(3) Previously reported financial information has been adjusted to reflect the reclassification of the underwriting operation as a discontinued operation.
Revenue Recognition. Commission income is recorded on the effective date of the policy or the billing date, whichever is later. In the case of contingent commissions tied to achieving specified volume levels, revenue is recorded when the related criteria has been met. Contingent commission income associated with profit sharing arrangements is recorded at the earlier of the amounts being reasonably estimatable or receipt of such amounts. Service fees are earned over the period the related services are performed.
Discontinued Operations. As of December 31, 2001, PICO’s Risk Based Capital fell into the “Mandatory Control Level.” Consequently, on March 12, 2002, PICO and the California DOI entered into an Oversight Agreement which effectively gave the California DOI control over PICO’s operations.
On April 26, 2002, the California DOI obtained a conservation order for PICO which was followed on June 21, 2002 by a liquidation order. Subsequent to the liquation order, the Company provided limited operation support to PICO. Given the continued activity with PICO through the third quarter of 2002, the Company was precluded from treating PICO as a discontinued operation for accounting purposes.
significant portion of its related business with SCIF. Prior to August 2003, SCIF’s maximum commission rate was 8.0%. Effective August 2003, the maximum commission rate is 5.5%. Since commission rates are only adjusted at renewal, the full impact of this change will not be reflected in the Company’s consolidated financial statements until the last half of 2004.
The Company is continuing to see the impact of its diversification efforts. For the year ended December 31, 2003, workers’ compensation accounted for 43% of commission income as compared to 45% for the comparable 2002 period.
Salaries and related expenses. Salaries and employee benefits increased 27.7% to $10.2 million for 2003 from $8.0 million for 2002. The increase is due to three primary factors: the transfer of selected employees from PICO’s payroll to Pan Am in early to mid-2002, the addition of new employees beginning in July 2002 and the elimination of previous cost sharing arrangements that were in effect with PICO through mid-2002. Salaries and related expenses was 52% of total revenues for 2003 as compared to 58% for the comparable 2002 period
Interest expense. Interest expense decreased 44.4% to $149,000 for 2003 from $268,000 for 2002. The decrease is due to a decline in the outstanding balance of the related note payable as well as a decrease in the interest rate on the note payable. As of the beginning of 2002, the note payable to bank had a balance of $4.1 million which was reduced to $2.8 million at the beginning of 2003 and further reduced to $1.7 million by the end of 2003.
Amortization expense. Amortization expense increased 38.3% to $538,000 for 2003 from $389,000 for 2002. The increase is due to an increase in intangible assets related to agency purchases in mid 2002 and early 2003.
Operating expenses. Operating expenses increased 57.8% to $6.0 million for 2003 from $3.8 million for 2002. The increase is primarily due to the elimination of previous cost sharing arrangements that were in effect with PICO until mid-2002 as well as the costs associated with an increased number of employees, including insurance and facilities expense. Also contributing to the increase in operating expenses are accruals associated with legal matters.
On a Federal income tax basis, the Company currently has significant net operating loss carryforwards. The income tax expense in 2003 largely reflects the utilization of those net operating loss carryforwards and does not represent taxes paid or payable.
The net deferred tax asset is the amount the Company believes is more likely than not will be realized in the next several years and is adjusted based on anticipated future operating results. In 2002, changes in the tax law made available for recovery certain alternative minimum tax payments made for years which were previously closed.
Net investment income. Net investment income is comprised of interest income on various trustee savings accounts. Net investment income decreased 89.2% to $17,000 for 2002 from $158,000 for 2001.
The decline is due to a combination of a lower interest rate environment and less funds being held in these interest bearing accounts.
Amortization expense. Amortization expense decreased 48.5% to $389,000 for 2002 from $755,000 for 2001. The decrease in amortization on intangibles is due to the related intangible asset becoming fully amortized at the end of 2001. In addition, the Company ceased recording goodwill amortization in accordance with SFAS 142 beginning on January 1, 2002.
Operating expenses. Operating expenses decreased 1.0% to $3.8 million for 2002 from $3.9 million for 2001.
Income from continuing operations before taxes. Income from continuing operations before taxes increased to $1.3 million in 2002 from $460,000 in 2001. The increase was primarily driven by an increase in commission income.
The net deferred tax asset is the amount the Company believes is more likely than not will be realized and is adjusted based on anticipated future operating results and various tax planning strategies. In 2002, changes in the tax law made available for recovery certain alternative minimum tax payments made for years which were previously closed.
Net income (loss). Net income for 2002 was $580,000 compared to a loss of $31.3 million in 2001. The 2001 net loss was due to loss from discontinued operations.
As a holding company, PAULA Financial’s principal sources of funds are dividends and expense reimbursements from its operating subsidiaries and proceeds from the sale of its capital stock. PAULA Financial’s principal uses of funds are capital contributions to its subsidiaries, payment of operating expenses, and repurchase of Company common stock.
The following is a summary of the Company’s contractual obligations as of December 31, 2003:
Management believes that funds currently available and expected to be generated by agency operations will be sufficient to meet the required contractual obligations.
The sources of funds of the agency operations are cash flows from operating activities and the major use of funds is operating expenses. In the most recent years, operating cash flows at Pan Am have met the agency subsidiaries’ liquidity requirements as well as a substantial portion of the parent company’s cash flow requirements, including debt service requirements.
As of December 31, 2003 the Company had no off-balance sheet arrangements.
Consolidated Statements of Comprehensive Income (Loss) for each of the three years in the period ended December 31, 2003
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of PAULA Financial and subsidiaries at December 31, 2003, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules as of and for the year ended December 31, 2003, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed further in Note 9 - Discontinued Operations, prior to 2002 the Company also underwrote workers’ compensation insurance through its subsidiary PAULA Insurance Company (“PICO).
Office furniture and equipment is depreciated over the estimated useful lives of the respective assets, primarily using the modified accelerated cost recovery system (which approximates the double-declining-balance method). Automobiles are depreciated on a straight-line basis. Principal estimated useful lives used in computing the depreciation provisions are five to seven years for furniture and equipment and three to five years for automobiles. 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.
At December 31, 2003 and 2002, excess of cost over net assets acquired was $2,149 and $1,670, respectively, less accumulated amortization of $80 and $80 in 2003 and 2002, respectively. In accordance with SFAS 142, the Company ceased recording goodwill amortization beginning on January 1, 2002.
Other intangible assets, which consist mainly of contracts not to compete and expiration lists, are amortized on a straight-line basis over periods not to exceed seven years. At December 31, 2003 and 2002, other intangible assets were $4,379 and $2,739, respectively, less accumulated amortization of $2,220 and $1,683, respectively. Aggregate amortization expense for the years ended December 31, 2003 and 2002 was $538 and $389, respectively. Estimated amortization expense for the next five years is $585 in 2004, $584 in 2005, $563 in 2006, $307 in 2007, $110 in 2008 and $10 in 2009.
The Company accounts for income taxes under the 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. A valuation allowance is recorded to reduce deferred tax assets to the amount that is more likely than not to be realized. Because of the quasi-reorganization effected by the Company in 2003, any decrease in the valuation allowance will be a direct increase to additional paid in capital.
Cash, accounts and commissions receivable, due to underwriters and assureds, other current liabilities and the note payable to bank are considered financial instruments. Due to the short duration of certain financial instruments, specifically cash, accounts and commissions receivable, due to underwriters and assureds and other current liabilities, the carrying amounts approximate fair value. The fair values of the note payable to bank is estimated using discounted cash flow analyses based on current market interest rates. The estimated fair value of the note payable to bank approximates the related carrying value.
The EPS calculations for the years ended December 31, 2003, 2002 and 2001 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 common stock equivalents. Stock options and warrants are considered to be common stock equivalents, except when their effect is antidilutive.
Stock options to purchase 20,000 shares that were outstanding as of December 31, 2003 and 2002 were not included in the computation of earnings per share for 2003 and 2002 as inclusion of such shares would be antidilutive.
The Company’s stock-based employee compensation plans are described more fully in Note 5. 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”) and Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123” (“SFAS 148”).
The fair value for options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions: risk free interest rate of 3% for options granted in 2002 and 2001, average option exercise period of seven years, and a volatility factor of 50%. The fair value per option was $0.25 for options granted in 2002 and $0.98 to $1.14 for options granted in 2001.
At December 31, 2002, the Company had an outstanding credit agreement with Bank of the West that required that the loan balance be paid over the next two years with the final principal payment due January 1, 2005. On November 1, 2003, the Company refinanced its outstanding bank debt with a $1,800 reducing revolving line of credit (the “Line of Credit”) with US Bank (the “Lender”). The Line of Credit matures one year from funding, with a one-year automatic option to extend as long as the Company is in compliance with
Aggregate annual commitments under notes payable to bank are as following as of December 31, 2003:
The Company’s subsidiaries have guaranteed the obligations of PAULA Financial under the Line of Credit. Additionally, the Lender has a security interest in the assets of the Company.
The recoverability of the net deferred tax asset is demonstrated by anticipated future operating results. Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income in the periods necessary to realize the net deferred tax asset.
Effective January 1, 2003, the Company implemented a quasi-reorganization of its capital accounts. At December 31, 2002, the Company had an accumulated deficit of $54.4 million which was primarily generated by the Company’s former underwriting operations, PICO (see Note 9). After approval by the stockholders on May 21, 2003, the Company effected the quasi-reorganization pursuant to which the Company eliminated its accumulated deficit and charged the corresponding amount to additional paid-in-capital.
In September 1998, the Board of Directors adopted a Stockholder Rights Plan (“Rights Plan”). The Rights Plan provided for the distribution of one Right for each share of common stock outstanding on October 1, 1998 (6,085,315 shares). The Rights Plan provides that if any person acquires 10% or more of the Company’s common stock, each Right (other than the Rights held by the 10% stockholder) will become exercisable to purchase PAULA common stock with a value equal to two times the Right’s exercise price. In addition, if on or after such event the Company is merged out of existence or 50% or more of its assets or earning power are sold, each Right (other than Rights held by the 10% stockholder) will become exercisable to purchase common shares of the acquiring corporation with a value equal to two times the Right’s exercise price. The Rights expire in ten years unless previously triggered and are subject to redemption by the Board of Directors prior to being triggered.
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 for continuing operations under the plan were $138, $154 and $177 for the years ended December 31, 2003, 2002 and 2001, respectively.
Employees of the Company receive an annual year-end bonus. Amounts expensed under bonus programs related to continuing operations were $495, $95 and $360 for the years ended December 31, 2003, 2002 and 2001, respectively.
In 1998, the Company implemented a key employee/consultant loan program which provided funds exclusively for the borrowers’ purchase of Company stock. The Company authorized loans of up to $1,000. The loans were full recourse, bore interest at the rate of 8.5% per annum, were payable quarterly, and were 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, 2003 and 2002, the Company had outstanding loans in the principal amount of $20 and $450, respectively. During 2003, the Company forgave loans due from former employees totaling $191. Stock held as collateral of $32 was taken back into treasury stock.
The Company leases buildings for its home office and certain other premises under long-term operating leases that expire in various years to 2007. Certain of these leases contain renewal provisions. Rent expense for continuing operations was $748, $730 and $759 for the years ended December 31, 2003, 2002 and 2001, respectively.
Approximate aggregate minimum rental commitments under capital leases at December 31, 2003 are as follows:
The Oversight Agreement generally provided that all of the ongoing operations of PICO were subject to California DOI regulatory control. More specifically the Oversight Agreement provided, most significantly, that the California DOI would appoint a Special Deputy Examiner to provide supervision and regulatory oversight, limited PICO’s ability to enter transactions with any affiliated company without the prior approval of the California DOI, restricted PICO’s ability to pay dividends to PAULA Financial without prior approval of the California DOI and restricted PICO’s ability to consummate transactions outside the normal course of business or to incur debt without prior approval of the California DOI. Additionally, PICO could not write any new or renewal business of any type without the prior approval of the California DOI.
As a result of the events described above, in the fourth quarter of 2001, the Company began accounting for its investment in PICO using the equity method. Consequently, PICO’s results summarized below only reflect the result of PICO’s operation in the individual income and expense line items for the first nine months of 2001 while the fourth quarter activity is reflected as equity in net loss of PICO.
Premiums were earned by the insurance company on a monthly pro rata basis over the terms of the policies. Premiums were generally written on policies with a one year term.
The continued reserve development on prior accident years related primarily to the 1998-2000 accident years. The adverse development related primarily to the California operations. Similar to the claims development experienced by the California workers’ compensation insurance industry in general, PICO saw ongoing expansion in incurred claims values, primarily related to medical inflation and litigation activity. Also contributing to the adverse loss reserve development on the 1999 and 2000 accident years were the Texas operations.
Participating workers’ compensation policies represented approximately 25% of net written premium for the year ended December 31, 2001. Dividends were recorded as a liability based on estimates of ultimate amounts expected to be declared by PICO’s Board of Directors, at their discretion.
Effective July 1, 2000, PICO entered into a variable rate quota share agreement with the Insurance Corporation of Hannover (ICH). For the year ended December 31, 2001, PICO ceded 10% of policy year earned premium to ICH. The contract with ICH was terminated effective January 1, 2002.
A cost reimbursement allocation agreement among affiliates was in effect from March 1, 1992 through mid-2002 for administration, human resources, data processing services and facility utilization. Additionally, from April 2001 to June 2002, the Company’s TPA provided operational services to PICO. Services performed by the TPA included claims adjudication, underwriting, policyholder services, business development and loss control. As of December 31, 2003, the Company had balances owing from PICO under these cost reimbursement agreements totaling $446. The Company intends to pursue all available avenues for recovering such balances but given the nature of the receivable the Company has established a valuation allowance for the full amount of the outstanding balance. The expense associated with this allowance is included in discontinued operations for the year ended December 31, 2002.
In 2001, the shareholders elected to the Company’s board of directors Mr. James G. Parker, III who also has a significant ownership interest in an agency that placed business with PICO. Commissions paid by PICO to this agency were $603 for the year ended December 31, 2001.
Additionally, in 2001, the shareholders elected to the Company’s board of directors Mr. Joel Geddes, Jr. who also has a significant ownership interest in an agency that placed business with PICO. Commissions paid by PICO to this agency were $98 for the year ended December 31, 2001.