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, 2003, are derived from the consolidated financial statements of the Company. The consolidated financial statements as of December 31, 2003 and 2002 and for each of the years in the three-year period ended December 31, 2003 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.
(1) See Note 1 of Notes to Consolidated Financial Statements for a description of the calculation of weighted average shares outstanding and earnings (loss) per share.
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the applicable period. On an ongoing basis, management evaluates its estimates, assumptions and judgments, including those related to revenue recognition, intangible assets, income taxes, financing arrangements and contingencies. Management bases its estimates, assumptions and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Management believes the following critical accounting policies, among others, affect its more significant estimates, assumptions and judgments used in the preparation of the consolidated financial statements.
In the fourth quarter of 2002 the requirements of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets” (“SFAS 144”) for treating a segment as a discontinued operation were met. Consequently, operating activity related to workers’ compensation underwriting has been reclassified as discontinued operations. As a result, certain financial information previously issued has been adjusted to give effect to the classification of the PICO business as discontinued operations in accordance with SFAS 144.
Business Acquisitions and Purchase Price Allocations. All of the Company’s acquisitions have been accounted for using the purchase method. Consequently, the net assets and results of operations of the acquired operations have been included in the Company’s consolidated financial statements from the respective acquisition dates. The Company structures such transactions to include “earn out” provisions whereby the ultimate purchase price is tied to actual revenues in the months immediately following the effective date (generally twelve months). Additional or reduced consideration resulting from such “earn out” provisions is reflected as an adjustment to goodwill when the contingency is resolved.
The Company uses a methodology based on discounted future cash flows derived from acquired client lists and attrition rates to estimate the fair value of the expiration rights and other intangible assets at the date of acquisition. Expiration rights are amortized on a straight line basis over their estimates lives of five to seven years. Non-compete agreements are typically valued at their stated contractual amount and are amortized on a straight line basis over the terms of the agreements. Goodwill is not subject to amortization. Both the allocation of purchase price and the estimation of useful lives require management’s judgment. If historical fact patterns were to change, such as the rate of attrition of acquired client accounts, the Company may be required to allocate more purchase price to goodwill or accelerate the amortization of expiration rights, which may have a material negative impact on the Company’s financial position or results of operations.
Goodwill and Other Intangible Asset Impairment. The Company assesses the recoverability of goodwill and other intangible assets at least once a year or as required based on triggering events. A triggering event is a change in business circumstances that indicates that the carrying value of the asset may not be recoverable. Examples of a triggering event include poor financial results or projections, deterioration of client base, loss of key employees or changes in the marketplace. Reviews for triggering events require the use of management’s judgment. If as a result of the impairment review, the Company finds that the carrying value of an asset is in excess of the fair value, the Company would be required to take a charge against current earnings. The results of our reviews disclosed no such asset impairments in 2003 and 2002.
Income Taxes. Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and any related valuation allowance involves judgment. GAAP requires deferred tax assets and liabilities to be recognized for the estimated future tax effects attributed to temporary differences and carryforwards based on provisions of the enacted tax law. The effects of future changes in tax laws or rates are not anticipated. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. Carryforwards primarily include items such as net operating losses, which can be carried forward to future tax years.
The Company’s revenues consist primarily of commission income, contingent commission income, service fees 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, amortization expense and other general and administrative expenses.
Also, contributing to the increase in commission income in 2003 was an increase in the workers’ compensation line of business. In 2003, approximately 39% of the total increase in commission income is due to increases in the workers compensation line of business. Currently SCIF is the largest single market for workers’ compensation insurance in the state of California. Consequently, the Company places a
The Company is attempting to mitigate the impact of the SCIF commission adjustment in a number of significant ways. First, the Company is actively engaged in offering alternative risk structures, including proprietary access to a member owned Bermuda captive. Second, the Company is diversifying its revenue base by expanding its property and casualty commissions and developing a significant crop insurance platform as discussed above. Service fees are also becoming a more meaningful part of the revenue schedule.
Contingent commission income. Contingent commission income increased 18.5% to $2.0 million for 2003 from $1.7 million for 2002. Contingent commission fluctuates from year to year based on the profitability of the underlying business and external market conditions which can result in changes to contingency programs offered by insurance carriers.
In 2003, approximately 50% of the contingent commission income earned related to volume and retention bonuses related to the SCIF business. SCIF has discontinued these contingent commissions arrangements for the 2004 calendar year (although the profit share component remains), therefore, contingent commission income is expected to decline in 2004. See discussion above related to actions taken by the Company to mitigate the impact of SCIF commission adjustments.
Service Fees. Service fee income increased to $602,000 for 2003 from $80,000 for 2002. The increase in service fees is due to new service arrangements where the Company is paid for providing loss control and other field support services to selected accounts. Pan Am provides loss control and other services both as a contractor to selected insurance carriers and on a direct basis to its customers.
Income from continuing operations before taxes. Income from continuing operations before taxes increased to $2.5 million in 2003 from $1.3 million in 2002. The increase was primarily driven by an increase in commission income.
Income taxes on continuing operations. Income tax expense on continuing operations for 2003 was $1.1 million compared to a benefit of $144,000 for 2002. The effective income tax rates for 2003 and 2002 were 43.4% and (11.4%), respectively. The total tax expense (benefit) from continuing operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):
Commission income. Commission income increased 13.2% to $11.6 million for 2002 from $10.3 million for 2001. The increase was largely driven by Pan Am’s entry into crop insurance and an increase in the placement of general liability, property, and commercial auto lines of business. The increase in these lines of business account for more than 90% of the increase in commission income. Also, contributing to the increase were rate increases on underlying workers’ compensation and accident and health policies.
Contingent commission income. Contingent commission income increased 13.5% to $1.7 million for 2002 from $1.5 million for 2001. Contingent commission fluctuates from year to year based on the profitability of the underlying business.
Income taxes on continuing operations. Income tax benefit on continuing operations for 2002 was $144,000 compared to an expense of $198,000 for 2001. The effective income tax rates for 2002 and 2001 were (11.4%) and 43.0%, respectively. The total tax expense (benefit) from continuing operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):
Loss from discontinued operations before taxes. In 2002, these costs primarily included the write off of PICO receivables and employee severance costs associated with the discontinuance of PICO operations. In 2001 the loss from discontinued operations largely related to adverse development on prior accident year loss reserves.
Prior to the refinancing discussed below, PAULA Financial had a credit agreement with Bank of the West. On November 1, 2003, the Company refinanced its outstanding bank debt with a $1,800,000 reducing revolving line of credit (the “Line of Credit”) with US Bank (the “Lender”). The line of credit matures one year from funding, with a one-year automatic option to extend as long as the Company is in compliance with all covenants. As of December 31, 2003, PAULA Financial was in compliance with all of the covenants. Balances outstanding under the term loan bear interest at prime rate plus 1.0%. As of March 15, 2004, the interest rate was 5.0%.
PAULA Financial’s subsidiaries have guaranteed the obligations of PAULA Financial under the Line of Credit. Additionally, the Lender has a security interest in the assets of the Company.
The Company’s Board of Directors had previously approved a 1,000,000 share repurchase program. On February 20, 2003, the Board of Directors authorized an additional 2,000,000 shares for the share repurchase program. As of December 31, 2003, the Company held 924,734 shares in treasury stock.
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, James G. Parker, III, was elected to the Company’s board of directors. Fees paid by the Company’s agency to the service center were $1.5 million, $1.3 million and $1.1 million for the years ended December 31, 2003, 2002 and 2001, respectively which consisted primarily of direct expense reimbursements. Additionally, the Company has a $0.7 million minority investment in the related agency.
In December 2002, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123”. This Statement amends SFAS No. 123, “Accounting for Stock Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock based employee compensation. In addition, this SFAS amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the notes to the accompanying consolidated financial statements.
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 commission revenue and fee income, and acquisitions of companies or blocks of business. 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 statements.
Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2003
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2003
We have audited the accompanying consolidated balance sheet of PAULA Financial and subsidiaries as of December 31, 2003, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedules as of and for the year ended December 31, 2003 listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit.
We have audited the accompanying consolidated balance sheet of PAULA Financial and subsidiaries as of December 31, 2002 and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the years in the two-year period ended December 31, 2002. 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, 2002 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 141, “Business Combinations” and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” which changed the Company’s method of accounting for goodwill and other intangible assets effective January 1, 2002.
The accompanying consolidated financial statements include the accounts of PAULA Financial and its wholly owned subsidiaries. The principal subsidiaries are: Pan American Underwriters, Inc., Pan American Underwriters Insurance Agents and Brokers, Inc., and PAULA Trading Company Insurance Agents and Brokers, Inc. (agency operations) and Pan Pacific Benefit Administrators, Inc. (third-party administration operation). All significant intercompany balances and transactions have been eliminated in consolidation.
Where necessary, prior years’ information has been reclassified to conform to the 2003 presentation.
In certain instances, the agency operations invoice the customer for the full premium amount and remit payment, less commission, to the insurance companies. Restricted cash consists of premiums collected by the agencies but not yet remitted to insurance companies which is restricted as to use by law in the states in which the agencies operate. The balance sheet account balances related to accounts receivable and due to underwriters and assured are also associated with this activity.
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 at the earlier of the amounts being reasonably estimatable or receipt of such amounts. Service fees are earned over the period the related services are performed.
Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) requires that an intangible asset that is acquired shall be initially recognized and measured based on its fair value. The statement also provides that goodwill should not be amortized, but shall be tested for impairment annually or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount.
Comprehensive income (loss) includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. In 2001, the Company’s only component of other comprehensive income (loss) relates to unrealized gains and losses on investments from discontinued operations. The Company has included consolidated statements of comprehensive income (loss) in the accompanying consolidated financial statements.
The fair value of stock based compensation to employees is calculated using an option pricing model developed to estimate the fair value of freely tradable and fully transferable options without vesting restrictions, which differ from the Company’s stock option program. The model also requires considerable judgment, including assumptions regarding the future stock price volatility and expected time to exercise, which greatly affect the calculated value.
all covenants. Balances outstanding under the term loan bear interest at prime rate plus 1.0%. As of March 15, 2004, the interest rate was 5.0%.
Management believes that funds currently available and expense reimbursements and dividends from its operating subsidiaries will be sufficient to meet the required principal and interest payments.
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, 2003, 2002 and 2001 is shown as follows:
The net operating loss carryforward includes losses generated by PICO which are available to offset future taxable income of the Company. As of December 31, 2003 and 2002, the Company has established a $20,969 valuation allowance related to the net operating loss carryforward.
The Company received Federal income tax refunds of $123, $92 and $672 during the years ended December 31, 2003, 2002 and 2001, respectively.
At December 31, 2003, the Company had a tax net operating loss carryforward of $74,184 that begins to expire in 2018.
Additionally, in late 2003, the Company implemented a loan forgiveness program for current employees totaling $200. Under the program, stock collateral of $39 was returned to the Company and the remaining loan balance will be forgiven over a vesting period of two years. Any unpaid balances outstanding at separation of employment is immediatley due and payable. During 2003, $54 of the balance outstanding was amortized as services were performed. Amortization expense is estimated to be $54 for both 2004 and 2005 at which time the outstanding balance will be fully amortized.
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. At December 31, 2003, 3,233 shares of common stock were available for issuance under the 1994 plan.
In 1997, the Company adopted its 1997 Stock Incentive Plan, reserving 200,000 shares of common stock. In 2001, shares authorized under the 1997 plan were increased to 900,000 shares. At December 31, 2003, 283,310 shares of common stock were available for issuance under the 1997 plan. In the past, the Company has issued options to purchase shares of common stock to officers and directors of the Company outside the Plan. The options were granted at fair value as determined by the Executive Compensation Committee of the Board of Directors.
Changes in the status of options granted under the 1997 plan are summarized as follows:
There were no changes in the status of options granted outside the plans for 2003 and 2002. Changes in the status of options granted outside the plans for 2001 are summarized as follows:
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 was included in unearned compensation in the accompanying consolidated financial statements for the year ended December 31, 2002.
Approximate aggregate minimum rental commitments under operating leases at December 31, 2003 are as follows:
Included in the property and equipment disclosures in Note 1 are amounts related to capital leases. Additionally, amortization expense related to property and equipment subject to capital leases is included in depreciation expense.
At the time of the filing of the bankruptcy, SGP allegedly owed plaintiffs certain unpaid benefits under its plans. Plaintiffs allege that those benefits total approximately $935,000. The plaintiffs contend that the MEWA required a license from the Arizona Department of Insurance, that the MEWA lacked such a license, and that the Arizona Company is liable for unpaid benefits pursuant to Arizona Revised Statute 20-402 (B) which provides for an agents liability when an unlicensed insurer fails to pay any claim or loss within the provisions of the insurance contract.
The Arizona Company has filed an answer to the complaint denying liability and has filed a counterclaim against the hospital plaintiffs and a cross complaint against a third party, Sunkist Growers, Inc. alleging that it is responsible in whole or part for any damages caused to plaintiffs to the extent that it was unjustly enriched by its relationship with SGP.
While it is difficult to predict the outcome of any litigation, as the nature of litigation is always uncertain, the Company believes that the outcome of the above discussed litigation will not have a material impact on the financial operations of the Company.
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 $1,502, $1,251 and $1,123 for the years ended December 31, 2003, 2002 and 2001, 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 structured, the Company acquired the business as related accounts were 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. The purchase price allocation was finalized in 2003. Of the total purchase price of $2,023, $1,237 has been allocated to other amortizable intangible assets, with the remaining $786 allocated to goodwill. Other amortizable intangible assets relate to expiration lists and covenants not to compete. In 2003, $289 was paid related to this transaction. As of December 31, 2003, the remaining obligation related to this transaction was $1,681, with $826 due in 2004, $593 due in 2005 and $262 due in 2006. Of the obligation outstanding, $1,459 will be paid in cash and $222 will be paid by issuance of stock.
Since 2002, the Company has made efforts to dramatically expand crop insurance sales, primarily through producer recruitment. In the first quarter of 2003, the Company purchased the existing book of business of Roudebush & Avina Insurance Agency, Inc. (“R&A”). R&A is based in Modesto, California and specializes in providing crop insurance to commercial wine grape growers. As part of the associated employment agreements, the Company issued 60,000 shares of common stock. Balances owing under the arrangement will be paid over a five year period. Of the total purchase price of $938, $325 has been allocated to other amortizable intangible assets, with the remaining $613 allocated to goodwill. Other amortizable intangible assets relate to expiration lists and covenants not to compete. In 2003, $300 was paid related to this transaction. As of December 31, 2003, the obligation related to this transaction was $638, with $167 due in 2004, $135 due in 2005, $135 due in 2006, $134 due in 2007 and $67 due in 2008. The purchase price for R&A is subject to adjustment based on actual results for the first twelve months of the agreement. Consequently, the purchase price will not be finalized until the first quarter of 2004.
The Oversight Agreement remained in effect until April 26, 2002. On that date, the California DOI obtained a court order appointing the Insurance Commissioner of the State of California (the “Commissioner”) the conservator of PICO. In accordance with the order the Commissioner took possession of the property, business, books, records, accounts and offices occupied by PICO. Additionally, the Commissioner assumed responsibility for conducting the business operations of PICO. On June 21, 2002, the Commissioner obtained a liquidation order.
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.
The following income statement activity summarize amounts included in discontinued operations for the years ended December 31, 2001:
The premium and discount on fixed maturities and collateralized mortgage obligations were amortized using the interest method. Amortization and accretion of premiums and discounts on collateralized mortgage obligations were adjusted for principal paydowns and changes in expected maturities. Investments in which a decline in market value was deemed other than temporary were reduced to the estimated realizable value through a charge to income.
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.
The following amounts have been deducted from PICO’s discontinued operations as a result of reinsurance ceded:
PAULA Financial 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 related to discontinued operations under the plan were $80 for the year ended December 31, 2001.