The Company's principal executive offices, comprised of approximately 34,000 square feet of office space leased through April 2003, are located in Pasadena, California. In addition, the Company maintains 21 branch offices in various locations in the western United States in leased facilities with various lease terms. Management believes that the Company's facilities are suitable and adequate for their intended uses.
The selected data presented below under the captions "Income Statement Data" and "Balance Sheet Data" as of and for each of the years in the five-year period ended December 31, 2000, are derived from the consolidated financial statements of the Company, which financial statements have been audited by KPMG LLP, independent certified public accountants. The consolidated financial statements as of December 31, 2000 and 1999 and for each of the years in the three-year period ended December 31, 2000, and the report thereon are included elsewhere herein. The information presented below under the caption "Other Data" is unaudited. The selected financial data set forth below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto appearing elsewhere herein.
(3)"PICO EAP" means, as of any date, the estimated total annualized premiums for all policies written by PICO in force on that date, whether earned prior to or after such date.
The Company's expenses have consisted of losses and LAE incurred, dividends provided for policyholders and operating expenses. Losses include reserves for future payments for medical care and rehabilitation costs and indemnity payments for lost wages. LAE include expenses incurred in connection with services provided by third parties, including expenses of independent medical examinations, surveillance costs, and legal expenses, as well as staff and related expenses incurred to administer and settle claims. Loss and LAE are offset in part by estimated recoveries from reinsurers under reinsurance treaties. Operating expenses include commission expenses to third party insurance agencies and other expenses that vary with premium volume, such as premium taxes, state guaranty fund assessments and underwriting and marketing expenses, as well as general and administrative expenses, which are less closely related to premium volume.
The "Adjusted" columns exclude the impact of low layer reinsurance treaties which were not in effect in 2000.
Gross premiums written. The Company's gross premiums written for 2000 decreased 17.3% to $97.4 million from $117.8 million in 1999. The decrease in gross premiums written relates primarily to a 24.3% decline in the California writings due to the Company's pricing stance in the state. Since mid-1998, the Company has been aggressively pursuing rate increases on its California book of business. Rate increases on business retained by the Company averaged 25% in 2000 and 5% in 1999.
Equity in net loss of unconsolidated affiliate. The equity in net loss of unconsolidated affiliate represents the Company's share of the net loss of Montlake. The Company is accounting for this investment using the equity method. The increase in the equity in net loss of Montlake is primarily due to adverse loss development at its Bermuda captive, which is in run-off.
Income taxes. Income tax benefit for 2000 was $3.4 million compared to $7.5 million for 1999. The effective combined income tax rates for 2000 and 1999 were (15.1%) and (35.3%), respectively. The 2000 effective tax rate is impacted by the establishment of a $4.6 million valuation allowance.
Net income (loss). Net loss for 2000 was $19.2 million compared to $13.7 million in 1999. The 2000 and 1999 net losses are primarily attributable to actions taken by the Company to increase loss reserves on the prior accident years.
Gross premiums written. The Company's gross premiums written for 1999 decreased 22.7% to $117.8 million from $152.4 million in 1998. The decrease in gross premiums written relates primarily to declines in the Company's large account business in California, where gross premiums written were down 36.4%. The decrease in gross premiums written in California was due to the Company's pricing stance in the state and was partially offset by a 12.2% growth in gross premiums written in other states. This growth was particularly strong in Texas and New Mexico.
Net realized investment gains and losses. The Company had net realized investment losses of $1.5 million for 1999 compared to net realized investment gains of $1.7 million for 1998. In the third quarter of 1998, the Company repositioned a portion of its investment portfolio from tax exempt to taxable securities. This resulted in a $1.8 million gain. In 1999, the Company realized an "other than temporary" decline of $1.6 million on a non-performing investment.
Losses and LAE incurred. The Company's net loss ratio for 1999 increased to 101.6% from 88.9% for 1998. The increase in the 1999 net loss ratio is due to a reserving action taken by the Company in the fourth quarter of 1999. This reserving action, principally related to the 1997 and 1998 accident years, totaled $23.7 million. The strengthening principally related to the California book of business and is generally attributable to longer claim durations, principally on claims that are litigated. The 1998 net loss ratio includes the impact of actions taken by the Company to increase loss reserves on the 1997 and 1998 accident years by a total of $14.8 million in the second quarter of 1998. The accident year net loss ratios for 1999 and 1998 were 80.9% and 87.3%, respectively. Also impacting the net loss ratios for 1999 and 1998 were the Reliance treaties which were in effect for the first nine months in 1999 and the last three months in 1998.
Operating expenses. Operating expenses decreased 12.8% to $32.8 million for 1999 from $37.6 million for 1998. Variable expenses include the benefit of $6.9 million and $3.0 million in ceding commissions in 1999 and 1998, respectively, received in conjunction with the Reliance reinsurance arrangement. Excluding the benefit of the ceding commissions, operating expenses would have decreased $0.9 million or 2.3% over 1998.
Income taxes. Income tax benefit for 1999 was $7.5 million compared to $3.8 million for 1998. The effective combined income tax rates for 1999 and 1998 were (35.3%) and (44.0%), respectively. The difference in the effective tax rates is due to a repositioning of the investment portfolio from tax exempt securities to taxable securities in the third quarter of 1998.
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.
California law places significant restrictions on the ability of the insurance subsidiaries to pay dividends to PAULA Financial. All dividends from PICO and PACO, as California-domiciled insurers, require prior notice to the California DOI. All "extraordinary" dividends must be approved in advance by the California DOI. A dividend is deemed "extraordinary" if, when aggregated with all other dividends paid within the preceding twelve months, the dividend exceeds the greater of (i) PICO's statutory net income or PACO's statutory net gain from operations (both excluding unrealized capital gains) for the preceding calendar year or (ii) 10% of policyholder surplus as of the preceding December 31st. Additionally, unless approved in advance by the California DOI, no dividend may be paid by PICO or PACO except from earned surplus. Based on these limitations and statutory results, as of December 31, 2000, PAULA Financial would be able to receive $0.3 million in dividends in 2001 from PACO without obtaining prior regulatory approval from the California DOI. No dividends were paid by the insurance subsidiaries to PAULA Financial during 2000.
Since December 31, 1999, the Company has been out of compliance with certain of its debt covenants. However, PAULA Financial has been and remains current on the term loan's scheduled principal and interest payments. On January 30, 2001, the Company and the lender completed negotiations and signed an Amendment to the Credit Agreement (the "Amendment"). Under the terms of the Amendment, the Company will make principal payments totaling $6.9 million during 2001 with the remaining principal balance of $4.4 million due on December 31, 2001. Balances outstanding under the term loan bear interest at the lender's reference rate plus 2.0%. As of March 15, 2001, the interest rate is 11.5%.
On August 12, 1998, the Company announced the approval of the Board of Directors of a 500,000 share stock repurchase program. On October 29, 1998, the Board authorized an additional 500,000 shares bringing the total authorization under the program to 1,000,000 shares. As of December 31, 2000, the Company had repurchased 995,100 shares at an average price of $6.31 per share.
The following is a summary of operations by quarter for the years ended December 31, 2000 and 1999:
*Quarters do not add to full year due to changes in shares outstanding.
Historically, the sources of funds of the Company's operating subsidiaries are cash flows from operating activities, investment income and capital contributions from PAULA Financial. The insurance company operating subsidiaries' major uses of funds are claim payments and underwriting and administrative expenses and maintaining the required surplus to expand their insurance business. In recent years, cash flows at PICO have been negatively impacted by declines in premium volume and increases in claim payments for prior accident years. In 2000, 1999 and 1998 PICO made claim payments on prior accident years totaling $85.9 million, $53.3 million and $40.0 million, respectively. The increase in prior years is related to the increased premium volume in 1997 and 1998. PICO's operating cash flows in 2000 were positively impacted by the receipt of a $42.0 million reinsurance settlement. The agency operating subsidiaries' major use of funds are operating expenses. The nature of the workers' compensation insurance business is such that claim payments are made over a longer period of time than the period over which related premiums are collected. Operating cash flows and the portion of the investment portfolio consisting of cash and liquid securities have historically met the insurance company operating subsidiaries' liquidity requirements. In the future, PICO believes that its liquidity needs will be met through premium receipts, investment income and releases of securities on deposits. In the most recent years, operating cash flows have met the agency subsidiaries' liquidity requirements.
The Company's investments consist primarily of taxable and tax-exempt United States government and other investment grade securities and investment grade fixed maturity commercial paper and, to a lesser extent, equity securities. The Company does not generally invest in below investment grade fixed maturity securities, mortgage loans or real estate. The Company's investments in fixed maturity securities are carried at market value as such securities may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. As of December 31, 2000, the carrying value of the Company's fixed maturity securities portfolio was $134.8 million and 99.3% of the portfolio was rated "A" or better by S&P, Moody's or Fitch. See "Business Investments and Investment Results".
California workers' compensation insurance companies are required to maintain some of their investments on deposit with the California DOI for the protection of policyholders. The deposit requirements are generally determined annually based on loss and LAE reserve levels and are designed to insure that funds are available for the future payment of claim obligations. Other states in which PICO is licensed have also required PICO to post deposits for the protection of those states' policyholders. In December 2000, PICO applied for and received the early release of $13.4 million in investment securities held on deposit by the California DOI. In 2000, PICO made claim payments for prior accident years totaling $85.9 million. As these obligations were paid, there was a corresponding reduction in the deposit requirement. However, in practice the deposit requirement calculations are only performed annually based on year-end balances. The release of deposits in December 2000 represents an acceleration in the timing of the release of funds and not an exception to the deposit requirement. Pursuant to applicable state laws, PICO had, as of December 31, 2000, securities with a book value of $135.6 million held by authorized depositories pursuant to these deposit requirements. In addition to the deposits, the insurance company operating subsidiaries must maintain capital and surplus levels related to premiums written and the risks retained by the subsidiaries.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for fiscal years beginning after June 15, 2000 and establishes standards for the reporting for derivative instruments. It requires changes in the fair value of a derivative instrument and the changes in fair value of assets or liabilities hedged by that instrument to be included in income. To
the extent that the hedge transaction is effective, income is equally offset by both investments. Currently the changes in fair value of derivative instruments and hedged items are reported in net unrealized gain (loss) on securities. The Company does not participate in derivative instruments or hedging activities. Consequently, the Company's financial statements would not be impacted by the adoption of SFAS 133.
We have audited the accompanying consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 2000 and 1999 and the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PAULA Financial and subsidiaries as of December 31, 2000 and 1999 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America.
At December 31, 2000 and 1999, the entire investment portfolio is classified as available-for-sale and is reflected at estimated fair value with unrealized gains and losses recorded as a separate component of stockholders' equity, net of related deferred income taxes. The premium and discount on fixed maturities and collateralized mortgage obligations are amortized using the interest method. Amortization and accretion of premiums and discounts on collateralized mortgage obligations are adjusted for principal paydowns and changes in expected maturities. Investments in which the decline in market value is deemed other than temporary are reduced to the estimated realizable value through a charge to income.
Invested cash consists primarily of treasury and agency instruments with short durations.
Excess of cost over net assets acquired is amortized on a straight-line basis over seven years. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the balance over its remaining life can be recovered through the undiscounted future operating cash flows of the acquired operation. Accumulated amortization totaled $2,728 and $1,956 at December 31, 2000 and 1999, respectively.
The liability for unpaid losses and loss adjustment expenses represents (a) case basis estimates of reported losses and loss adjustment expenses and (b) estimates based on past experience of unreported losses and loss adjustment expenses, net of anticipated salvage and subrogation. Management believes that the provisions for losses and loss adjustment expenses are adequate to cover the net cost of incurred losses and loss adjustment expenses; however, the liability is by necessity based on estimates, and, accordingly, there can be no assurance that the ultimate liability will not differ from such estimates.
The Company accounts for income taxes under the asset and liability method. Accordingly, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the
The following table reflects the weighted average shares of common stock outstanding used in the EPS calculation, as well as the EPS-assuming dilution calculation. (In loss periods options are excluded from the calculation of EPS-assuming dilution as the inclusion of such options would have an antidilutive effect.) There is no difference in the earnings used in the two calculations.
The amortized cost and estimated fair value of investments in fixed maturities classified as available for sale at December 31, 2000 and 1999 are as follows:
The amortized cost and estimated fair value of fixed maturities classified as available for sale at December 31, 2000 by the earlier of the pre-escrowed date or contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Unrealized investment gains (losses) on preferred stock at December 31, 2000 and 1999 are as follows:
A summary of notes payable at December 31, 2000 and 1999 is as follows:
On March 31, 1997, the Company entered into a $15,000 unsecured line of credit with a commercial bank. On December 31, 1999, the Company elected to convert all of the borrowings into a term loan maturing on December 31, 2001. At the date of conversion, the line of credit had an outstanding balance of $15,000. As of December 31, 1999, the interest rate was 8.5%. As of December 31, 2000, the outstanding balance was $11,250 and the interest rate was 11.5%.
Since December 31, 1999, the Company has been out of compliance with certain of its debt covenants. However, the Company has been and remains current on the term loans scheduled principal and interest payments. On January 30, 2001, the Company and the lender completed negotiations and signed an Amendment to the Credit Agreement (the "Amendment"). Under the terms of the Amendment, the Company makes principal payments totaling $6,874 during 2001 with the remaining principal balance of $4,376 due on December 31, 2001. Balances outstanding under the term loan bear interest at the lender's reference rate plus 2.0%.
The original Credit Agreement contained various financial covenants such as minimum stockholders' equity, minimum statutory surplus, a ratio of debt to stockholders' equity, a ratio of PICO's premiums written to statutory surplus, and a debt service coverage ratio. The Amendment includes waivers for prior violations of certain covenants and modifies or eliminates selected covenants going forward. However, in the event of a default in 2001, the interest rate would increase by 2.0%. The Company believes it will be in compliance with the remaining covenants during 2001.
Management believes that funds currently available, funds released upon the liquidation of PACO and expense reimbursements and dividends from its non-regulated operating subsidiaries will be sufficient to meet the required principal and interest payments except for a portion of its December 31, 2001 balloon payment. The Company has already begun the process of identifying financing to fully meet its December 31, 2001 payment obligation. Management believes that such financing is available and can be obtained under appropriate and reasonable terms. As alternatives, the Company could sell
or securitize non-regulated assets sufficient to meet the remaining obligation. While the Company believes that it is remote that it will not meet its required principal and interest payments when due, in the event of default, the commercial bank may exercise the rights and remedies available to it under law. These remedies could be adverse to the Company's financial condition.
Total interest paid by the Company on all notes during the years ended December 31, 2000, 1999 and 1998 was $1,536, $758 and $61, respectively.
As of December 31, 2000, the Company has established a $4,610 valuation allowance related to the net operating loss carry forward generated in 2000.
The maximum retention for each loss occurrence on workers' compensation policies has been $250 since July 1996. In July 1998, PICO modified its prior existing excess of loss reinsurance treaty on the $250 excess $250 layer to retain the first $2,000 in annual aggregate losses, with a corresponding reduction in the reinsurance rate. In July 2000, PICO modified the terms of the deductible from a fixed $2,000 to 2.0% of earned premium.
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, 2000, PICO ceded 10% of policy year 2000 earned premium to ICH.
In July 1998, the Company entered into an assumption agreement with the New Mexico Retail Association Self-Insured Group ("the SIG"). The agreement provides for the complete assumption by PICO of the SIG reserves outstanding as of July 1, 1998, as well as a 100% quota-share participation on policies in-force as of that date. The prospective piece of the treaty has been accounted for as reinsurance in the accompanying consolidated financial statements. Premiums assumed under the prospective piece of this agreement were $37, $326 and $1,647 while loss incurred were $237, $13 and $1,031 for the years ended December 31, 2000, 1999 and 1998, respectively. The portion of the contract related to the loss portfolio transfer does not meet risk transfer requirements and has therefore been accounted for using the deposit method of accounting. At December 31, 2000 and 1999, the related liability of $1,021 and $1,205, respectively, are included in accounts payable and accrued expenses in the accompanying consolidated financial statements.
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. 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
PAULA Financial is dependent on the transfer of funds from its subsidiaries. Dividends and advances from PICO and PAULA Assurance Company ("PACO") are restricted by law and minimum capitalization requirements and, above certain thresholds, are subject to approval by insurance regulatory authorities. Net assets of the insurance subsidiaries in the amount of $42,951 and $47,082 at December 31, 2000 and 1999, respectively, are restricted as to their availability for advances or dividends to PAULA Financial due to insurance regulatory requirements.
The Company maintains a 401(k) plan covering substantially all employees. Employees may contribute up to 17% of their compensation. The Company makes a matching contribution of 50% of the employee contribution, limited to 6% of compensation. Total employer costs under the plan were $288, $293 and $252 for the years ended December 31, 2000, 1999 and 1998, respectively.
Historically, the Company also maintained a defined contribution employee stock ownership plan ("ESOP") covering all full-time employees, excluding hourly employees. Effective September 30, 1999, the ESOP merged with the 401(k) plan. At the time of the merger, the ESOP had 802,396 shares of Company common stock. No contributions were made in 1999 or 1998.
In 1994, the Company adopted a stock incentive plan, reserving 550,000 shares of common stock, which provides for granting of stock options and restricted stock bonuses to officers and directors and key employees of the Company. Options and restricted stock are granted at the discretion of the Executive Compensation Committee of the Board of Directors. Prior to the initial public offering, options were granted at fair value as determined by the Executive Compensation Committee of the Board of Directors. At December 31, 2000, 31,225 shares of common stock were available for issuance under the 1994 plan.
Stock options vest either immediately or over periods not to exceed five years and carry an exercise price equal to or in excess of the fair market value of the common stock on the date of grant. The stock options are generally exercisable for a ten-year term. The weighted average contractual life of options outstanding under the 1994 and 1997 plans is 5.0 years and 8.1 years, respectively.
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("Opinion 25"), and related interpretations in accounting for its employee stock options and adopt the disclosure requirements of Statement of Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Had compensation cost for the Company's stock-based compensation plan been reflected in the accompanying consolidated financial statements based on the fair value at the grant dates for option awards consistent with the method of SFAS 123, the Company's net income would have been reduced to the pro forma amounts indicated below:
The Company leases buildings for its home office and certain other premises under long-term operating leases that expire in various years to 2005. Certain of these leases contain renewal provisions. Rent expense was $2,087, $1,950 and $1,719 for the years ended December 31, 2000, 1999 and 1998, respectively.
The NAIC has adopted a risk-based capital ("RBC") formula for both property and casualty and life insurance companies. The formula calculates a minimum level of capital and surplus which should be maintained by each insurer. The formula is designed to allow state regulators to identify potentially under-capitalized companies. Under the formula, a company determines its RBC by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). The RBC rules provide for different levels of regulatory attention depending upon the ratio of the company's total adjusted capital to its "authorized control level" of RBC.
limited to, its assets, anticipated business growth and associated surplus strain, extraordinary exposure to risk, mix of business, and use of reinsurance in each case.
As of December 31, 2000, PICO's adjusted capital fell within the Company Action Level. Consequently, the Company is required to file a detailed financial plan with the California DOI. The Company has had ongoing discussions with the California DOI. In the course of those discussions, the Company has provided the California DOI with much of the information required in the comprehensive plan. The California DOI has informed the Company that it is currently not contemplating any action other than requesting the formal comprehensive plan. The Company plans to file the formal action plan within the allotted time frame.
At December 31, 2000, PACO's adjusted capital and surplus exceeded its risk-based capital requirements.