The Company entered into a lease agreement effective May 1992 for the leasing of 93,000 square feet of office space for its principal office. The lease expires in 2002. The space is in Woodland Hills, California, which is within Los Angeles County. The Company also entered into a lease agreement effective November 1992 for the leasing of 3,000 square feet of office space in Fresno, California. That lease expires in 1997. The Company entered into a lease agreement effective August 1995 for the leasing of 3,692 square feet of office space in Phoenix, Arizona. That lease expires in 2000.
The following selected consolidated financial data is derived from the audited financial statements of the Company and should be read in conjunction with the audited consolidated financial statements included elsewhere herein.
During the third quarter of 1996, the Company increased loss and loss adjustment expense ("LAE") reserves related to accident years 1995 and prior by approximately $4,500,000; the total adverse development recognized on prior accident years during the first nine months of the year was approximately $5,600,000. Also during the third quarter, the Company signed a definitive agreement to be acquired by Superior National Insurance Group, Inc. ("Superior") for total consideration that would have been $54,000,000 in cash upon closing of the transaction, which would have resulted in payment of approximately $3.00 to $3.10 per share of common stock held by its common stockholders, and a like sum to convertible debenture holders, and warrant and option holders (assuming the conversion of such security interests).
As a result of the $12,000,000 increase in reserves during the fourth quarter, on February 17, 1997, the Company signed the Amended Agreement regarding the acquisition by Superior, pursuant to the terms of which the stockholders would receive $2.11 per share (a total of approximately $20,063,293), the convertible debenture holders would receive face value for the debentures or $20,000,000, and $1,957,739 would be paid to acquire all of the issued and outstanding warrants of the Company and options to purchase common stock that are "in-the- money", for a total consideration of approximately $42,021,032. The $12,000,000 reduction in the purchase price was directly attributable to the fourth quarter increase in reserves. The Company and its actuaries believe that the strengthening of reserves will conclude the Department's triennial examination and facilitate securing of the necessary regulatory approval of the acquisition. However, other unforeseen factors could affect either the regulatory approval process or the ultimate closing of the transaction. (See "Business-Claims, Loss, and Loss Reserves".)
Statements herein that use the words "the Company believes", "the Company expects", and "in the Company's opinion," are forward-looking statements and the actual results could differ materially from those projected in the forward- looking statement. These forward-looking statements therefore involve risks and uncertainties that could render them materially different, including, but not limited to, the effect of economic conditions, premium rate adequacy as a result of pricing factors related to competition or regulation, actual versus estimated claims experience, the effect of the Company's accounting policies, the effect of regulatory and legal developments, and other factors detailed herein.
Net premiums earned increased by $10,472,000 or 13.8% during 1996, to $86,488,000 from $76,016,000 during 1995. This increase was primarily the result of increased premium rates by the Company in California, during 1996, as well as continued expansion by the Company into additional geographic areas, which had begun in 1995. In May 1995, Pacific Rim Assurance received a Certificate of Authority to write workers' compensation insurance in the State of Arizona, and commenced operations in June 1995. During August 1995, Pacific Rim Assurance received a Certificate of Authority
to write workers' compensation insurance in the State of Texas, and commenced operations in October 1995. In March 1996, Pacific Rim Assurance received a Certificate of Authority to write workers' compensation insurance in the State of Georgia, and commenced operations in April 1996. Pacific Rim Assurance also received a Certificate of Authority to write workers' compensation insurance in the State of Alabama, in October 1996; it commenced operations there, but did not earn premium there in 1996. Premiums earned outside of California equaled approximately $10,510,000 or 12.2% of the Company's total premiums earned during 1996. The Company believes that geographic expansion will enable it to increase its premium revenues and operate regionally in more, and potentially less volatile, markets. However, there can be no assurance that such expansion will ultimately increase revenues or prove to be profitable.
The Company sold bonds with total proceeds of $104,172,000 during 1996 to take advantage of favorable market conditions, and to meet cash flow demands. These sales resulted in a net pre-tax realized investment gain of $1,640,000. During 1995, the Company sold bonds with total proceeds of $61,343,000 and realized net pre-tax gains of $453,000.
To illustrate the uncertainty and its effects, paid loss activity during 1996 has continued at a level higher than previously projected on the more difficult 1990-1992 accident years, which were affected by the negative impacts of legislative, economic, and litigation factors; and 1996 case reserve activity on remaining open claims from those years has accelerated in response to the paid loss activity. Thus, as a precaution, the Company has further increased loss and LAE reserves on those years. Further, even though there has been more favorable case reserve and paid loss activity on the 1993-1994 accident years, following positive impacts of legislative reforms, improved managed medical care cost containment, and cost-effective litigation expense factors, the Company, with the concurrence of its actuaries and the Department, has elected to take a precautionary stance and maintain higher 1996 reserves on those more recent and favorable accident years. The Company believes that given the patterns of claim payments and closures, despite the gradual reduction in
the number of claims that remain outstanding on 1990-1992 accident years and the generally improved 1993 and subsequent accident years, it should not anticipate further favorable loss and LAE development.
It should be noted that despite the increases recorded during 1996 to loss and LAE reserves from accident years 1995 and prior, the 1993 through 1995 accident year results even at the current higher reserve estimates appear to have produced underwriting profits. The improving conditions in the California workers' compensation market, including legislation reforms and some economic recovery, have improved the frequency and severity of claims. The accident years that produced significant underwriting losses were 1992 and prior; the actual size of these losses has become known only with additional passage of time.
Policyholder dividends for 1996 were a net credit of ($11,000), compared to a net charge of $132,000 for 1995. The net credit reflects the elimination of approximately $291,000 of dividend reserves for which no further future liability is expected. The remaining reserve for policyholder dividends of $364,000 as of December 31, 1996 represents current expectations of future policyholder dividend payments on participating policies inforce. In determining the appropriate policyholder dividend reserve level, the Company analyzes competitive factors related to quality of service, loss prevention, claims management and cost control, and adequacy of premium rates, as well as its own underwriting results.
The loss before taxes was $15,294,000 for the year ended December 31, 1996, compared to net income before taxes of $854,000 for 1995. This loss was due primarily to an increase in losses and LAE from adverse development of accident years prior to 1995, offset by decreases in underwriting expenses and dividends, and an increase in premiums earned.
Because of the significant operating loss during 1996, management believed that it was prudent to record a valuation allowance against a portion of the deferred tax asset. That resulted in a deferred tax provision of $606,000 for the year ended December 31, 1996.
In connection with efforts to expand its business into additional geographic areas and increase future revenues, during May 1995, Pacific Rim Assurance received a Certificate of Authority to write workers' compensation insurance in the State of Arizona, and commenced operations in June 1995. The Company's net premiums earned in Arizona were
The Company sold bonds with total proceeds of $61,343,000 during 1995 to take advantage of certain advantageous market conditions, reposition into higher yielding securities, and to meet cash flow demands. These sales resulted in a net pre-tax realized investment gain of $453,000. There were no sales in 1994.
Interest expense increased to $2,306,000 in 1995 from $857,000 in 1994. This increase was the result of having its Series A Convertible Debenture outstanding for all of 1995 versus only four and one-half months in 1994.
Income before taxes was $854,000 for the year ended December 31, 1995, as compared to $1,970,000 for the year ended December 31, 1994. This decrease was due primarily to increased investment income and decreased expenses, offset by decreased premium volume.
Net income for the year ended December 31, 1995 was $575,000, as compared to $1,158,000 for 1994.
Four ratios are traditionally used to measure underwriting performance in the workers' compensation insurance industry: the loss ratio, the underwriting expense ratio, and the policyholder dividend ratio, which when added together constitute the combined ratio. A combined ratio greater than 100% indicates an underwriting loss, while a combined ratio less than 100% indicates an underwriting profit.
The following table sets forth the Company's combined ratio and its component ratios, as measured on the basis of generally accepted accounting principles ("GAAP"):
The following table sets forth the Company's combined ratio and its component ratios, as measured on the basis of statutory accounting practices.
Pac Rim Holding was organized in May 1987 and has been capitalized from sales of the Company's common stock. Pac Rim Holding is dependent on dividends from Pacific Rim Assurance for operating funds. Pacific Rim Assurance may pay dividends without prior California Insurance Department approval to the extent it has available "earned surplus". Dividends are further limited to an amount up to the greater of net income from the preceding calendar year or 10% of policyholders' surplus as of the end of the preceding year. Under these provisions, Pacific Rim Assurance paid $1,100,000 in dividends to Pac Rim Holding in 1996. At December 31, 1996, Pacific Rim Assurance had a deficit of $17,202,000 in its earned surplus account. Accordingly, Pacific Rim Assurance cannot pay dividends to Pac Rim Holding during 1997 without Department approval.
One of the most widely accepted factors used by regulators and rating agencies in evaluating insurance companies is the ratio of net premiums written to policyholders' surplus, which is an indication of the degree to which an insurer is leveraged. While there is no statutory requirement applicable to Pacific Rim Assurance that establishes a permissible net premiums written to policyholders' surplus ratio, as determined in accordance with statutory accounting practices, the National Association of Insurance Commissioners ("NAIC") uses a ratio of three to one as an appropriate guideline in
Insurance companies are required to maintain on deposit with the Regulatory Agencies deposits for the benefit of policyholders, in an amount prescribed by regulations. At December 31, 1996, the Company was in good standing with all Departments of Insurance with respect to its deposit requirements, maintaining securities with a total fair value of $105,301,000 on deposit with authorized depositories in various states.
The Company's present policyholders surplus is not adequate to sustain 1996 premium volume at a leverage ratio of 3 to 1. Concerns regarding the financial strength of the Company could adversely affect the Company's relationships with its policyholders, agents and brokers, reinsurers, and regulators. On February 17, 1997, the Company executed the Amended Agreement with Superior. The Company believes that obtaining regulatory and shareholder approval for, and completing the pending merger with Superior, which contemplates the contribution of additional capital, will restore confidence in Pacific Rim Assurance and enable it to support its present operations and moderate growth in premium volume for the foreseeable future.