NET INVESTMENT INCOME. Net investment income increased 70.9% to $9.5 million for 1998 from $5.6 million for 1997. The increase was the result of significant cash flow increases from PICO's underwriting activity and, to a lesser extent, the funds received in the fourth quarter of 1997 from the Company's initial public offering. Average invested assets increased to $156.9 million for 1998 from $110.6 million for 1997. The Company's average yield on its portfolio was 6.1% in 1998 and 5.0% in 1997. The 1997 average yield was diluted by the increase in the Company's investment portfolio in October 1997 following the Company's initial public offering.
NET REALIZED INVESTMENT GAINS. The Company had net realized investment gains of $1.7 million for 1998 compared to $0.2 million for 1997. The increase is a result of a tax planning strategy to reposition a portion of the investment portfolio from tax exempt to taxable securities.
INCOME TAXES. Income tax benefit for 1998 was $3.8 million compared to an expense of $1.8 million for 1997. The effective combined income tax rates for 1998 and 1997 were (44.0%) and 25.6%, respectively. These rates vary from the combined statutory rate due to the investment income on tax-exempt securities.
NET INCOME (LOSS). Net loss for 1998 was $4.9 million compared to net income of $5.2 million in 1997. The 1998 net loss is primarily attributable to 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.
GROSS PREMIUMS WRITTEN. The Company's gross premiums written for 1997 increased 58.5% to $100.8 million from $63.6 million in 1996. The growth in gross 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.
NET INVESTMENT INCOME. Net investment income increased 18.7% to $5.6 million for 1997 from $4.7 million for 1996. The increase was the result of significant cash flow increases from PICO's underwriting activity and to a lesser extent the funds received in the fourth quarter as a result of the Company's initial public offering. Average invested assets increased to $110.6 million for 1997 from $83.6 million for 1996. The Company's average yield on its portfolio was 5.0% in 1997 and 5.6% in 1996. The 1997 average yield was diluted by the increase in the Company's investment portfolio in October 1997 following the Company's initial public offering. The increase in the portfolio late in the year inflated the Company's average total invested assets for 1997.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's net loss ratio for 1997 increased to 73.4% from 61.1% for 1996. The Company's net 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 net loss ratio in 1997 was offset in part by a reduction in the Company's policyholder dividend accrual.
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, 1998, PAULA Financial would be able to receive $5.4 million in dividends in 1999 from its insurance subsidiaries without obtaining prior regulatory approval from the California DOI. No dividends were paid by the insurance subsidiaries to PAULA Financial during 1998.
Management believes that the remaining proceeds from the Company's initial public offering held at the parent company level, 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 the next twelve months.
In early 1999, the Company made an investment in the recently formed Altus Insurance Holdings, LLC, the parent company of Altus Casualty Company Ltd. ("Altus"), a specialty workers' compensation insurance company. The Company made a capital commitment of $5.5 million and has the option to acquire additional equity and provide quota-share reinsurance to Altus through PICO.
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. The agency and TPA 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. Operating cash flows and intercompany loans from PAULA Financial have historically met the agency and TPA 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 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, 1998, the carrying value of the Company's fixed maturity securities portfolio was $170.8 million and 92.5% of the portfolio was rated "A" or better by S&P, Moody's or Fitch. See "Business Investments and Investment Results".
GL SYSTEM. The Company has completed in-house construction and testing of a new GL system which is Year 2000 compliant.
Although the windowing project is proceeding more slowly than anticipated, the Company expects the windowing project, involving correction and testing of all necessary Underwriting system programs, to be completed during the end of the second quarter of 1999. This represents a delay of approximately 45 days from the Company's prior disclosures.
The Company has determined that it cannot modify the programs of the existing version of the Claims system to make it Year 2000 compliant. However, the Company does not believe that continuing to utilize the non-Year 2000 compliant version of the Claims adjudication system through the third quarter of 1999 will materially impair operations. The Company expects to implement the customized upgrade early during the third quarter. If necessary, the Company will commence using the "standard" version of the claims system upgrade it has already received and installed.
NON-IT SYSTEMS. The Company has addressed its primary Year 2000 issues relating to Non-IT Systems by purchasing a new IBM mainframe computer to run its IT Systems. The Company intends to purchase a new second mainframe from IBM to extend the Company's computing capacity during the second quarter of 1999. At that time, the Company's old IBM mainframe will be relegated to a back-up role. The Company has obtained satisfactory evidence that the operating system of the Company's new mainframe computers are Year 2000 compliant from IBM's Internet website.
The Company is continuing to inventory its other Non-IT Systems as part of the Project. These systems include the Company's personal computer network, telephone switching equipment and other office equipment. Once these systems are inventoried, the Company will prioritize the impact of their failure due to Year 2000 issues and then begin testing and correcting to bring them into Year 2000 compliance. The Company expects the inventory and prioritization phases to be completed by the end of the first quarter of 1999 and corrective action to be completed by the end of the second quarter of 1999.
THIRD PARTY YEAR 2000 ISSUES. The Company has made good progress in obtaining Year 2000 compliance assurances from third parties with whom the Company has material trading arrangements, or upon whom the Company relies to a material extent in its normal operations. The Company will continue working to satisfy itself that each third party performing important functions for the Company has taken necessary measures to ensure that their IT and Non-IT Systems will be Year 2000 compliant in a timely manner. The Company believes it will suffer no material disruption of its operations from its trading partners' Year 2000 issues. The Company has not, and will not, attempt to assess the Year 2000 compliance of regulatory authorities, statistical rating bureaus or public utilities as the Company cannot cause such entities to increase their efforts to become Year 2000 compliant.
RISKS. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, financial condition and cash flow. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of regulatory authorities, statistical rating bureaus and public utilities, the Company is unable to determine at
this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, financial condition or cash flows. The Company believes the Project will significantly reduce the Company's level of uncertainty about the Year 2000 problem.
CONSULTANTS. The Company has not used the services of independent Year 2000 consultants to assess its IT System and Non-IT System needs, although the Company is utilizing the services of independent consultants in its Underwriting System windowing project and in constructing its new Underwriting system. The Company continues to review its Year 2000 program with its outside auditors on a regular basis.
derivative instruments and hedged items are reported in net unrealized gain (loss) on securities. The Company has not adopted SFAS 133. However, the effect of adoption on the consolidated financial statements at December 31, 1998 would not be material.
In connection with, and because it desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers to recognize the existence of certain forward-looking statements in this Form 10-K and in any other statement made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Some forward-looking statements may be identified by the use of terms such as "expects," "believes," "anticipates," "intends," or "judgment." Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties, many of which are beyond the Company's control and many of which, with respect to future business decisions, are subject to change. Examples of such uncertainties and contingencies include, among other important factors, those affecting the insurance industry in general, such as the economic and interest rate environment, legislative and regulatory developments and market pricing and competitive trends, and those relating specifically to the Company and its businesses, such as the level of its insurance premiums and fee income, the claims experience of its insurance products, the performance of its investment portfolio, the successful completion by the Company of its Year 2000 compliance program, acquisitions of companies or blocks of business, and the ratings by major rating organizations of its insurance subsidiaries. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company disclaims any obligation to update forward-looking information.
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, 1998 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, 1998 in conformity with generally accepted accounting principles.
In 1996, the Company granted to employees 22,500 shares of restricted common stock for a total value of $177. Also in 1996, 1,400 shares were forfeited at a value of $12 (see note 9).
PAULA Financial and subsidiaries (collectively referred to as "the Company") is an integrated insurance organization specializing in the production, underwriting and servicing of workers' compensation and accident and health insurance for agribusiness clients in California, Arizona, Oregon, Idaho, Alaska, Texas, Florida and New Mexico. For the year ended December 31, 1998, California accounted for 72% of premiums earned. The Company operates from many offices located throughout prime agricultural areas and places coverage with its insurance company subsidiaries and nonaffiliated insurance companies.
At December 31, 1998 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 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.
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 $1,286 and $1,140 at December 31, 1998 and 1997, respectively.
There is a high level of uncertainty inherent in the evaluation of the liability for unpaid losses and loss adjustment expenses. The ultimate costs of such claims are dependent upon future events, the outcomes of which are affected by many factors. Loss reserving procedures and settlement philosophy, current and perceived social and economic factors, inflation, current and future court rulings and jury attitudes, and many other economic, scientific, legal, political and social factors can all have significant effects on the ultimate costs of claims. Changes in Company operations and management philosophy may also cause actual developments to vary from the past.
The insurance subsidiaries underwrite workers' compensation, accident and health and life insurance policies. Participating workers' compensation policies represented approximately 28%, 46%, and 64% of net written premium for the years ended December 31, 1998, 1997 and 1996, respectively. Dividends are recorded as a liability based on estimates of ultimate amounts expected to be declared by the insurance subsidiaries' Boards of Directors, at their discretion.
In 1998, the Company adopted the provisions of FASB Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires companies to report comprehensive income and its components in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital. Comprehensive income includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. The Company's only component of other comprehensive income relates to unrealized gains and losses on investments. In accordance with the provisions of SFAS 130, the Company has included consolidated statements of comprehensive income (loss) in the accompanying consolidated financial statements.
The EPS calculations for the years ended December 31, 1998, 1997 and 1996 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 to be common stock equivalents. Stock options and warrants are considered to be common stock equivalents, except when their effect is antidilutive.
In loss periods options are excluded from the calculation of EPS-assuming dilution as the inclusion of such options would have an antidilutive effect.
The amortized cost and estimated fair value of investments in fixed maturities classified as available for sale at December 31, 1998 and 1997 are as follows:
Unrealized investment gains (losses) on preferred stock at December 31, 1998 and 1997 are as follows:
The favorable incurred development for prior periods in 1996 in the liability for unpaid losses and loss adjustment expenses relates principally to reduced claim frequency and stable severity.
A large portion of the reinsurance is effected under reinsurance contracts known as treaties. PAULA Insurance Company ("PICO") maintains excess of loss and catastrophic reinsurance arrangements to protect it against losses above its retention on workers' compensation policies. Additionally, PICO has also chosen to quota-share a portion of its retained claims exposure. In a quota share reinsurance contract, the company and the reinsurer share premiums, losses and loss adjustment expenses on a proportional basis based on each parties interest in the quota-shared risk.
The maximum retention for each loss occurrence on workers' compensation policies has been $250 since July 1996 and was $200 in the first half of 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 the fourth quarter of 1998 PICO entered into a two year excess of loss reinsurance arrangement with a retention of $50. Concurrent with this agreement, PICO entered into an excess of loss agreement which covers a portion of the losses in the $40 excess of $10 layer and a quota-share agreement which covers a portion of losses below $10.
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 $62,378 and $55,497 at December 31, 1998 and 1997, 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 $252, $224 and $208 for the years ended December 31, 1998, 1997 and 1996, respectively.
Employees of the Company receive an annual year-end bonus based upon the results of the Company. Amounts expensed under bonus programs were $641, $1,068 and $1,053 for the years ended December 31, 1998, 1997 and 1996, respectively.
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
The fair value for options granted in 1998 was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions: risk free interest rate of 5.3%, average option exercise period of seven years, and a volatility factor of 50%. The fair value for options granted prior to 1998 was estimated at the date of grant using the minimum value method. The risk free interest rate used for options granted during 1995 and 1996 was 6.4%. An average option exercise period of seven years was used. Pro forma net income (loss) does not reflect options granted prior to 1995. During the initial phase-in period of SFAS 123, the full impact of calculating compensation cost for stock options is not reflected in the pro forma net income (loss) amounts presented above because compensation cost is reflected over the options' vesting periods and compensation cost for options granted prior to January 1, 1995 is not considered.
The Company leases buildings for its home office and certain other premises under long-term operating leases that expire in various years to 2002. Certain of these leases contain renewal provisions. In 1997 and 1996 certain of these leases are with related parties. Rent expense was $1,719, $1,613 and $1,657 for the years ended December 31, 1998, 1997 and 1996, respectively. Included in rent expense is rent paid to related parties of the Company totaling $52 and $149 for the years ended December 31, 1997 and 1996, respectively.
In August 1996, the Company acquired the assets of Guinn Sinclair Insurance Services, an insurance agency specializing in farm labor contractor insurance needs, for total consideration of $221. The purchase price was comprised of a $44 cash payment and the issuance of common stock for the remaining balance (11,764 shares). The acquisition has been accounted for as an asset purchase 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.
In March 1999, the Company announced that it had agreed to purchase the insurance agency assets of the Sacramento and Stockton, California offices of CAPAX Management & Insurance Services ("CAPAX") for approximately $3,200. The Company will fund the transaction with $2,100 in cash plus $1,100 in CAPAX securities currently held by the Company. The transaction is expected to close in April, subject to certain conditions. The acquisition will be accounted for as an asset purchase.