES: Rate: [Redacted]% GNEP, payable monthly as earned.
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<PAGE>
SECOND EXCESS
Rate: [Redacted]% GNEP, payable monthly as earned.
Monthly bordereaux within 45 days of the end of
each month of premiums and losses; loss
bordereaux to delineate claims for occupational
disease, cumulative trauma, employers liability,
extra contractual obligations, and excess limits
liability claims. Bordeaux to include GNEP
associated with class codes with a "D" or "E"
modifier. Settlement with bordereaux if balance
is due the Reinsurer; if balance is due the
Company, settlement due from the Reinsurer within
15 days after receipt of bordereaux.
ESTIMATED
SUBJECT
PREMIUM: $162,500,000 - First twelve-months
$162,500,000 - Second twelve-months
ORIGINAL The liability of the Reinsurer will be subject in all
CONDITIONS: respects to the same interpretations, terms, conditions,
waivers, modifications, and alterations, as the respective
policies of the Company to which this Agreement relates.
However, in no event will this be construed in
any way to provide coverage outside the terms and
conditions set forth in this Agreement.
The Company will be the sole judge as to what
will constitute a claim or loss covered under the
Company's policy and as to the Company's
liability thereunder and will, at its sole
discretion, adjust, settle, or compromise all
claims and losses. All such adjustments,
settlements, or compromises will be
unconditionally binding on the Reinsurer in
proportion to its participation, provided they
are within the terms and conditions of this
Agreement. The Company will, likewise, at its
sole discretion, commence, continue, defend, or
withdraw from actions, suits, or proceedings and
generally handle all matters related to all
claims and losses, and all payments made and
costs and expenses incurred in connection
therewith or taking legal advice therefor will be
shared by the Reinsurer.
When so requested, however, the Company will
afford the Reinsurer, at the Reinsurer's own
expense, an opportunity to be associated with the
Company in the defense of any claim, suit, or
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<PAGE>
proceeding involving this Agreement, and the
Company and the Reinsurer will cooperate in every
respect in such defense.
OTHER Access to Records Clause
PROVISIONS: Aon Re Inc. Intermediary Clause
Arbitration Clause
Currency (U.S. Dollars) Clause
Delays, Errors, or Omissions Clause
90% ECO/90% ELL (counsel and concur) - included
within ultimate net loss
Entire Agreement and Amendments Clause
Insolvency Clause
Loss Notices and Settlements Clause
Net Retained Liability Clause
Salvage and Subrogation Clause
Offset Clause
Tax Clause
Ultimate Net Loss Clause -- UNL to include any
deductible under the insured's policy
* * * * *
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<PAGE>
We ask that you review the terms and conditions set forth hereon. Assuming that
you find everything in order, please indicate your acceptance and approval by
signing and returning one (1) copy of this Placement Slip to Aon Re Inc., 201
California Street, Suite 900, San Francisco, California 94111.
REINSURER: RELIANCE INSURANCE COMPANY_________________________________________
FIRST LAYER
SIGNED LINE: 75% BEING $30,000_______________________________________________
SECOND LAYER
SIGNED LINE: 100% BEING $200,000______________________________________________
ACCEPTED AND
APPROVED BY: /s/ JAMES A. FOWLER________________ DATED: January 11,1999 _____
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<PAGE>
EXCLUSIONS
No reinsurance indemnity will be afforded under this Agreement for:
A. Loss arising out of operations employing the process of
nuclear fission or fusion or handling radioactive material,
which operations include but are not limited to:
1. The use of nuclear reactors such as atomic piles,
particle accelerators, or generators, or
2. The use, handling, or transportation of radioactive
materials, or
3. The use, handling, or transportation of any weapon of
war or explosive device employing nuclear fission or
fusion.
Subsections 1., 2., and 3. above do not apply to:
a. The exclusive use of particle accelerators incidental
to ordinary industrial or educational research
pursuits, or
b. The exclusive use, handling, or transportation of
radioisotopes for medical or industrial use, or
c. Radium or radium compounds.
The term "any weapon of war or explosive device employing
nuclear fission or fusion" will not apply to a device not
equipped for intended explosive purposes, which employs
nuclear fission or fusion for propulsion only.
B. Class code with a "D" or "E" modifier (except on an incidental
basis, i.e., less than 20% of total book).
C. Class code nos. 1164 and 1165.
D. Second Injury Funds or Residual Market Assessments.
E. Jones Act.
F. Loss Portfolio Transfers.
G. Insolvency Funds.
H. Aggregate Excess Workers' Compensation Policies.
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<PAGE>
I. Liability assumed by the Company under any form of treaty or
facultative reinsurance, however, this exclusion does not
apply to policies written by another carrier at the Company's
request and reinsured 100% by the Company.
The above Exclusions (other than Exclusion A, C, D, E, F, G, and H) will not
apply when they are merely incidental to the main operations of the insured
provided such main operations are covered by the Company and are not themselves
excluded from the scope of this Agreement. The Company will be the sole judge
(except as respects exclusion B) as to what constitutes "incidental."
Furthermore, should any judicial, regulatory, or legislative entity having
jurisdiction invalidate any exclusion of the Company's policy, any amount of
loss for which the Company would not be liable except for such invalidation will
not be subject to the Exclusions hereunder.
Should the Company, by reason of an inadvertent act, error, or omission, be
bound to afford coverage excluded hereunder or should an existing insured extend
its operations to include coverage excluded hereunder, the Reinsurer will waive
the exclusion(s) with the exception of Exclusion A, C, D, E, F, G, and H. The
duration of said waiver will not extend beyond the time that notice of such
coverage has been received by the responsible underwriting authority of the
Company plus the minimum time period required thereafter for the Company to
terminate such coverage.
The Company may submit in writing to the Reinsurer, for special acceptance
hereunder, business not covered by this Agreement. If said business is accepted
in writing by the Reinsurer, it will be subject to the terms of this Agreement,
except as such terms are modified by such acceptance. Any special acceptance
business covered under the reinsurance Agreement being replaced by this
Agreement will be automatically covered hereunder. Further, should Reinsurers
become a party to this Agreement subsequent to the acceptance of any business
not normally covered hereunder, they will automatically accept same as being a
part of this Agreement.
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<PAGE>
ACCESS TO RECORDS
The Reinsurer or its duly-accredited representatives will have the
right, upon prior notice to the Company, to inspect the books and records of the
Company relating to the subject matter of this Agreement at all reasonable times
while this Agreement is in force and subsequent to its termination so long as
any claim or premium matters remain outstanding.
The inspecting party will have the right, at its own expense, to make
copies of any relevant information in the Company's files. At the conclusion of
the inspection the inspecting party will meet with and discuss the review with
the Company and will provide a written report of its findings.
All non-public information provided in the course of the inspection
will be kept confidential by the Reinsurer as against third parties, except as
respects any obligation to do so by law or contract to retrocessionaires of the
Reinsurer, to counsel retained by the Reinsurer, or to external accounting or
compliance auditors.
DEFINITIONS
"Ultimate net loss" will mean the actual loss or losses paid or payable
by the Company under its policies, after deduction of all salvages and
recoveries that are actually received, and inuring reinsurance whether
recoverable or not. Ultimate net loss will be inclusive of loss expense, any
deductible under the insureds' policies, and 90% of any claims-related extra
contractual obligations and excess limits liability. All salvages, recoveries,
or reinsurance received subsequent to any loss settlement hereunder will be
applied as if received prior to the settlement, and all necessary adjustments
will be made by the parties hereto. Nothing in this definition, however, should
be construed to mean that losses under this Agreement are not recoverable until
the Company's ultimate net loss has been ascertained. In the event a verdict or
judgment is reduced by an appeal or a settlement, subsequent to the entry of the
judgment, however, resulting in an ultimate saving on such verdict or judgment,
or a judgment is reversed outright, the loss expense incurred in securing such
final reduction or reversal will be prorated between the Reinsurer and the
Company in the proportion that each benefits from such reduction or reversal.
"Declaratory judgment expense" will mean all expenses incurred by the
Company in connection with declaratory judgment actions brought to determine the
Company's defense and indemnification obligations that are allocable to specific
policies and claims subject to this Agreement. Declaratory judgment expense will
be deemed to have been fully incurred by the Company on the date of the actual
or alleged loss giving rise to the action under the Company's policy.
-8 of 9-
<PAGE>
OFFSET
The Company and each Reinsurer hereunder may offset any paid claims
against ceded premiums due from one party to the other under this Agreement or
any other agreement entered into between them.
-9 of 9-
<PAGE>
CHANGE OF CONTROL AGREEMENT
This change of control agreement (the "Agreement") is made effective as of
November 1, 1998 by and between PAULA FINANCIAL, a Delaware corporation (the
"Company"), and Jeffrey A. Snider ("Employee").
WITNESSETH
WHEREAS, if certain corporate transactions were proposed or pending, such
potential transactions could result in distractions to Employee's performance at
a critical period; and
WHEREAS, Employee and Company wish to enter into this Agreement in order to
provide security to Employee as a means of maintaining performance under such
circumstances;
NOW, THEREFORE, in consideration of the mutual promises and agreements set forth
herein, the Company and Employee agree as follows:
1. TERM.
1.1 The term of this Agreement (the "Term") shall commence on November 1,
1998 and shall be for three years, subject to earlier termination in accordance
with the provisions of Section 4 hereinbelow. Beginning on November 1, 1998 and
on each day thereafter, the Term shall automatically be extended for an
additional day, unless the Company notifies Employee in writing that it does not
wish to further extend the Term.
2. POSITION AND TITLE.
2.1 The Company on behalf of itself and its affiliates and subsidiaries
currently employs Employee as Chairman of the Board of Directors, President and
Chief Executive Officer.
2.2 Employee shall devote substantially all of his efforts on a full-time
basis to the business and affairs of the Company and shall not engage in any
business or perform any services in any capacity whatsoever adverse to the
interests of the Company.
2.3 Employee shall at all times faithfully, industriously, and to the best
of his ability, experience, and talents, perform all of the duties of his
position.
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<PAGE>
3. COMPENSATION.
3.1 As of the date of this Agreement, Employee's annual base salary is
$360,000. Employee's base salary and performance shall be reviewed periodically
at intervals approved by the Executive Compensation Committee of the Board of
Directors of the Company (the "Committee"), and Employee's base salary may be
increased from time to time based on merit or such other considerations as the
Committee may deem appropriate.
4. TERMINATION OF EMPLOYMENT.
For purposes of this Agreement, a Termination Without Cause shall exist if
Employee is terminated by the Company for any reason except:
(1) Intentional conduct or action by Employee which, in the opinion
of a majority of the Board of Directors (the "Board"), is
materially harmful to the Company;
(2) Willful failure by Employee to follow an order of the Board,
except in a case where the Employee reasonably believes in good
faith that following such order would be materially detrimental
to the interests of the Company; or
(3) Employee's conviction of a felony.
Additionally, if (a) Employee's annual base salary is reduced below the
amount stated in Paragraph 3.1 hereinabove (unless such reduction is part of an
across the board reduction affecting all executive officers of the Company), (b)
Employee is removed from or denied participation in incentive plans, benefit
plans, or perquisites generally provided by the Company to other executive
officers, (c) Employee's target incentive opportunity, benefits or perquisites
are reduced relative to other executive officers, (d) Employee is assigned
duties or obligations inconsistent with his position with the Company, (e)
Employee is required to relocate to an area outside the Metropolitan Los Angeles
area, or (f) there is a material reduction in Employee's position (status,
offices, titles, or reporting requirements), duties or responsibilities or a
significant change in the nature and scope of Employee's authority or his
overall working environment, such event shall be considered a Termination
Without Cause.
5. CHANGE OF CONTROL.
5.1 Employee shall be entitled to the benefits set forth in this Section 5
in the event:
(i) a Change of Control of the Company occurs at any time during the Term
of this Agreement; AND
(ii) Employee is Terminated Without Cause within a period of twenty-four
(24) months following the date of such Change of Control:
2
<PAGE>
(1) The Company shall pay Employee a lump-sum severance amount within
thirty (30) days following his Termination Without Cause equal to
the sum of (a) three (3) times the higher of the Employee's
annual base salary at the time of Termination Without Cause or
the annual base salary stated in Paragraph 3.1 hereinabove, and
(b) one (1) times the target annual bonus of Employee for the
fiscal year in which such Termination Without Cause occurs.
(2) The Company shall provide for Employee to receive medical,
dental, life, and disability insurance coverage for three (3)
years following his Termination Without Cause at levels and a net
cost to Employee comparable to that provided to Employee
immediately prior to Employee's Termination Without Cause. The
Company shall also provide Employee with the use of the
automobile then provided to him under the same terms as then in
force for three (3) years following his Termination Without
Cause.
(3) The Company shall pay for Employee's use of an executive office
with secretarial support in premises outside of Company
facilities for a period of six (6) months following his
Termination Without Cause.
5.2 All stock options, restricted stock and other stock based awards held by
Employee which are not then fully vested shall become 100% vested upon his
Termination Without Cause if the Termination Without Cause occurs within a
period of twenty-four (24) months following the date of a Change of Control.
5.3 If it is determined that any payment, distribution or benefit made or
provided by the Company to Employee pursuant to this Agreement (determined
without regard to any additional payments required pursuant to this sentence) (a
"Payment") would be subject to the excise tax imposed by Section 4999 of the
Internal Revenue Code of 1986, as amended (the "Code"), or any interest or
penalties are incurred by the Employee with respect to such excise tax (such
excise tax, together with any such interest and penalties, are hereinafter
collectively referred to as the "Excise Tax"), then upon such determination the
Employee shall be entitled to receive with respect to each Payment an additional
payment (a "Gross-Up Payment") in an amount such that after payment by the
Employee of all taxes (including any interest or penalties imposed with respect
to such taxes), including, without limitation, any income and employment taxes
(and any interest and penalties imposed with respect thereto) and Excise Tax
imposed upon the Gross-Up Payment, the Employee retains an amount of the
Gross-Up Payment equal to the Excise Tax imposed upon the Payments.
5.4 As used herein, the term "Change of Control" shall mean any of the
following events:
(W) any date upon which the directors of the Company who were
nominated by the Board for election as directors cease to constitute a
majority of the directors of the Company;
(X) the date of the first public announcement that any person or
entity, together with all Affiliates and Associates (as such
capitalized terms are defined
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<PAGE>
in Rule 12b-2 promulgated under the Securities Exchange Act of 1934,
as amended (the "Exchange Act")) of such person or entity, shall have
become the Beneficial Owner (as defined in Rule 13d-3 promulgated
under the Exchange Act) of voting securities of the Company
representing 50% or more of the voting power of the Company (a "50%
Stockholder"), provided, however, that the terms "person" and
"entity," as used in this clause (Y), shall not include (1) the
Company or any of its subsidiaries, (2) any employee benefit plan of
the Company or any of its subsidiaries, including the Company s
Employee Stock Ownership Plan, or (3) any entity holding voting
securities of the Company for or pursuant to the terms of any such
plan;
(Y) a reorganization, merger or consolidation of the Company in which
the holders of voting stock of the Company immediately before the
reorganization, merger or consolidation will not own more than fifty
percent (50%) of the outstanding voting shares of the continuing or
surviving entity immediately after such reorganization, merger or
consolidation; or
(Z) a sale of all or substantially all of the assets of the Company
to an entity the voting securities of which are not then owned at
least fifty percent (50%) by the holders of the voting securities of
the Company immediately prior to the closing of the transaction.
5.5 Employee shall not be obligated to seek other employment or take any other
action by way of mitigation of the amounts and benefits payable to Employee
under any provisions of this Agreement, and the amounts and benefits payable
under this Agreement shall not be offset by any amounts or benefits which
Employee earns from any other employment or services. Notwithstanding the
foregoing, in the event that Employee actually receives group medical, dental,
disability and/or life insurance benefits from a subsequent employer, the
Company shall not be required to provide such benefits to Employee to the extent
that the benefits which would be provided by the Company would be redundant.
6. COVENANTS.
6.1 Employee agrees that any and all confidential knowledge or
information, including but not limited to customer lists, books, records, data,
formulae, inventions, processes and methods, which have been or may be obtained
or learned by Employee in the course of his employment with the Company, will be
held confidential by Employee, and that Employee shall not disclose the same to
any person outside of the Company either during his employment with the Company
or after his employment by the Company has terminated.
6.2 Employee agrees that, upon termination of his employment with the
Company, he will immediately surrender and turn over to the Company all books,
records, forms, and all other property belonging to the Company.
4
<PAGE>
7. MISCELLANEOUS PROVISIONS.
7.1 All terms and conditions of this Agreement are set forth herein, and
there are no warranties, agreements or understandings, express or implied,
except those expressly set forth herein.
7.2 Any modifications to this Agreement shall be binding only if evidenced
in writing signed by all parties hereto.
7.3 Any notice or other communication required or permitted to be given
hereunder shall be deemed properly given if personally delivered or deposited in
the United States Mail, registered or certified and postage prepaid, addressed
to the Company at 300 North Lake Avenue, Suite 300, Pasadena, CA 91101 or to
Employee at his most recent home address on file with the Company, or at other
such addresses as may from time to time be designated in writing by the
respective parties.
7.4 The laws of the State of California shall govern the validity of this
Agreement, the construction of its terms, and the interpretation of the rights
and duties of the parties involved.
7.5 In the event that any one or more of the provisions contained in this
Agreement shall for any reason be held to be invalid, illegal or unenforceable,
the same shall not affect any other provision of this Agreement, but this
Agreement shall be construed as if such invalid, illegal or unenforceable
provisions had never been contained herein.
7.6 This Agreement shall be binding upon, and inure to the benefit of, the
successors and assigns of the Company and the personal representatives, heirs
and legatees of Employee.
5
<PAGE>
7.7 The term "Company" shall include, with respect to employment
hereunder, any subsidiary or affiliate of the Company, as well as any successor
employer following a Change of Control.
IN WITNESS WHEREOF, the parties have executed this Agreement effective as
of the date first above written.
PAULA FINANCIAL
BY: /s/ John B. Clinton
-------------------
Chairman of the Executive Compensation Committee
of the Board of Directors
EMPLOYEE
BY: /s/ Jeffrey A. Snider
---------------------
Jeffrey A. Snider
6
<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,
--------------------------------------------------
1998 1997 1996
-------------- ------------- -------------
<S> <C> <C> <C>
Net income (loss) $ (4,877) $ 5,159 $ 3,923
-------------- ------------- -------------
-------------- ------------- -------------
Weighted average shares outstanding for calculating
basic earnings per share 6,228 2,737 1,897
Convertible preferred stock - 1,527 1,882
Warrants - 49 40
Options - 352 92
-------------- ------------- -------------
Total shares for calculating diluted earnings
per share 6,228 4,665 3,911
-------------- ------------- -------------
-------------- ------------- -------------
Basic earnings (loss) per share $ (0.78) $ 1.88 $ 2.07
-------------- ------------- -------------
-------------- ------------- -------------
Diluted earnings (loss) per share $ (0.78) $ 1.11 $ 1.00
-------------- ------------- -------------
-------------- ------------- -------------
</TABLE>
Options are excluded from the calculation of diluted loss per share as the
inclusion of such options would have an anti-dilutive effect.
<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 2, 1999, relating to the consolidated
balance sheets of PAULA Financial and subsidiaries as of December 31, 1998
and 1997, and the related consolidated statements of operations,
comprehensive income (loss), stockholders' equity, and cash flows for each of
the years in the three-year period ended December 31, 1998, and all related
schedules, which report appears in the December 31, 1998, annual report on
Form 10-K of PAULA Financial.
/s/ KPMG LLP
Los Angeles, California
March 30, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<DEBT-HELD-FOR-SALE> 170,792
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 4,259
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 177,623
<CASH> 4,145
<RECOVER-REINSURE> 715
<DEFERRED-ACQUISITION> 2,533
<TOTAL-ASSETS> 254,948
<POLICY-LOSSES> 136,316
<UNEARNED-PREMIUMS> 20,234
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 335
<NOTES-PAYABLE> 2,667
0
0
<COMMON> 63
<OTHER-SE> 73,973
<TOTAL-LIABILITY-AND-EQUITY> 254,948
128,770
<INVESTMENT-INCOME> 9,540
<INVESTMENT-GAINS> 1,706
<OTHER-INCOME> 4,076
<BENEFITS> 114,483
<UNDERWRITING-AMORTIZATION> 37,636
<UNDERWRITING-OTHER> 677
<INCOME-PRETAX> (8,704)
<INCOME-TAX> (3,827)
<INCOME-CONTINUING> (4,877)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,877)
<EPS-PRIMARY> (0.78)
<EPS-DILUTED> (0.78)
<RESERVE-OPEN> 71,390
<PROVISION-CURRENT> 108,454
<PROVISION-PRIOR> 6,029
<PAYMENTS-CURRENT> 34,674
<PAYMENTS-PRIOR> 40,020
<RESERVE-CLOSE> 111,179
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
