<PAGE>
PAULA FINANCIAL & SUBSIDIARIES
ANNUAL REPORT
1998
<PAGE>
FINANCIAL HIGHLIGHTS
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AS OF AND FOR THE YEARS ENDED DECEMBER 31,
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1998 1997 1996 1995 1994
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<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Gross premiums written $152,448 $100,797 $ 63,606 $ 46,762 $ 53,545
Net premiums earned 128,770 92,835 55,504 44,531 51,289
Total revenue 144,092 103,070 65,758 54,918 61,836
Losses and loss adjustment expenses 114,483 68,107 33,900 29,363 28,618
Net income (loss) $ (4,877) $ 5,159 $ 3,923 $ 300 $ 4,705
Earnings (loss) per share $ (0.78) $ 1.88 $ 2.07 $ 0.16 $ 1.54
Earnings (loss) per share -- assuming dilution $ (0.78) $ 1.11 $ 1.00 $ 0.08 $ 1.23
BALANCE SHEET DATA
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Investments $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 -- -- 21,402 19,501 18,918
Net stockholders' equity $ 74,036 $ 84,820 $ 4,574 $ 6,104 $ 7,995
OPERATING RATIOS
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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
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Combined ratio 115.8% 97.4% 96.1% 105.9% 94.6%
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<PAGE>
TO OUR STOCKHOLDERS, EMPLOYEES AND CLIENTS
[PHOTO] 1998 was PAULA's 52nd year as an operating company and its full
calendar year as a public company. Part of the challenge in 1998, for
me, had a lot to do with sticking to the analysis and decision making
that had built the company over a long period of time. The reserves
we posted in the second quarter is a case in point. The majority of
the reserve adjustment was applied to the 1998 accident year, and much
of it on business that had yet to produce meaningful claims. I know of
no other company that is committed to acting on its reserve analysis
on a mid-year basis, including a company only nine months out from a
public equity financing.
PAULA paid a big price in 1998 with its decision to strengthen balance sheet
reserves on its California business. This second quarter action effectively
eliminated any chance for positive earnings for fiscal year 1998. The $14.8
million reserve increase led to a full year loss of $4.9 million or ($0.78)
per share. Our stockholders, individuals and institutions, are to be thanked
for their support.
By year-end 1998 the evidence continued to point to the merits of the decision
to strengthen reserves. Workers' compensation industry regulators and rating
agencies began to talk openly about industry-wide under-reserving. Major
reinsurers were beginning to acknowledge the same. After our second quarter
announcement, our underwriters began to stake out a position in the market
that was consistent with our view on reserving. Our rates started to move up
meaningfully while our competitors continued to price as if old patterns were
continuing. I gave direction that our account persistency for the insurance
company fall off its historical 90% level. Our agency, Pan American
Underwriters, and the rest of the PAULA Trading Company agents were encouraged
to maintain their customer relationships and to move to other markets
policyholders who would not agree to the PAULA price/value proposition.
Our relationship with these customers is intact as a result of our
distribution strategy, and we expect to welcome them back to PAULA Insurance
Company should pricing in California improve as a whole. We achieved
meaningful rate development and held on to the better underwritten accounts
to finish off 1998. Our agents are to be thanked for their good work.
"WHILE PAULA FINANCIAL'S RECORD SINCE 1972 INCLUDES A 20% COMPOUNDED RETURN
ON EQUITY PER SHARE, THAT PATTERN INCLUDES DOWN YEARS AS WELL AS UP."
page 1
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"BY YEAR-END 1998 THE EVIDENCE CONTINUED TO POINT TO THE MERITS OF THE
DECISION TO STRENGTHEN RESERVES."
While PAULA Financial's record since 1972 includes a 20% compounded return on
equity per share, that pattern includes down years as well as up. Our 50+
year perspective tells me that putting up meaningful reserves once, rather
than little by little, always serves the company best in the long run. A
management team intent upon growing the company for near term rewards would
not have taken this step or subsequent pricing actions. The senior managers
did the correct thing. They protected the company while forfeiting bonus
compensation for the 1998 results. All the PAULA employees have borne the
impact of an over punished stock price as it effects their direct holdings
and their ESOP. The employees of PAULA are to be thanked for their support as
well.
The hard and necessary decisions of 1998 are having their intended impact on
the company. We continue to believe that our distribution and underwriting
franchise and its proprietary agribusiness platform are valuable--and indeed
these are the reasons that customers agreed to pay us a premium to market
pricing in the recent cycle.
Our reserve action in California, having taken place during our first year as
a public company, clouded many of the excellent ways our franchise became
more valuable. In 1998, we became an integral fixture in the citrus industry
of Florida, the realization of a strategy we began pursuing several years
ago. We rounded out our Western capability with our entry into New Mexico
and our acquisition of the New Mexico Retail Association Self Insured Group
business to extend PAULA's coverage from the Pacific Northwest along the West
coast and across the border to Texas. Our commitment to developing our
distribution capabilities through joint ventures and new investments moved
forward undeterred. We now have the ability to write business in all 50
states through our relationship with General Reinsurance Corporation. In
total, 5,000 customers outside of California have workers' compensation
coverage through PAULA, a strong and loyal following.
"WE ACHIEVED MEANINGFUL RATE DEVELOPMENT AND HELD ON TO THE BETTER
UNDERWRITTEN ACCOUNTS TO FINISH OFF 1998."
<PAGE>
"IN THE END, COMPANIES LIKE PAULA, WITH THE BEST VALUE PROPOSITION AND THE
DISCIPLINE TO EXECUTE WELL WILL PREVAIL."
With franchise, proprietary delivery and products, loyal agents, fully
invested employees and faithful customers-what could be better? Little, save
for one item: industry pricing in California remains highly competitive.
Some blame over-capacity. In my view, recent reinsurance interest in first
dollar reinsurance coverage explains why pricing continued to soften through
the end of 1998. In the end, companies like PAULA, with the best value
proposition and the discipline to execute well will prevail.
In closing, our fee businesses, the agencies, continue to do well, with
margins in 1998 at excellent and sustainable levels. The insurance company
will continue to focus on its gross underwriting results - we always have -
our pricing strategy will lead to reduced new business flows in 1999. We are
confident that recent reinsurance developments will sort themselves out,
rewarding underwriting and otherwise giving pause to those who would pursue
reinsurance arbitrage to grow. We will be diligent about watching our costs
and relentless in our pursuit of proper pricing. Our audited book value at
the end of December 1998 was $12.49 per share. Watch it grow.
Thank you,
/s/ Jeffrey A. Snider
---------------------------
Jeffrey A. Snider
Chairman
Chief Executive Officer
<PAGE>
BOARD OF DIRECTORS AND OFFICERS
[PHOTO] [PHOTO] [PHOTO]
JEFFREY A. SNIDER ANDREW M. SLAVITT JAMES A. NICHOLSON
President Senior Vice President and Senior Vice President
Chief Executive Officer Chief Operating Officer Chief Financial Officer
and Chairman and Treasurer
[PHOTO] [PHOTO] [PHOTO]
BRADLEY K. SERWIN ROBERT A. PUCCINELLI JOHN B. CLINTON
Senior Vice President Former Chief Executive Officer Executive Vice President
General Counsel and Industrial Indemnity Company Conning & Company
Secretary
[PHOTO] [PHOTO] [PHOTO]
GERARD VECCHIO RONALD W. WAISNER JERRY M. MILLER
Senior Vice President Former Senior Vice President Former Partner
Conning & Company Continental Insurance Company KPMG LLP
<PAGE>
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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
--- ---
(Cover page 1 of 2 pages)
<PAGE>
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
----------
The aggregate market value of 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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2
<PAGE>
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.
1
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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
2
<PAGE>
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.
3
<PAGE>
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>
4
<PAGE>
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.
5
<PAGE>
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.
6
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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.
7
<PAGE>
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.
8
<PAGE>
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.
9
<PAGE>
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>
CORPORATE INFORMATION
CORPORATE OFFICE
300 North Lake Avenue
Suite 300
Pasadena, CA 91101
(626) 304-0401
CORPORATE COUNSEL
Gibson, Dunn & Crutcher LLP
333 South Grand Avenue
Los Angeles, CA 90071
INDEPENDENT AUDITORS
KPMG LLP
725 South Figueroa Street
Los Angeles, CA 90017
STOCK LISTING
The Company's stock is traded
on the Nasdaq Stock Market
under the symbol "PFCO."
STOCKHOLDER INFORMATION
Stockholder information may be
obtained by writing to the General
Counsel at the above Corporate
address.
STOCKHOLDER ACCOUNT INFORMATION
ChaseMellon Shareholder Services, L.L.C. is the
transfer agent, registrar and dividend disbursing
agent for the Company. Stockholders of record
with questions about lost certificates, lost or
missing dividend checks, or notification of
change of address should contact:
ChaseMellon Shareholder Services, L.L.C.
Overpeck Center
85 Challenger Road
Ridgefield Park, NJ 07660
(800) 356-2017
Internet address: http://www.chasemellon.com
<PAGE>
[LOGO]
OFFICE LOCATIONS
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