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, 2002, 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, 2002 and 2001 and for each of the years in the three-year period ended December 31, 2002, and the report thereon are included elsewhere herein. 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.
The following is a summary of operations by quarter for the years ended December 31, 2002 and 2001:
* Quarters do not add to full year due to changes in shares outstanding.
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 when known.
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. As a result of these events, in the fourth quarter of 2001, the Company began accounting for its investment in PICO using the equity method. Consequently, PICO’s balance sheet amounts were excluded from the consolidated financial statements as of December 31, 2001 and only the first nine months of PICO’s operating results were reflected in the individual income and expense line items of the consolidated statement of operations. In the fourth quarter of 2001, the Company wrote its investment in PICO down to $-0-.
Excess of Cost over Net Assets Acquired and Other Intangibles. In 2002, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” The impact of adoption was not material to the consolidated financial statements of the Company.
The Company’s revenues consist primarily of commission income, contingent commission income, and other income. Commission income is earned from Pan Am’s distribution of insurance. Contingent commission income is related to volume and profit sharing arrangements with insurance carriers.
The Company’s expenses consist of salaries and related expenses, interest expense and other general and administrative expenses.
Interest expense. Interest expense decreased 60.1% to $268,000 for 2002 from $672,000 for 2001. The decrease is due to a decline in the outstanding balance of the related note payable. As of the beginning of 2001, the note payable to bank had a balance of $12.9 million which was reduced to $4.1 million at the beginning of 2002 and further reduced to $2.8 million by the end of 2002.
Income taxes on discontinued operations. Income tax benefit on discontinued operations for 2002 was $604,000 compared to $7.0 million for 2001. The effective income tax rates for 2002 and 2001 were 42.4% and 18.3%, respectively. The total tax benefit from discontinued operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):
Commission income. Commission income increased 15.2% to $10.3 million for 2001 from $8.9 million for 2000. Contributing to the increase was rate increases on underlying workers’ compensation and accident and health policies.
Contingent commission income. Contingent commission income decreased 5.7% to $1.5 million for 2001 from $1.6 million for 2000. Contingent commission fluctuates from year to year based on the profitability of the underlying business.
Net investment income. Net investment income decreased 70.2% to $158,000 for 2001 from $531,000 for 2000. In 2000, the Company held additional funds in selected investments. In 2001, these funds were used to make principal payments on the bank note.
Net realized investment gains and losses. The Company had net realized investment gains of $72,000 for 2001 compared to net realized losses of $5.2 million for 2000. In 2000, the Company recorded an impairment loss of $3.3 million related to its investment in Montlake Insurance Holdings, LLC (“Montlake”). This reduced the carrying value of the Company’s investment in Montlake to $-0-. In 2002, Montlake was liquidated.
Other income. Other income decreased 92.3% to $54,000 for 2001 from $704,000 for 2000. The decrease is due to the Company’s exit from underwriting selected group medical products.
Operating expenses. Operating expenses decreased 1.4% to $4.6 million for 2001 from $4.7 million for 2000.
Income from continuing operations before taxes. Income from continuing operations before taxes increased to $460,000 in 2001 from a loss of $6.9 million in 2000. The increase was primarily driven by the elimination of net realized investment losses of $5.2 million and equity in net loss of unconsolidated affiliate of $1.4 million, which were present in 2000, but not in 2001.
Loss from discontinued operations before taxes. Loss from discontinued operations before taxes was $38.6 million for 2001 and $15.7 million in 2000. The discontinued operations relate to the Company’s former underwriting operations. The loss in both periods was driven by adverse development on prior accident years loss reseves. For the entire year in 2001, PICO experienced an aggregate of approximately $43.1 million in net reserve development compared to $21.2 million in 2000.
Income taxes on discontinued operations. Income tax benefit on discontinued operations for 2001 was $7.0 million compared to $5.0 million for 2000. The effective income tax rates for 2001 and 2000 were 18.3% and 31.5%, respectively. The total tax benefit from discontinued operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):
In March 1997, PAULA Financial entered into a Credit Agreement with Bank of the West (formerly Sanwa Bank) providing PAULA Financial with a revolving credit facility of $15.0 million until December 31, 1999. On December 31, 1999, PAULA Financial 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 $15.0 million and an interest rate of 8.5%. The use of the credit facility was for repurchase of the Company’s common stock and investments in new ventures.
On January 30, 2001, the Company and the lender completed negotiations and signed the first Amendment to the Credit Agreement (the “First Amendment”). Under the terms of the First Amendment, the Company was scheduled to make principal payments of $6.9 million with the $4.4 million balance due on December 31, 2001. The Company made principal payments totaling $7.2 million in 2001.
On December 31, 2001, the Company and the lender completed negotiations and signed the second Amendment to the Credit Agreement (the “Second Amendment”). Under the terms of the Second Amendment, the Company made principal payments totaling $1.3 million during 2002 with the remaining principal balance of $2.8 million due on January 1, 2003.
On December 31, 2002, the Company and the lender completed negotiations and signed the third Amendment to the Credit Agreement (the “Third Amendment”). Under the terms of the Third Amendment, the remaining principal balance, $2.8 million, will be paid over the next two years with the final principal payment due on January 1, 2005. Balances outstanding under the term loan bear interest at the lender’s prime rate plus 2.0%. As of March 15, 2003, the interest rate is 6.25%.
The Credit Agreement limits the Company’s ability to (i) enter new lines of business; (ii) incur or assume debt; (iii) pay dividends and repurchase or retire capital stock; and (iv) make acquisitions, investments and capital expenditures. Under the terms of the Third Amendment, in the event of default, the interest rate would increase by 2.0%. Each of PAULA Financial’s non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement. Additionally, the Company has pledged as collateral its stock in PICO.
The Company’s Board of Directors had previously approved a 1,000,000 share repurchase program. As of December 31, 2002, the Company held 873,500 shares in treasury stock. On February 20, 2003, the Board of Directors authorized an additional 2,000,000 shares for the share repurchase program. The Company’s current credit agreement restricts its ability to repurchase capital stock.
The following is a summary of the Company’s contractual obligations as of December 31, 2002:
Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2002
PAULA Financial and subsidiaries (collectively, “the Company”) is a California-based specialty distributor of commercial insurance products. The Company’s agency operations place a full array of commercial insurance products for their customers. In addition, the Company owns a third party administration operation which has minimal operations.
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 approximates the related carrying value.
The EPS calculations for the years ended December 31, 2002, 2001 and 2000 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.
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”). 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:
On January 30, 2001, the Company and the lender completed negotiations and signed an Amendment to the Credit Agreement (the “First Amendment”). Under the terms of the First Amendment, the Company was scheduled to make principal payments totaling $6,874 during 2001. The remaining principal balance of $4,376 was due on December 31, 2001. The Company made principal payments totaling $7,198 in 2001.
The loan agreement limits the Company’s ability to (i) enter new lines of business; (ii) incur or assume debt; (iii) pay dividends and repurchase or retire capital stock; and (iv) make acquisitions, investments and capital expenditures. Each of the Company’s non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement. Additionally, under the terms of the First Amendment, the Company has pledged as collateral its stock in PICO.
The Company and its subsidiaries file a consolidated Federal income tax return. Income tax expense (benefit) from continuing operations for the years ended December 31, 2002, 2001 and 2000 is shown as follows:
The net operating loss carry forward includes losses generated by PICO which are available to offset future taxable income of the Company. As of December 31, 2002 and 2001, the Company has established a $22,646 and $25,106, respectively, valuation allowance related to the net operating loss carry forward.
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 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.
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.
In 2001 the Company offered current employees, directors and consultants the opportunity to exchange outstanding options for shares of restricted stock. In conjunction with the program, options to purchase 629,000 shares of stock, which were originally granted both inside and outside the plans, were canceled and exchanged for 629,000 shares of restricted stock. The fair value of the restricted shares was $1.40 per share, the closing price of the common stock as of the date the Board of Directors approved the exchange program. The restricted stock generally vests over a two year period with one-third of the grant vesting immediately. The unvested portion of the restricted stock grant is included in unearned compensation in the accompanying consolidated financial statements.
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 $730, $759 and $782 for the years ended December 31, 2002, 2001 and 2000, respectively.
Since 1999, the Company’s agency operations have outsourced certain backroom functions to a service center operation. In 2001, a partial owner of this agency was elected to the Company’s board of directors. Fees paid by the Company’s agency to the service center were $1,251, $1,123 and $1,042 for the years ended December 31, 2002, 2001 and 2000, respectively. These fees primarily relate to direct expense reimbursement. Additionally, the Company has a $703 minority investment in the agency which is a long-term investment accounted for under the cost basis.
In July 2002, the Company successfully recruited an experienced, large account agribusiness producer to the organization. As part of the agreement, the Company agreed to purchase his business. As structured, the Company will acquire the business as related accounts are renewed. No cash was paid by the Company in 2002 related to the acquisition of this business, but the Company did issue 60,000 shares of common stock. Balances owing under the arrangement will be paid over a five year period. As of December 31, 2002, the obligation related to this transaction was $706 with $106 of the balance due in 2003.
Historically, the Company underwrote workers compensation insurance products through its underwriting subsidiary, PICO. On February 28, 2002, the Company announced that PICO would voluntarily cease underwriting workers’ compensation insurance in all jurisdictions. The decision came as a result of claims reserve development primarily relating to accident years 1997-1999 on California workers’ compensation business. In the fourth quarter of 2001, PICO posted an increase to prior year reserves of $37 million. This reserve increase caused PICO’s Risk Based Capital to fall into the “Mandatory Control Level.” As a result, on March 12, 2002, the Company and the California Department of Insurance (“California DOI”) entered into an agreement of regulatory oversight (“Oversight Agreement”).
California insurance regulation provides that when an insurance company is deemed insolvent, the state steps in and assumes control of all operations of the insurance company, including a provision for any shortfall in funds to pay claims. The California Insurance Guaranty Association is the entity responsible for all policyholder claims obligations of insolvent insurance companies. Because PAULA Financial has no continuing legal obligation, the Company has made no provision for the excess of liabilities over assets of PICO as of December 31, 2002.
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 balance sheet amounts are excluded from the consolidated financial statements at December 31, 2002 and 2001 and the operating 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. As of December 31, 2001, PAULA Financial was carrying its investment in PICO at $-0-.
Amounts included in discontinued operations for the year ended December 31, 2002, primarily relate to the write off of PICO receivables and employee severance costs associated with the discontinuance of PICO operations.
The following income statement activity summarize amounts included in discontinued operations for the years ended December 31, 2001 and 2000:
Effective January 1, 2001, PICO entered into a quota share agreement with Everest Reinsurance Company (Everest Re). Under the terms of the agreement, PICO ceded a minimum of 30% and had the option to cede up to a maximum of 50% of policy year 2001 earned premium to Everest Re. During the first six months of 2001, PICO ceded 50% of policy year 2001 earned premium to Everest Re. For the last six months of 2001, the quota share was adjusted to 30% of policy year 2001 earned premium. Effective January 1, 2002, the contract with Everest Re was canceled.
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, 2002, 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.
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 and $89 for the years ended December 31, 2001 and 2000, respectively.
Employees of the Company receive an annual year-end bonus. Amounts expensed under bonus programs related to discontinued operations were $209 and $247 for the years ended December 31, 2001 and 2000, respectively