Physicians owns a facility with approximately 40,708 square feet in Pickerington, Ohio. Sequoia leases office space for its and Citation's headquarters in Monterey, California and for regional claims and underwriting offices in Modesto, Monterey, Rancho Cordova, Ventura, Visalia, Oceanside, Orange, Pleasanton, and San Jose, California, as well as Reno, Nevada. CLM's only office space consists of a leased facility in Monterey, California. GEC and Summit share office space with PICO in La Jolla, California. NLRC leases office space in Carson City, Nevada. Vidler and NLRC hold significant investments in land, water and mineral rights in the western United States. F&WUSA leases office space in New York City, New York. See "ITEM 1 - BUSINESS-INTRODUCTION."
- - simplification of PICO's corporate structure and elimination of cross-ownership of investments between companies;
- - elimination of public confusion, costs and duplication of efforts inherent in maintaining two public entities with similar business strategies, management and investment philosophies;
- - providing a single publicly traded corporation with a distinct value investment philosophy;
PICO, with PQT's agreement, converted its outstanding debt and accrued interest into convertible preferred stock and common stock warrants. The average cost of our investment, including exercise of our warrants, is approximately $1.52 per share and at December 31, 1998, the carrying value of our investment in PC Quote is approximately $11.8 million.
During 1998, PICO added significant assets to its portfolio of surface, water and mineral rights.
One of the most critical issues regarding water in the southwest is allocation -- that is, transferring water from areas of excess supply to areas of accelerating demand and instituting the infrastructure to facilitate it. This is Vidler's primary business.
1. Water that is wasted or commandeered (California taking water that has been allocated to Nevada and Arizona, for example) is captured for future use; and
2. Water can be stored when there is a surplus and used when there is a scarcity.
Management believes that MBT Ranch is ideally located to provide storage to facilitate interstate transfers of water. It is anticipated that MBT Ranch will be the first privately operated storage facility in operation.
In 1998, Vidler entered into agreements to acquire additional 42,000 acre-feet of water, which should make Vidler the largest private owner of readily transferable water. It is uncertain how long it will take Vidler's assets to generate cash flow. Vidler operates within an industry that is regulated by local and state government, with an overlay of federal regulations. Similar to land development permits, the process can be slow.
During 1998 and the first quarter of 1999, the Company acquired stock in Australian Oil and Gas Corporation Ltd. ("AOG"), whose shares are traded on the Australian Stock Exchange. As of March 1999, the Company has acquired approximately 14.9% of the outstanding shares of AOG for approximately $7.1 million. Our average purchase price per share is at a multiple of 3.8 times AOG's fiscal 1998 operating cash flow per share.
Shareholders' equity at December 31, 1998 was $174.1 million, representing an increase of $61.9 million over December 31, 1997. Book value per share calculated on an undiluted basis, net of treasury shares, increased to $19.46 at year end 1998, compared to $18.63 at December 31, 1997. The increase in book value per share during 1998 resulted primarily from the PICO/GEC Combination and the purchase of 412,846 PICO treasury shares during the 1998 third quarter at an average cost of $0.78 per share. On December 31, 1998 options representing 57,307 of the shares were exercised. The remaining shares are held in treasury subject to option agreements. SEE NOTE 17 OF NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, "OTHER RELATED PARTY TRANSACTIONS."
Income from discontinued operations included in net income for 1998, 1997 and 1996, was $1.1 million, $0.5 million and $3.3 million, respectively. Income from discontinued operations in 1998 includes a $1.1 million pre-tax gain from the sale of APL, the Company's former life and health insurance subsidiary, on December 4, 1998. Discontinued operations include the results of APL as well as Global Equity Corporation's ("GEC") discontinued Sri Lankan operations. SEE NOTE 6 OF NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, "DISCONTINUED OPERATIONS," for additional information.
* A $5 million strengthening of Physicians' insurance reserves based upon year-end actuarial studies;
* Permanent write-downs of two of GEC's investments by $5.9 million:
1) A write-off of $3 million from a convertible note that has fallen into default. Management became aware in the fourth quarter of 1998 of substantial additional debt incurred and assets pledged by the borrower in violation of the loan agreement which has resulted in a dispute over collateral.
2) In exiting the inherited assets in Sri Lanka, GEC received bonds and shares as part consideration. Liquidation of these assets created a loss. Including gains taken in 1997, the sale of Sri Lankan assets was approximately at cost.
Land sales were limited until an overall assessment was completed. Realized gains on land sales totaled $1.2 million during this period.
Total assets at December 31, 1998 were $395.9 million. This compares to $430.3 million at the end of 1997. Most of the 1998 decline resulted from the payment of insurance claims by Physicians and was reflected in investments and cash and cash equivalent balances which decreased by approximately $27.9 million compared to 1997. Surface, water and mineral rights increased $41.5 million as a result of the Combination with GEC and further acquisitions. Net assets of discontinued operations declined from $15.9 million at December 31, 1997 to zero as a result of the sale of APL. Total liabilities declined $28.1 million between years with year end 1998 loss and loss adjustment expense reserves dropping by more than $41.1 million, principally as a result of payment of insurance claims.
Net of expenses, but before taxes, INVESTMENT OPERATIONS reduced 1998 pre-tax operating income by $7.2 million loss compared to income of $17.8 million in 1997 and $23.3 million in 1996. Realized investment losses, as discussed previously and shown in the previous table, accounted for nearly $4.4 million of the 1998 amount and realized investment gains of $21.3 million and $26.4 million were included in 1997 and 1996, respectively. As shown in the table below, the Company's INVESTMENT OPERATIONS income can fluctuate greatly from year to year. A number of factors contribute to these fluctuations, including, among other things, the mix of the Company's portfolio, timing of the Company's realization of capital gains, the volume of trading and demand for individual securities the Company owns and fluctuations in the U.S. and world stock and bond markets in general. Therefore, future results cannot and should not be predicted based upon past performance alone. See "RISK FACTORS."
The breakdown of operating income before tax from INVESTMENT OPERATIONS is as follows:
Equity in unconsolidated investee for 1996 represents the Company's share of GEC's net income prior to its consolidation with PICO. GEC's financial results were first consolidated with those of the Company in 1997. The 1998 amount represents GEC's share of the loss in its unconsolidated affiliate, Conex.
Effective November 14, 1995, a wholly-owned subsidiary of GEC acquired all the outstanding common stock of Vidler, a Colorado corporation engaged in the water marketing and transfer business. Vidler's business plan calls for Vidler to identify areas where water supplies are needed in the southwestern United States and then facilitate the transfer from current ownership to Vidler, and subsequently to municipalities, water districts, developers and others. Since its acquisition, Vidler has purchased or leased water rights and related assets in Colorado, Nevada, Arizona and California. On April 23, 1997, GEC acquired a 74.77% membership interest in NLRC and PICO acquired the remaining 25.23% interest. NLRC owns approximately 1.3 million acres of deeded land located in northern Nevada, together with appurtenant surface, water and mineral rights. NLRC is actively engaged in activities it believes will maximize the property's value in relation to water rights, mineral rights and land development.
During 1998, Vidler has, through the acquisition of additional agricultural water assets and the continued development of its underground storage facilities, established itself as the leader in the private water development and storage business in the Southwestern United States. With control over approximately 56,000 acre-feet of readily transferable water rights in Arizona, Nevada, and Colorado, Vidler is the largest owner of marketable water in this region. In addition, Vidler has an ability to develop 57,000 additional acre-feet of water rights in Nevada through ownership of 57,000 acre-feet of water rights applications. Vidler currently leases water rights in Colorado and anticipates initiating leasing activity in Arizona and Nevada within twelve months.
NLRC holds title to 1.3 million acres located in northern Nevada, at an average cost of $39 per acre, and is the largest private landowner in the state. NLRC anticipates that revenues will be generated from the asset by land sales, exchanges and development and exploitation of mineral and water rights. During 1997 and 1998, NLRC completed, or has in escrow, sales of 19,528 acres of land with an average price of $161 per acre. As NLRC progresses with its land assessment and is able to further prioritize properties, NLRC anticipates increasing its land available for sale, exchange, or development.
NLRC's mineral exploitation strategy is to identify potential gold discoveries (or other high unit resources), develop them to the point where a meaningful data set can be established and then vend the properties to advanced stage exploration or production companies. To date, exploration work continues to advance over a dozen areas that have been identified as containing anomalous gold values. Several companies have expressed an interest in receiving data packages from NLRC for the purpose of analyzing potential mineral exploration opportunities. In addition, Santa Fe Pacific Gold Corporation has leased 4,320 acres from NLRC, which includes a 3.5% net smelter royalty on production.
Sequoia and Citation account for all of the ongoing revenues of the PROPERTY AND CASUALTY ("P&C") INSURANCE business segment. These companies write predominately light commercial and multiple peril insurance coverage in central and northern California and Nevada. Sequoia and Citation are continually seeking ways to realize savings and take advantage of synergies and to combine operations, wherever possible. To this end, Sequoia and Citation consolidated their home office operations in Monterey, California in July 1997. Prior to June 30, 1997, Citation and CNIC wrote workers' compensation insurance policies. CNIC is no longer a part of the group following its sale on June 30, 1997 along with Citation's workers compensation business.
Total PROPERTY AND CASUALTY INSURANCE revenues for 1998 of $42.9 million were $14.1 million less than the $57 million recorded in 1997 and $7.6 million greater than the $35.3 million of 1996, which included less than two months of Citation's revenues. Declining earned premiums accounted for most of this decrease between years, principally as a result of continuing increased underwriting selectivity applied to Citation's business and aggressive competition for commercial multiple peril business within the state of California. Total PROPERTY AND CASUALTY INSURANCE earned premiums for 1998 were $36.2 million compared to $50.2 million in 1997 and $31.4 million in 1996. All new P&C insurance applications and policies scheduled to renew are now being processed through Sequoia and subjected to Sequoia's underwriting standards which are much tighter than those previously employed by Citation. As a result, a significant portion of Citation's prior book of business has not been renewed. As previously mentioned, increased competition within the state of California for commercial insurance has also decreased 1998 earned premiums. Direct premium writings in 1998 for Sequoia were $40.7 million, down $0.3 million from the $41.0 million of 1997 and up $3 million from the $37.7 million reported for 1996. Citation wrote $1.9 million in direct premiums in 1998, compared to $ 14.9 million in 1997 and $57.4 million for the full year of 1996, including the period prior to the Merger. Citation's 1997 direct written premiums declined from those of 1996 due to the renewal of qualified policies of Citation into Sequoia effective March 1, 1997 and the subsequent sale of CNIC and the workers compensation business on June 30, 1997.
Industry ratios as determined on a GAAP basis for Sequoia were:
MPL premiums continued to be earned during 1996 based upon premiums written prior to July 16, 1995, the effective date of the 100 percent quota share reinsurance treaty with Mutual. Investment income revenues will continue to accrue to the MPL runoff.
MPL insurance revenues were $2.4 million in 1998 compared to $3.9 million during 1997 and $12.2 million during 1996. The decline in MPL earned premiums accounted for most of the variance as compared to 1996. Declining investment income was the principal contributor to the difference between 1998 and 1997 MPL revenues. Investment income continued to decline in 1998 as it had in 1997 and 1996, principally as a result of the reduced level of MPL claims and, correspondingly, the resultant reduced level of invested assets allocated to the MEDICAL PROFESSIONAL LIABILITY INSURANCE business segment.
MPL operations produced a 1998 pre-tax loss of approximately $4.4 million compared to income of $0.8 million in 1997 and $8.5 million in income in 1996. Results for 1998 and 1997 were negatively impacted by additions to loss and LAE reserves, approximately $5 million in 1998 and $2.2 million in 1997. These additions to reserves during the third quarter of 1997 and the fourth quarter of 1998 were based upon actuarial analyses indicating some deterioration of Physicians' loss experience. The addition to 1998 reserves included additions to loss and LAE reserves for virtually all loss years (years in which losses were incurred). These additions primarily were necessitated by an increased incidence of claims reported on behalf of claimants that allegedly were injured as minors and had now attained the age of majority. Pre-tax operating results for 1996 were aided by a $1.4 million reduction in MPL death, disability and retirement unearned premium reserves related to the Mutual transaction, and loss and LAE reserve reductions of approximately $6.0 million due to favorable development of MPL reserves. As discussed above, MPL investment income and earned premiums continually declined from 1996 through 1998 due to the runoff of the MPL business and the decreasing level of loss and LAE reserves.
OTHER OPERATIONS consists principally of Summit's investment management operations, the activities of Raven Development Company ("Raven"), a now inactive real estate development subsidiary.
Revenues from OTHER OPERATIONS were $0.5 million in 1998 compared to $0.1 million in 1997 and $2.2 million in 1996. Nearly all the decline from 1996 was due to the wind down of real estate development operations of Physicians' subsidiary, Raven, which had virtually no activity in 1997 and little activity in 1998. Raven sold its final real estate holdings in early 1998.
APL, Physicians' wholly-owned life insurance subsidiary, produced revenues of $9.2 million and pre-tax income of $0.3 million in 1998 prior to its sale. This compares to $5.3 million and $9.0 million in revenues in 1997 and 1996, respectively, and a pre-tax loss of $112,000 in 1997 and $4 million of pre-tax income in 1996. Revenues and income before tax for 1996 included realized investment gains of approximately $3.9 million from the sale of APL's investment in Fairfield Communities common stock.
On June 16, 1997, Physicians announced the signing of a binding agreement to sell APL subject to certain closing conditions. The closing took place on December 4, 1998. The Company received $9 million in cash from the sale in addition to an $8 million dividend prior to the sale, and recorded a gain of $1.1 million, included in discontinued operations on the consolidated statements of operations.
LIQUIDITY AND CAPITAL RESOURCES -- YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
In the past, the assets of the insurance subsidiaries had been a major source of funds for the Company. However, due to the use of those assets to satisfy claims, and to adhere to the stringent guidelines of the state insurance departments, these funds are no longer as readily available. Since the acquisition of GEC, the Company has used the cash acquired to carry out the investment acquisitions, and other operations of PICO. In addition, the $45 million public offering of GEC provided the funds necessary to acquire GEC's interest in NLRC, as well as the initial European investments.
Physicians initially provided virtually all the funding necessary for the Company. Since the acquisition of Sequoia in 1995, management made significant strides in improving Sequoia's operating performance. Management has taken a number of steps to improve Citation's profitability and cash flow since its acquisition in November 1996, including the June 1997 sale of its workers' compensation business and its subsidiary, Citation National Insurance Company. During the past several years, Physicians' cash flow had the greatest impact on the consolidated group and should continue to do so for the foreseeable future due to the wind down of the MPL business. At December 31, 1998, Physicians, Sequoia and Citation had a combined cash and cash equivalent balance of $60.6 million compared to $46.5 million at December 31, 1997. Due to the relatively short lag period between the receipt of premiums and payment of claims in the commercial property and casualty insurance business lines written by Sequoia and Citation, a significant amount of their investment balances is in cash and cash equivalents.
Physicians' operating cash flows, as a result of ceasing to write MPL insurance, are negative and should continue to be negative for the foreseeable future. Positive cash flows from other sources within Physicians, primarily reinsurance recoveries, and the sale of invested assets may partially or fully offset uses of cash. Major cash outflows will likely include the funding of claims and loss adjustment expenses, investment purchases, and operating costs.
The Company's insurance subsidiaries attempt to structure the duration of invested assets to match the cash flows required to settle the related unpaid claims liabilities. Invested assets provide adequate liquidity to fund projected claims and LAE payments for the coming years. The Ohio and California Insurance Departments monitor and set guidelines for the insurance companies' investments. The Ohio and California Insurance Departments also set minimum levels of policyholder capital and surplus and monitor these levels through various means.
The Company's active P&C insurance subsidiaries, Sequoia and Citation, should provide cash flows from operations once industry combined ratios (SEE "PROPERTY AND CASUALTY INSURANCE.") stabilize below 100% and premiums remain at a constant or increasing levels. At times, it may be necessary to liquidate invested assets to provide the additional funds necessary to cover operating expenses. Summit produces positive cash flow from operations, which is expected to continue.
million less than in 1997, primarily due to the differences in pre-tax income between years. The $62.1 million in cash used by operations in 1997 also included a $9.7 million use of funds from reclassification of APL's year-end 1996 cash balances to discontinued operations in 1997. The $10.4 million decrease in cash from operations comparing 1998 to 1996 was a direct result of increased cash outflow from insurance operations and increased operating expenses in other areas, including the start-up and operation of NLRC in 1997 and 1998 and increased activities within Vidler in 1997 and 1998.
Cash flow from investing activities for 1998 was $40.8 million compared to $68.1 million provided in 1997 and $31.4 million in 1996. For 1998, cash investing activities included $17 million of cash received from the sale of APL, and $10.1 million receipt from the disposition of the Sri Lankan investments. In addition, the Company sold property, generating approximately $6.5 million. The Company used cash to pay $1.7 million in direct costs associated with the acquisition of the remaining shares of GEC. Purchases of $4.1 million were made for additional surface, water and mineral rights, offset by sales of $518,000. The cash provided by investing activities in 1997 resulted primarily from $52 million of cash provided by net investment transactions, and $18.1 million of cash provided by consolidation of GEC. Specifically, significant uses of investment cash in 1997 include the purchase of NLRC for $48.6 million, and $36.7 million used to acquire shares of GEC common stock. Cash provided by investing activities in 1996 principally reflected the maturity of fixed income securities and investment proceeds from the sale of Fairfield Communities, Inc.
During 1998, the Company purchased 857,000 shares of common stock of Australian Oil and Gas Corporation Ltd. ("AOG"), whose shares are traded on the Australian Stock Exchange, for $803,000. During 1999, an additional 5.9 million shares were acquired for $6.3 million. As of March 1999, the Company owns a 14.9% interest in AOG. Also during 1997 and 1998, the Company purchased 16,350 shares of Jungfraubahn Holding AG ("Jungfraubahn") based in Interlaken, Switzerland. In February 1999, an additional 70,000 shares were acquired. In total the Company holds a 17.6% shareholding for $15.9 million. The acquisition was financed with $7 million in cash and the remaining balance in debt.
The initial phase of planning, inventorying and evaluating all information technology systems, and non-information technology systems and their components, for Y2K compliance is approximately 90% complete. The evaluation has not disclosed any significant Y2K processing difficulties or concerns. The focus is primarily on the insurance operations of the Company because of the custom applications software used to process insurance policies, policy claims, and insurance underwriting. After internal review and communication with system vendors, the majority of the non-insurance information and non-information technology systems are deemed Y2K compliant and do not require any significant alterations. The focus of remediation is on the insurance specific applications.
The secondary phase of the project, which primarily includes implementing corrections to remedy Y2K deficiencies, is approximately 90% complete. As noted above, the insurance systems software has been the primary focus of such efforts. To renovate the insurance systems to a Y2K ready state, the Company's internal information systems staff is re-writing lines of existing code to function with a four-digit date field. The Company also replaced existing DOS software with a current Y2K compliant version.
Testing and validation of each system comprises phase three. As hardware and software changes are made to the systems, they are tested for compliance. This phase continues as insurance specific applications are reprogrammed and tested. Final completion of this phase should be by the end of the second quarter of 1999. Despite the best efforts by management, problems will arise requiring the Company to quickly respond while there is still time. Phase four, when completed, will set forth contingency plans addressing potential business interruption and failure, is expected to be finalized during the last half of 1999.
The financial impact of making the required systems changes has not been material, nor is it expected to be material, to the Company's consolidated financial position, results of operations or cash flows. For the year ending December 31, 1998 the Company incurred approximately $85,000 for hardware and computer programming. The Company expects to incur another $40,000 to $60,000 to complete the project.
THE RISKS OF THE COMPANY'S YEAR 2000 ISSUES AND CONTINGENCY PLANS
A reasonable, most likely worst case scenario of the Y2K impact would be a slow down in internal and external reporting, and insurance related processing of policies, claims and underwriting functions. It is unlikely the Company would experience any material business cessation or significant business disruption.
The Company is completing its specific plans to continue operations in case of unexpected delays in completing remediation or if Y2K problems impact the Company in unforeseen ways. It appears many business systems could function manually for a limited amount of time. The Company anticipates completing its contingency plan during the last half of 1999. Overall, the Company is approximately 85% complete in its Y2K project.
We may not be able to sell our investments in both private and public companies when it appears to be advantageous to do so and we may have to sell these investments at a discount. Investments in private companies are not as marketable as investments in public companies. Investments in public companies are subject to prices determined in the public markets and, therefore, values can vary dramatically. In particular, the ability of the public markets to absorb a large block of shares offered for sale can affect our ability to dispose of an investment in a public company.
MEDICAL MALPRACTICE INSURANCE CLAIMS MAY BE GREATER THAN THE RESERVES WE ESTABLISH TO PAY THEM
Under the terms of our medical malpractice liability policies, there is an extended reporting period for claims. Under Ohio law the statute of limitations is one year after the cause of action accrues. Also, under Ohio law a person must make a claim within four years; however, the courts have determined that the period may be longer in situations where the insured could not have reasonably discovered the injury in that four-year period. Claims of minors must be brought within one year of the date of majority. As a result, some claims may be reported a number of years following the expiration of the medical malpractice liability policy period.
Company and Professionals Insurance Company annually obtain a certification from an independent actuary that their respective reserves for losses are adequate. They also obtain a concurring actuarial opinion. Due to the inherent uncertainties in the reserving process, there is a risk that Physicians Insurance Company's and Professionals Insurance Company's reserves for losses could prove to be inadequate. This could result in a decrease in income and shareholders' equity. If we underestimate our reserves, they could reach levels which are lower than required by law.
The inherent uncertainties in estimating loss reserves are greater for some insurance products than for others, and are dependent on:
* the degree of impact that changing regulations and legal precedents may have on open claims; the
STATE REGULATORS COULD TAKE OVER OUR INSURANCE SUBSIDIARIES IF WE FAIL TO MAINTAIN ADEQUATE RESERVE LEVELS
In the past few years, the National Association of Insurance Commissioners has developed risk-based capital measurements for both property and casualty and life and health insurers. These measurements proscribe the reserve levels that insurance companies must maintain. The Commissioners have delegated to the state regulators varying levels of authority based on the adequacy of an insurer's reserves. The insurance companies' reserve levels are reported annually in their statutory annual statements to the insurance departments.
Failure to meet one or more reserve levels may result in state regulators requiring the insurance company to submit a business plan demonstrating achievement of the required reserve levels. This may include the addition of capital, a restructuring of assets and liabilities, or changes in operations. At or below certain lower reserve levels, state regulators may supervise the operation of the insurance company and/or require the liquidation of the insurance company. Failing to meet reserve levels could adversely affect our business, financial condition, results of operations and cash flows.
As with other property and casualty insurers, operating results and financial condition can be adversely affected by volatile and unpredictable natural and man made disasters, such as hurricanes, windstorms, earthquakes, fires, and explosions. Our insurance subsidiaries generally seek to reduce their exposure to catastrophic events through individual risk selection and the purchase of reinsurance. Our insurance subsidiaries' estimates of their exposures depend on their views of the possibility of a catastrophic event in a given area and on the probable maximum loss created by that event. While our insurance subsidiaries attempt to limit their exposure to acceptable levels, it is possible that an actual catastrophic event or multiple catastrophic events could significantly exceed the maximum loss anticipated, resulting in a material adverse effect on our business, financial condition, results of operations and cash flows.
* Sequoia Insurance Company B++ (Very Good) * Citation Insurance Company B+ (Very Good) * Physicians Insurance Company NR-3 (rating procedure inapplicable) * Professionals Insurance Company NR-3 (rating procedure inapplicable)
Insurance policy renewals have historically accounted for a significant portion of our net revenue. We may not be able to sustain historic renewal rates for our products in the future. A decrease in renewal rates could adversely affect our business, financial condition, results of operations and cash flows.
IF WE ARE REQUIRED TO REGISTER AS AN INVESTMENT COMPANY, THEN WE WILL BE SUBJECT TO A SIGNIFICANT REGULATORY BURDEN
We at all times intend to conduct our business so as to avoid being regulated as an investment company under the Investment Company Act of 1940. However, if we were required to register as an investment company, our ability to use debt would be substantially reduced, and we would be subject to significant additional disclosure obligations and restrictions on our operational activities. This would adversely affect our business, financial condition, results of operations and cash flows.
The trading price of our common stock has historically been, and is expected to be, subject to fluctuations. The market price of the common stock may be significantly impacted by: * quarterly variations in financial performance; * shortfalls in revenue or earnings from levels * forecast by securities analysts; changes in * estimates by such analysts; product introductions; * our competitors' announcements of extraordinary events such as * acquisitions; * litigation; and * general economic conditions.
We have several key executive officers. If they leave PICO, it could have a significant adverse effect on us. In particular, Ronald Langley, our Chairman, and John R. Hart, our President and Chief Executive Officer, play key roles in investment decisions. Messrs. Langley and Hart have entered into employment agreements with us dated as of December 31, 1997, for a period of four years. Messrs. Langley and Hart are key to the implementation of our strategic focus, and our ability to successfully develop our current strategy is dependent upon our ability to retain the services of Messrs. Langley and Hart.
WE ARE SUBJECT TO YEAR 2000 RISKS FOR WHICH WE MAY NOT BE PREPARED
Many currently installed computer systems and software products are not capable of distinguishing 20th century dates from 21st century dates. As a result, in less than one year, computer systems and/or software used by many companies in a very wide variety of applications may experience operating difficulties unless they are modified or upgraded to adequately process information involving, related to or dependent upon the century change. Significant uncertainty exists in the software and information services industries concerning the scope and magnitude of problems associated with the century change. In light of the potentially broad effects of the year 2000 on a wide range of business systems, we may be affected.
We continue to progress in our efforts to define the scope and magnitude of the Year 2000 ("Y2K") problem and to execute our plans to ensure information technology and non-information technology systems are Y2K ready. There is an evolving plan to achieve compliance that is currently divided into four phases. As the project has proceeded, overlap of the different phases has occurred. For the year ending December 31, 1998 the Company incurred approximately $85,000 for hardware and computer programming. The Company expects to incur another $40,000 to $60,000 to complete the project.
Testing and validation of each system comprises phase three. As hardware and software changes are made to the systems, they are tested for compliance. This phase, however, will continue as insurance specific applications are reprogrammed and tested. Final completion of phase three is planned for second quarter of 1999. Despite the best efforts by management, problems will arise requiring us to quickly respond while there is still time. Phase four, when completed, will set forth contingency plans addressing potential business interruption and failure, is expected to be finalized during the last half of 1999.
The likely worst case scenario is a partial failure of some accounting and reporting functions that could be corrected by manually recording and delivering the required information.
The foregoing factors, individually or in the aggregate, could materially adversely affect our operating results and could make comparison of historic operating results and balances difficult or not meaningful.
The Company is exposed to certain market risks that are inherent in the Company's financial instruments arising from transactions entered into in the normal course of business. Although the Company does not currently use derivative financial instruments that expose the Company to significant market risk, the Company is exposed to cash flow and fair value risk associated with fluctuating interest rates and market values.
The Company invests in many foreign entities. As a result, it is subject to foreign currency exchange risk related to the buying, selling and operating investments in foreign countries. More specifically, the Company is exposed to the uncertainty of future income and various asset values denominated in foreign currencies. The Company's most significant foreign currency exposure is in Europe, Asia and Australia. As of December 31, 1998 the fair value of investments exposed to this risk was approximately $32.7 million.
Summarized unaudited quarterly financial data (in thousands, except share and per share amounts) for 1998 and 1997 are shown below. In management's opinion, the interim financial data contains all adjustments, consisting of only normal recurring accruals, necessary for a fair presentation of results for such interim periods. Prior period share and per share amounts have been adjusted to conform to the current period presentation reflecting the December 16, 1998 1-for-5 Reverse Stock Split.
To the Shareholders and Board of Directors of PICO Holdings, Inc.:
To the Shareholders and Board of Directors of PICO Holdings, Inc.
PICO HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
Global Equity Corporation ("GEC"). Prior to the PICO/GEC Combination, GEC was a publicly held corporation listed on the Toronto Stock Exchange and The Montreal Exchange under the symbol "GEQ". Following the PICO/GEC Combination, PICO owns 100% of GEC. The Chairman of the Board of Directors ("Chairman") and the President and Chief Executive Officer ("CEO") of the Company are the Chairman and CEO of GEC, respectively. GEC is a Canadian corporation engaging in strategic investments; surface, water, and mineral rights; and other activities, operating primarily in the United States, but also with investments in Canada, Asia, Europe, and the Caribbean. GEC holds a portfolio of equity and debt securities, and interests in surface, water and mineral rights through Vidler Water Company, Inc. and Nevada Land and Resource Company, LLC.
Physicians Insurance Company of Ohio ("Physicians"). Prior to selling its book of medical professional liability ("MPL") insurance business in 1995, Physicians engaged in providing MPL insurance coverage to physicians and surgeons, primarily in Ohio. On August 28, 1995, Physicians entered into an agreement with Mutual Assurance, Inc. ("Mutual") pursuant to which Physicians sold its recurring MPL insurance business to Mutual. Physicians still holds MPL unpaid losses and loss adjustment expense liabilities that are being settled.
Summit Global Management, Inc. ("Summit"). Summit is an investment advisory company, which provides investment management services in a number of states throughout the United States. The majority of Summit's assets under management are those of affiliates.
The accompanying consolidated financial statements include the accounts of the Company and its majority owned subsidiaries, and have been prepared in conformity with generally accepted accounting principles. All significant intercompany balances and transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for each reporting period. The significant estimates made in the preparation of the Company's consolidated financial statements relate to the assessment of the carrying value of unpaid losses and loss adjustment expenses, future policy benefits, deferred policy acquisition costs, deferred income taxes and contingent liabilities. While management believes that the carrying value of such assets and liabilities are appropriate as of December 31, 1998 and 1997, it is reasonably possible that actual results could differ from the estimates upon which the carrying values were based.
The Company's investment portfolio at December 31, 1998 and 1997 is comprised of investments with fixed maturities, including U.S. government instruments, certificates of deposit, and corporate bonds; equity securities, including investments in common and preferred stocks, and warrants; other investments, including debentures of public and private companies and oil and gas leases; short term investments, including, certificates of deposit, U.S. Treasuries and mortgage securities: and real estate.
Investment income includes amortization of premium and accretion of discount on the level yield method relating to bonds acquired at other than par value. Realized investment gains and losses are included in income and are determined on the identified certificate basis and are recorded on a trade date basis.
Real estate represents the carrying value of real property held for investment.
Water rights consist of various water interests acquired independently or in conjunction with the acquisition of real properties. Water rights are stated at cost and, when applicable, consist of an allocation of the original purchase price between water rights and other assets acquired based on their relative fair values. In addition, costs directly related to the acquisition and development of water rights are capitalized. Surface and mineral rights and land improvements are carried at cost. This cost includes, when applicable, the allocation of the original purchase price, costs directly related to acquisition, and interest and other costs directly related to developing land for its intended use. Amortization of land improvements is computed on the straight-line method over the estimated useful lives of the improvements ranging from 5 to 15 years. Provision is made for any diminution in value that is considered to be other than temporary.
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," effective for financial statements issued after December 15, 1997. SFAS No. 128 requires dual presentation of "Basic" and "Diluted" earnings per share ("EPS") by entities with complex capital structures, replacing "Primary" and "Fully Diluted" EPS under Accounting Principles Board ("APB") Opinion No. 15. Basic EPS excludes dilution from common stock equivalents and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from common stock equivalents, similar to fully diluted EPS, but uses only the average stock price during the period as part of the computation. The Company adopted the new method of reporting EPS for the year ended December 31, 1997, and the 1996 financial statements were restated in 1997 to reflect the change.
Certain amounts in the financial statements for prior periods have been reclassified to conform to the current year presentation.
The acquisition was accounted for using the purchase method of accounting. Accordingly, a portion of the purchase price was allocated to the net assets acquired based on their estimated fair values as noted in the following table:
On April 23, 1997, GEC and PICO acquired 100% of the membership interest of NLRC, a Delaware limited liability company. The total purchase price was approximately $48.6 million. A wholly-owned subsidiary of GEC, Global Nevada Land Resource Corporation, owns 74.77% of the membership interests of NLRC. PICO paid approximately $12 million for the remaining 25.23% membership interest. GEC financed its portion of the acquisition in part by issuing to the Company a 7% debenture in the principal amount of approximately $25 million. The debenture was subsequently repaid along with accrued interest.
The amortized cost and carrying value of investments in fixed maturities at December 31, 1998, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In December 1998, the Company converted its $2.5 million PC Quote debenture, $3.3 million line of credit and $969,000 in accrued interest into 1,907,463 shares of PC Quote Series A preferred shares, 2,879,077 series B preferred shares, and 3,106,163 million warrants to purchase PC Quote common shares, expiring in 2006. The Company owns approximately 18% of the outstanding common stock of PC Quote. The common stock is carried at a market value of $5 million at December 31, 1998. At acquisition, the value of the series A and B preferred shares and warrants was determined using the Black Scholes pricing model and are carried at approximately $6.9 million.
During 1998, the Company purchased 857,000 shares of Australian Oil and Gas ("AOG") for $803,000. During 1999, an additional 5.9 million shares were acquired for $6.3 million. As of March 1999, the Company owns a 14.9% interest in AOG. Also during 1998, the Company purchased 5,000 shares of Jungfraubahn Holding AG ("Jungfraubahn") based in Interlaken, Switzerland. In February 1999, an additional 70,000 shares were acquired. In total the Company purchased a 17.6% shareholding for $15.9 million. The acquisition was financed with $7 million in cash and the remaining balance in debt.
On June 16, 1997, the Company announced a definitive agreement to sell its life and health insurance subsidiary, American Physicians Life ("APL"). The closing was completed on December 4, 1998. Proceeds from the sale were $17 million in cash. On August 21, 1997, GEC announced an agreement to sell its Sri Lankan subsidiaries. The closings occurred during 1997 for consideration of $17.3 million in cash and $7.7 million in marketable securities. Approximately $15 million of the $25 million purchase price was received in 1997, and the remaining balance was received in 1998.
Because these subsidiaries represented major segments of the Company's business, in accordance with APB No. 30 "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business," operations for all of 1998, 1997 and 1996 have been classified as discontinued operations. The net assets are shown as a single line item in the accompanying balance sheet as "Net assets of discontinued operations."
The Company and its U.S. subsidiaries, excluding U.S. subsidiaries of GEC, file a consolidated life/non-life federal income tax return. Non-U.S. subsidiaries file tax returns in various foreign countries.
The deferred tax asset valuation allowance as of December 31, 1998 and 1997 relates to the net operating loss carryforwards (NOL's) of Citation, PICO, GEC and its subsidiaries. NOL's for U.S. corporations, and to a similar extent Canadian tax NOL's, are subject to the separate return limitation rules. Therefore, certain of these NOL's can only be used to offset the respective future taxable income generated by Citation, PICO, GEC and its subsidiaries, individually. Due to the uncertainty related to future income of these subsidiaries, the Company recorded a valuation allowance to reflect the estimated amount of deferred tax assets that may not be realized. Deferred tax assets and liabilities, the recorded valuation allowance and federal income tax expense in future years can be significantly affected by changes in enacted tax rates or by changes in circumstances that would influence management's conclusions as to the ultimate realization of deferred tax assets.
11. SHAREHOLDERS' EQUITY (ALL SHARE AMOUNTS HAVE BEEN RESTATED TO GIVE EFFECT TO THE DECEMBER 16, 1998 1-FOR-5 REVERSE STOCK SPLIT):
On December 16, 1998, PICO acquired the remaining shares of GEC. This was accomplished through an exchange of PICO shares for GEC shares at the exchange ratio of .4628 of a PICO share for each share of GEC. PICO issued a total of 6,810,426 shares of PICO common stock to former GEC shareholders. PICO subsidiaries hold 3,110,837 of these newly issued shares which are recorded as treasury stock in the consolidated balance sheets of the Company. Following the transaction, PICO has approximately 13,328,770 shares of common stock issued and outstanding of which approximately 4,380,779 million are accounted for as treasury stock in the consolidated balances sheets. In addition, PICO exchanged 223,187 PICO warrants with an exercise price of $23.80 per share for all the outstanding GEC warrants using the same exchange ratio. The original October 23, 1998 expiration date of the warrants was extended to June 30, 1999. No other warrants exist. PICO also exchanged 484,967 stock options to GEC officers, two current GEC directors and a former GEC director in exchange for surrendering their GEC stock options. These grants placed the participants in a substantially similar position regarding shares and exercise price, vested according to their original terms.
On May 9, 1996, the Company, Guinness Peat Group plc ("GPG") and GEC entered into an agreement whereby GPG agreed to sell 851,683 common shares of the Company's common stock to GEC at an average price of approximately $18.00 per share. Prior to the sale, GPG owned approximately 40% of the Company's common stock. Following the sale, GPG and GEC owned approximately 23% and 16% of the Company's common stock, respectively. Subsequent to the Merger with CIG in November 1996, GPG and GEC owned approximately 19% and 13.1%, respectively. The shares of the Company owned by GEC are recorded as treasury stock in the Company's consolidated balance sheet. GPG sold 64,800 PICO shares in May 1997 pursuant to Securities Exchange Commission Rule 144 on the open market, decreasing its ownership of the Company to approximately 17.6%. On July 23, 1998, GPG sold 672,517 unregistered shares of PICO common stock to several institutional investors, representing substantially all of GPG's holdings in PICO. PICO acquired 412,846 shares from GPG at a cost of $1.6 million, and assumed call option obligations for the delivery of these shares when the options are exercised. These call options expire on December 30, 2003 and are held by PICO's chairman of the board and president and chief executive officer. On December 31, 1998, 57,307 of these options were exercised for a total of $200,000.
Pursuant to direction by the Board of Directors in the last quarter of 1997, management is in the process of terminating the CIG ESOP. No contributions were made to the plan in 1998, 1997 or 1996.
PICO Holdings' 1998 Option Plan. PICO is authorized to issue 100,000 shares of common stock pursuant to awards granted in various forms, including incentive stock options (intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended), non-qualified stock options, and other similar stock-based awards. On October 22, 1998, PICO granted 100,000 non-qualified common stock options to an officer of the Company at an exercise price of $15.625 per share. The options granted vest monthly over three years, expiring October 22, 2008.
PICO Holdings' 1998 GEC/PICO Option Plan. As discussed above, PICO assumed 484,967 options to existing GEC option holders pursuant to the acquisition of the remaining shares of GEC by exchanging PICO options for GEC options. The options granted from this plan placed the participants in an economically equivalent position regarding the number of shares, exercise price, and with vesting according to their original terms.
A summary of the status of the Company's stock options is presented below for the years ended December 31:
The following is a summary of the net effect of reinsurance activity on the consolidated financial statements for 1998, 1997, and 1996:
On January 10, 1997, GEC commenced an action in British Columbia against MKG Enterprises Corp. ("MKG"), Vignoble Wines Agency Inc. ("Vignoble") to enforce repayment of a $5 million loan made by GEC to MKG. On the same day, the Supreme Court of British Columbia granted an order preventing MKG from disposing of certain assets pending resolution of the action. GEC subsequently brought a motion to have a receiver-manager appointed for MKG and Vignoble, which motion has been adjourned. In addition, in March 1999 GEC filed an action in the Supreme Court of British Columbia against a third party. This action states the third party had fraudulently entered into loan agreements with MKG. Accordingly, under this action GEC is claiming damages from the third party and restraining the third party from further action.
On March 6, 1996, Charles E. Bancroft, the President and Chief Executive Officer of Sequoia entered into an incentive agreement with Sequoia after its acquisition by Physicians. Under the terms of this incentive agreement, Mr. Bancroft is to receive a payment equal to ten percent of the increase in Sequoia's value upon his retirement, removal from office for reasons other than cause, or the sale of Sequoia to a third party. For purposes of the incentive agreement, the increase in Sequoia's value is to be measured from August 1, 1995; the date Physicians acquired Sequoia. Mr. Bancroft was not eligible to receive any incentive payment, until he was continuously employed by Sequoia from August 1, 1995 through August 1, 1998. On March 20, 1998 this incentive agreement was clarified to include the combined increase in value of Sequoia and Citation. The increase in value of Citation will be measured from January 1, 1998. The Company recorded compensation expense of $110,000 and $250,000 during the years ended December 31, 1998 and 1997, respectively, related to this arrangement.
Certain of the Company's subsidiaries have stock option arrangements with officers and other employees for stock of the respective subsidiary. Options are granted under these arrangements at the estimated fair value of the subsidiary's stock at the time of grant. Therefore, no compensation has been recorded by the Company related to these arrangements. During 1998, 18,950 options to acquire approximately 1.9% of Vidler were exercised for $108,000.
In 1998, the Company entered into an agreement with its president and chief executive officer to defer a portion of his regular compensation in a Rabbi Trust account held in the name of the Company. The deferrals are included within the Company's consolidated balance sheet. Salary deferrals to the trust amounted to $316,000 for 1998.
The Company acquired 412,846 shares of its common stock at a cost of $1.6 million, and assumed call option obligations for the delivery of these shares when the options are exercised. These call options expire on December 30, 2003 and are held by PICO's chairman of the board and president and chief executive officer. On December 31, 1998, 57,307 of these options were exercised for a total of $200,000
4) Equity in net income of subsidiaries and affiliates is credited directly to shareholders' equity for statutory accounting purposes.
The Company is a diversified holding company engaged in five major operating segments: Investment Operations; Surface, Water and Mineral Rights Operations; Property and Casualty Insurance Operations; Medical Professional Liability ("MPL") Insurance Operations and Other Operations.
PICO holds a number of strategic and portfolio investments in both publicly and privately held corporations. These investments may be passive or they may represent positions where PICO is able to exert significant influence over the operating, financing and management strategies and decisions of the corporation. PICO invests in businesses that it believes to be undervalued or may benefit from additional capital, restructuring of operations or management or improved competitiveness through operational efficiencies with existing PICO operations. The Company makes investments for the purpose of enhancing and realizing additional value by means of appropriate levels of shareholder influence and control. This may involve restructuring of the financing or management of the entities in which the Company invests and initiating or facilitating mergers and acquisitions. The investments tend to be long term in nature however if returns are not as anticipated, there is an attractive exit, or a more productive use of capital is identified, the Company divest its position. Revenues are derived from interest, dividends and realized gains or losses upon sale of investments. In addition, the change in unrealized gains and losses for available for sale securities is used as a performance measurement. The Company invests in a number of industry segments and geographic regions and does not limit itself in either of these categories but rather uses criteria based on fundamental value principles in selecting investment targets. Investments directly related to the insurance operations are included within those segments.
PICO is engaged in surface, water and mineral rights operations through its subsidiaries, Vidler and NLRC. Vidler is a comprehensive provider of water services and, through the acquisition of water assets, water rights and upgrading priority and functionality of these rights generates revenues by marketing water to end-users. In addition, Vidler is developing water recharge (storage) facilities for future operation that will be directed to municipalities and water districts in the southwestern United States. Surplus supplies of water will be stored in the facility and storage fees will generate revenues, and when water is sold and delivered to the end-user.
NLRC owns a large inventory of surface, water and mineral rights. Revenue is generated from surface rights by land sales, land development, land exchanges and leasing for grazing, agricultural and other uses. Revenue is generated from the exploration and development of water rights and mineral rights in the form of outright sales and royalty streams.
PICO owns two property and casualty insurance companies, Citation and Sequoia. These companies are licensed to write commercial property and casualty insurance and, to a lesser extent personal lines of insurance. Workers Compensation insurance was written until 1997, when the business was sold to a third party. Revenues are derived from premiums earned on policies written as well as investment income on assets and investments held by the insurance operations.
The following is the segment results for December 31, 1998, 1997 and 1996 (in thousands):
(B) The life and health insurance segment was discontinued in 1997. Included in "Other" are amounts of identifiable assets of approximately $68,000 for 1996 relating to the discontinued life and health insurance segment. Income statement amounts for 1998, 1997 and 1996 are classified as discontinued operations.
- CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS: The carrying amounts for cash, cash equivalents, short-term investments, receivables, accounts payable and accrued liabilities approximate fair value because of the short maturity of these instruments.
The Company computes income (loss) per common share for each quarter independently of income (loss) per share for the year. The sum of the quarterly income (loss) per share may not equal the income (loss) per share for the year because of: (i) transactions affecting the weighted average number of shares outstanding in each quarter; and (ii) the uneven distribution of income during the year.
Fluctuations by quarter in revenues and net income (loss) are primarily due to realized gains or losses on investments.