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, 1997, are derived from the consolidated financial statements of the Company, which financial statements have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The consolidated financial statements as of December 31, 1996 and 1997 and for each of the years in the three-year period ended December 31, 1997, 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.
The Company's underwriting results are affected by its loss experience. The Company believes that legislation enacted in California in 1993 contributed to an industry-wide reduction in claims frequency and led to a stabilization of claims severity, which has helped improve the Company's loss experience. Due in part to the effect of these reforms, as well as to PICO's continued improvement in claims management and management of the medical and legal components of its workers' compensation claims, PICO experienced favorable development of reserves for the 1993-1995 accident years and recovered reserves of $3.9 million and $2.6 million in calendar years 1995 and 1996, respectively. PICO determined reserves for accident years 1993 and 1994, and to a lesser extent, 1995, based on the relatively high incurred loss and LAE trends for the 1989 - 1992 accident years. PICO's actual incurred losses and LAE for the 1993 - 1995 accident years initially proved to be lower than anticipated and PICO's original reserves for these periods were ultimately redundant. During calendar year 1997, the Company experienced $1.6 million in net adverse development, largely related to the 1996 accident year. The net development in 1997 was primarily a result of less favorable claims trends experienced by the Company for the 1996 accident year. There can be no assurance that the Company will have any reserve recoveries in future periods or that it will not experience additional net adverse development in future periods. See "Business Losses and Loss Reserves".
Workers' compensation policies can be written on a participating or non-participating basis. Participating policies allow the Company in its discretion to declare and pay dividends to a policyholder after the expiration of the policy based upon a policyholder's specific loss experience (or, if the policyholder is part of a safety group, the group's specific loss experience), the Company's overall loss experience and competitive conditions. With the advent of open rating in California and an emphasis on, among other things, competitive pricing at inception, the Company's dividends provided for policyholders decreased significantly in 1996 and 1997, although the relative mix of the Company's participating and non-participating policies has remained relatively constant (see Note 1 of the Notes to Consolidated Financial Statements). The Company currently does not anticipate paying any significant additional policyholder dividends on 1997 and prior policy years. Although the Company believes policyholder dividends are relatively insignificant as an element in workers' compensation in California, the Company intends to continue to issue participating policies that are eligible for policyholder dividend consideration in states outside of California.
PREMIUMS WRITTEN. The Company's premiums written for 1997 increased 58.5% to $100.8 million from $63.6 million in 1996. The growth in premiums written was primarily attributable to the net addition of new policyholders and increased policyholder payrolls, partially offset by lower premium rates resulting from increased price competition. The premium growth was particularly strong in California and the Northwest. In addition, the Company began writing business in Texas and Florida in the second and third quarters of 1997, respectively.
PREMIUMS EARNED. For the reasons described above for premiums written, the Company's premiums earned for 1997 increased 67.3% to $92.8 million from $55.5 million in 1996.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's loss ratio for 1997 increased to 73.4% from 61.1% for 1996. The Company's loss ratio for 1996 was positively impacted by net recoveries from loss and loss adjustment expense reserves for prior years, principally 1993-1995, of $2.6 million or 4.8% of 1996 earned premium. In 1997, the Company's loss ratio included a net strengthening of prior year reserves, principally 1996, of $1.6 million or 1.7% of 1997 earned premium. The increase in the 1997 loss ratio is also related to lower premium rates as a result of increased competition. The impact of the increase in loss ratio in 1997 was offset in part by a reduction in the Company's policyholder dividend accrual.
OPERATING EXPENSES. Operating expenses increased 20.6% to $30.7 million for 1997 from $25.5 million for 1996 due in part to a $2.8 million increase in commissions paid to unaffiliated agencies and a $1.8 million increase in personnel costs related to the growth in the Company's insurance operations.
INCOME TAXES. Income tax expense for 1997 increased to $1.8 million from $0.8 million for 1996. The effective combined income tax rates for 1997 and 1996 were 25.6% and 17.4%, respectively. These rates are below the combined statutory rate due to the significant portion of the Company's investment portfolio consisting of tax-exempt securities. The difference in effective tax rates between 1997 and 1996 is due to a change in the mix of tax-exempt and taxable investment income.
COMMISSION INCOME. Commission income increased 6.3% to $4.2 million for 1996 from $4.0 million for 1995.
OTHER INCOME. Other income decreased 42.9% to $0.9 million for 1996 from $1.6 million for 1995, primarily as a result of the termination of a large third party administration client contract in early 1996 which was matched with a comparable reduction in expenses.
OPERATING EXPENSES. Operating expenses increased 12.7% to $25.5 million for 1996 from $22.6 million for 1995 due in part to a $2.2 million increase in commissions paid to unaffiliated agencies.
As a holding company, PAULA Financial's principal sources of funds are dividends and expense reimbursements from its operating subsidiaries, proceeds from loans, 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 dividends to its stockholders.
The Company retained $16.6 million from the proceeds of its initial public offering at the parent company level. Management believes that this cash, funds available under the Credit Agreement described below and expense reimbursements and dividends from its operating subsidiaries will be sufficient to meet the parent company's operating cash needs for at least two and one-half years.
installments and maturing on December 31, 2001. Borrowings under the Credit Agreement bear interest at variable interest rates. 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 upon a default or event of default; and (iv) make acquisitions, investments and capital expenditures. The Credit Agreement contains financial covenants with respect to minimum stockholders' equity, minimum statutory surplus, a ratio of debt to stockholders' equity, a ratio of PICO's premiums written to statutory surplus and excess statutory reserves, a debt service coverage ratio, A.M. Best rating and risk-based capital levels. Each of PAULA Financial's non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement.
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 has invested in the equity securities of the two founders of PTC other than Pan Am as part of the parent company's investment portfolio. 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, 1997, the carrying value of the Company's fixed maturity securities portfolio was $114.5 million and 98.3% of the portfolio was rated "A" or better by S&P, Moody's or Fitch. See "Business Investments and Investment Results".
During the fourth quarter of 1997, the American Institute of Certified Accountants issued Statement of Position No. 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SOP 97-3"). SOP 97-3 addresses the recognition and measurement of assets and liabilities related to guaranty funds and other assessments. SOP 97-3 is effective for fiscal years beginning after December 15, 1998, although early adoption is encouraged. The Company has not determined the impact of SOP 97-3.
The discussions above contains statements that constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. The words "believe," "estimate," "expect," "intend," "anticipate," and similar expressions and variations thereof identify certain of such forward-looking statements, which speak only as of the dates on which they are made. PAULA Financial undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, or otherwise. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those indicated in the forward-looking statements as a result of various factors. Readers are cautioned not to place undue reliance on these forward-looking statements.
We have audited the accompanying consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 1996 and 1997 and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. 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, 1996 and 1997 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles.
In 1995, the Company purchased common stock from the retiring chairman through the issuance of a note payable in the amount of $4,458 (see note 8).
At December 31, 1996 and 1997, 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 scientific 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.
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 period that includes the enactment date.
and warrants considered to be common stock equivalents. Stock options and warrants are considered to be common stock equivalents, except when their effect is antidilutive.
The amortized cost and estimated fair value of investments in fixed maturities classified as available for sale at December 31, 1996 and 1997 are as follows:
Unrealized investment gains (losses) on common stock at December 31, 1996 and 1997 are as follows:
An affiliate of a significant holder of the Company's stock also acts as the Company's investment advisor. Fees paid for such investment services totaled $119, $146 and $160 in 1995, 1996 and 1997, respectively.
The favorable development in 1995 and 1996 in the liability for unpaid losses and loss adjustment expenses for prior years relates principally to reduced claim frequency and stable severity.
A summary of notes payable at December 31, 1996 and 1997 is as follows:
Total interest paid by the Company on all notes during the years ended December 31, 1995, 1996 and 1997 was $419, $1,300 and $1,014, respectively.
On March 31, 1997, the Company entered into a $15,000 unsecured line of credit with another commercial bank. The line of credit requires no principal payments during its term and matures December 31, 1999 and, at the Company's option, converts to a two-year term note. The interest rate on the line of credit is based on various indices. The line of credit imposes certain financial covenants. On March 31, 1997, the Company drew on the line of credit to repay in full and terminate the first line of credit. The line of credit was subsequently paid off in October 1997 and at December 31, 1997, the Company's available line of credit was $15,000.
The Company and its subsidiaries file a consolidated Federal income tax return. Income tax expense (benefit) for the years ended December 31, 1995, 1996 and 1997 is shown as follows:
Temporary differences which give rise to a significant portion of deferred tax assets and liabilities are as follows:
The Company paid $375, $1,400 and $2,300 of Federal income taxes during the years ended December 31, 1995, 1996 and 1997, respectively.
The preferred stock had dividend and voting rights consistent with common stockholders on an if-converted basis, and had a liquidation preference of $17.00 per share plus all accrued and unpaid dividends. The preferred stock was convertible into common shares on a one-for-two basis at the holder's option or automatically upon consummation of a qualified initial public offering with aggregate proceeds in excess of $20,000 and a per share price greater than $12.75 (a "Qualified Initial Public Offering"). The preferred stock was redeemable at the holder's option beginning December 31, 1998 at the greater of fair value as determined by an independent party or 1.15 times the Company's book value per share assuming conversion of the preferred stock. Such redemption right terminated upon the effectiveness of a registration statement for a Qualified Initial Public Offering. The preferred stock restricted both dividend payments and the repurchase of stock from the Company's employees and directors so long as the preferred stock remained outstanding. The preferred stock purchase agreement imposed certain additional covenants. The carrying value of the preferred stock was accreted based on the redemption formula outlined in the preferred stock agreement.
Concurrent with the initial public offering, the preferred shares were converted into 1,882,354 shares of common stock. Additionally, the warrants to purchase 164,706 shares of common stock were exercised. Cash totaling $933 was received for the exercise of 109,804 warrants while the remaining warrants were exercised in a cashless transaction in which 29,677 shares of common stock were issued.
Prior to the initial public offering, the purchase price of the Company's shares was determined annually by an independent appraisal firm, as required, and was approved by the ESOP committee. This appraisal was used for determining the market value of the shares with respect to the ESOP.
In January 1995, the Company agreed to repurchase 518,618 shares of common stock and options to acquire 40,000 shares, for a purchase price of $11.25 per share and $2.75 per option, from the retiring Chairman of the Board. The per share price was based on a third-party offer. The amount of the repurchase totaled $6,284, of which $1,486 was paid in each of January 1995 and 1996 and the remaining balance was paid in 1997.
PAULA Financial is dependent on the transfer of funds from its subsidiaries. Dividends and advances from PICO and 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 $39,800 and $55,497 at December 31, 1996 and 1997, respectively, are restricted as to their availability for advances or dividends to PAULA Financial due to insurance regulatory requirements.
Prior to the initial public offering, the Company was obligated under the terms of its ESOP to repurchase shares distributed to ESOP participants when the participants qualified for a distribution (i.e., retirement or break in service) in the event the participants chose to sell such shares and the ESOP was unable to repurchase the shares directly. Such shares had to be paid for within five years. (see note 8)
Changes in the status of options granted under the plan are summarized as follows:
Pursuant to the plan, the Company granted 28,700 shares at $9.03 per share and 22,500 shares at $7.88 per share of restricted common stock in 1995 and 1996, respectively. The per share price for these awards was based on an annual independent appraisal. The restrictions lapse pursuant to various vesting schedules. Holders of restricted stock are entitled to vote such shares and receive dividends, which are not subject to restrictions. As of December 31, 1997, the restrictions on an aggregate of 8,175 shares of restricted stock have lapsed; 9,500,
In addition, in 1996, the Company issued options to purchase an aggregate of 316,000 shares of common stock to officers and directors of the Company outside the Plan. The options carry an exercise price of $9.50 per share. Also, outstanding is an option to purchase an aggregate of 60,000 shares of common stock to an officer of the Company outside of the plan granted at $8.50 per share in 1994. The options were granted at fair value as determined by the Executive Compensation Committee of the Board of Directors. Such options have the same terms as options granted under the plan and are immediately exercisable.
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" (Statement 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 Statement 123, the Company's net income would have been reduced to the pro forma amounts indicated below:
Insurance regulatory authorities impose various restrictions on the payment of dividends and advances by insurance companies. As of December 31, 1997, the maximum dividend and advance payments that may be made during 1998 by the insurance subsidiaries to PAULA Financial without prior approval of the regulatory authorities are limited to the greater of net income for the preceding year or 10% of policyholder surplus as of the preceding December 31 and approximate $6.4 million.
In November 1995, the Company acquired the assets of Desert Benefits, Inc., an insurance agency specializing in agribusiness and rural market medical benefit programs, for total consideration of $700. The purchase price was comprised of a $140 cash payment and the issuance of common stock for the remaining balance (71,066 shares). The acquisition has been accounted for using the purchase method of accounting and the operations
have been included in the accompanying consolidated financial statements from the date of acquisition. The purchase price has principally been allocated to the excess of cost over net assets acquired.
On March 2, 1998, the Board of Directors declared a cash dividend of $0.04 per share to stockholders of record on March 17, 1998, to be paid by the Company on March 31, 1998.