The Company's principal executive offices, comprised of approximately 34,000 square feet of office space leased through April 1999, are located in Pasadena, California. The Company holds an option to extend its home office lease through April 2004. In addition, the Company maintains 20 branch offices in various locations in the western United States and Florida in leased facilities with various lease terms. Management believes that the Company's facilities are suitable and adequate for their intended uses.
(1) See Note 1 of Notes to Consolidated Financial Statements for a description of the calculation of weighted average shares outstanding and earnings per share. (2) Investments as of December 31, 1993 are reflected at amortized cost. As of December 31, 1994, a portion of the portfolio was classified as held to maturity and was therefore reflected at amortized cost and the remaining portfolio was shown at market value. Investments as of December 31, 1995, 1996 and 1997 are reflected at market value. (3) National average for workers' compensation insurance companies. Source: A.M. Best; Best's Insurance Reports, Property/Casualty, 1997 edition. (4) Note that the figure for 1997 differs from the one included in the Company's March 3, 1998 press release. The figure in the press release was actually the number of PICO policies as of January 31, 1998. (5) "PICO Estimated Annual Premium" means, as of any date, the estimated total annualized premiums for all policies written by PICO in force on that date, whether earned prior to or after such date.
The Company's expenses have consisted of losses and loss adjustment expenses incurred, dividends provided for policyholders and operating expenses. Losses include reserves for future payments for medical care and rehabilitation costs and indemnity payments for lost wages. Loss adjustment expenses include expenses incurred in connection with services provided by third parties, including expenses of independent medical examinations, surveillance costs, and legal expenses as well as staff and related expenses incurred to administer and settle claims. Loss and loss adjustment expenses are offset in part by estimated recoveries from reinsurers under excess of loss reinsurance treaties. Operating expenses include commission expenses to third party insurance agencies and other expenses that vary with premium volume, such as premium taxes, state guaranty fund assessments and underwriting and marketing expenses, as well as general and administrative expenses, which are less closely related to premium volume.
The Company's premiums earned are affected by changes in the competitive and regulatory environment that impact workers' compensation insurance rates. Prior to January 1, 1995, California had required workers' compensation insurers to adhere to minimum rates approved by the California DOI. Under this system, price competition among insurers had been generally restricted to the payment of dividends under participating policies. Effective January 1, 1995, this system was replaced with a file and use rate system, in which insurers may use any rate after filing it with the California DOI unless such rate is specifically disapproved. The repeal of the former minimum rate system in California has resulted in increased competition among workers' compensation insurers in California and has caused a material decrease in average rates charged by PICO.
PICO's and PACO's operating expenses as a percentage of premiums are an important component of the Company's profitability. In this regard, the Company has benefited from recent growth. For the year ended December 31, 1997, PICO's and PACO's expense ratio improved 5.2 percentage points from 32.1% for 1996 to 26.9%.
NET REALIZED INVESTMENT GAINS. The Company had net realized investment gains of $0.2 million for 1997 compared to $0.4 million for 1996.
PREMIUMS WRITTEN. The Company's premiums written for 1996 increased 36.0% to $63.6 million from $46.8 million for 1995. The increase was primarily attributable to an increase in PICO's California writings of $11.4 million (an increase of 39.8%) principally from newly-appointed independent agencies and the establishment of the PTC, net of California reductions due to increased price competition, and an increase of PICO's Oregon writings of $4.8 million (an increase of 104.3%).
PREMIUMS EARNED. For the reasons described above for premiums written, the Company's premiums earned for 1996 increased 24.6% to $55.5 million from $44.5 million for 1995.
NET INVESTMENT INCOME. Net investment income decreased 2.4% to $4.7 million for 1996 from $4.8 million for 1995. The Company's average yield on its portfolio was 5.6% for 1996 compared to 5.8% for 1995, reflecting generally lower market interest rates in 1996 compared to 1995. Average invested assets increased $0.7 million to $83.6 million in 1996 from $82.9 million in 1995.
NET REALIZED INVESTMENT GAINS. During 1996, the Company sold $17.2 million of its invested assets and realized $0.4 million of investment gains. There were no material investment gains realized in 1995. During 1996, the Company repositioned $7.0 million of its portfolio into AAA-rated agency-backed collateralized mortgage obligations to increase yield.
LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's loss ratio for 1996 improved to 61.1% from 65.9% for 1995. The improvement in this ratio is due to several factors, including a reduction in the incidence and severity of workers' compensation claims and the expedited closing of claims. Losses for 1996 include the effect of recoveries from prior years' reserves of $2.6 million, or 4.8% of 1996 premiums earned, compared with prior year recoveries of $3.9 million for 1995, or 8.8% of 1995 premiums earned. The Company believes its loss
experience was improved by overall trends in the industry due to regulatory reforms, a reduction and capitation of the Company's claims related legal expenses, the implementation of early return to work programs by the Company's clients and an aggressive program by the Company to combat workers' compensation insurance fraud.
DIVIDENDS PROVIDED FOR POLICYHOLDERS. Dividends provided for policyholders decreased to $1.6 million in 1996 from $3.4 million in 1995 and decreased as a percentage of premiums earned for 1996 to 2.9% from 7.7% for 1995. 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 commencing in late 1995.
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, 1997, PAULA Financial would be able to receive $6.4 million in dividends in 1998 from its insurance subsidiaries without obtaining prior regulatory approval from the California DOI.
In March 1997, PAULA Financial entered into the Credit Agreement with a commercial bank providing PAULA Financial with a revolving credit facility of $15.0 million until December 31, 1999. As of March 15, 1998, no amounts were outstanding under this facility. At such time PAULA Financial may elect to convert all or a portion of the borrowings then outstanding under such facility into a term loan payable in quarterly
California workers' compensation insurance companies are required to maintain some of their investments on deposit with the California DOI for the protection of policyholders. Other states in which PICO is licensed have also required PICO to post deposits for the protection of those states' policyholders. Pursuant to applicable state laws, PICO had, as of December 31, 1997, securities with a book value of $65.4 million held by authorized depositories pursuant to these deposit requirements. In addition to the deposits, the insurance company operating subsidiaries must maintain capital and surplus levels related to premiums written and the risks retained by the subsidiaries.
The Company is currently working to resolve the potential impact of the year 2000 on the processing of date-sensitive information systems. The year 2000 problem is the result of the Company's and its vendors' computer programs being written using two digits (rather than four) to define the applicable year. Any of those programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures. The Company believes that it has identified substantially all of its application software programs which require modification in order to become year 2000
compliant and has a formal plan to correct and test the programs affected by the conversion from a two-digit year to a four-digit year. The Company expects the early phases of the project to be completed during late 1998. The final phases of the project is scheduled to be completed by the third quarter of 1999. The review of systems also included the identification of vendors that may have a significant impact on the Company's operations and their expected completion of any conversions. Based on preliminary information, costs of addressing potential problems are not currently expected to have a material adverse impact on the Company's financial position, results of operations or cash flows in future periods. However, if the Company or its vendors are unable to resolve such processing issues in a timely manner, it could result in a material financial risk. Accordingly, the Company plans to devote the necessary resources to resolve all significant year 2000 issues in a timely manner.
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 is effective for periods beginning after December 15, 1997, including interim periods. 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 has not determined the impact of SFAS 130.
Also, in June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). This statement specifies revised guidelines for determination of an entity's operating segments and the type and level of financial information to be disclosed. SFAS 131 is effective for periods beginning after December 15, 1997, including interim periods. The Company has not determined the impact of SFAS 131.
In 1995, the Company granted to employees 28,700 shares of restricted common stock for a total value of $259. Also in 1995, 9,500 shares were forfeited at a value of $86 (see note 9).
In November 1995, the Company acquired Desert Benefits, Inc. for a total purchase price of $700. Common stock was issued to settle $560 of the purchase price (see note 12).
In 1996, the Company purchased Guinn Sinclair Insurance Services for a total purchase price of $221. Common stock was issued to settle $176 of the purchase price (see note 12).
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, 1997, California, Arizona and Oregon accounted for 70%, 13% and 11%, respectively, 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.
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., Agri-Comp Insurance Agency, Inc. and PAULA Trading Company Insurance Agents and Brokers, Inc. (insurance brokerages); Pan Pacific Benefit Administrators, Inc. (third-party administration operation); PAULA Mexico S.A. de C.V.; PAULA Insurance Company (casualty insurance); and PAULA Assurance Company (group accident and health and life insurance). All significant intercompany balances and transactions have been eliminated in consolidation.
Where necessary, prior years' information has been reclassified to conform to the 1997 presentation.
On November 21, 1995, the Company transferred its entire held-to-maturity portfolio to available-for-sale. The amortized cost at the transfer date was $37,508. The transfer resulted in an unrealized gain of $396, net of the tax impact. The transfer was made in accordance with implementation guidance provided in the Financial Accounting Standards Board's Special Report, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities."
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 $766 and $1,140 at December 31, 1996 and 1997, respectively.
The liability for unpaid losses and loss adjustment expenses represents (a) case basis estimates of reported losses and loss adjustment expenses and (b) estimates based on past experience of unreported losses and loss adjustment expenses, net of anticipated salvage and subrogation. Management believes that the provisions for losses and loss adjustment expenses are adequate to cover the net cost of incurred losses and loss adjustment expenses; however, the liability is by necessity based on estimates, and accordingly, there can be no assurance that the ultimate liability will not differ from such estimates.
The insurance subsidiaries underwrite workers' compensation, accident and health and life insurance policies. Participating workers' compensation policies represented approximately 89%, 84%, and 84% of net written premium for the years ended December 31, 1995, 1996 and 1997, 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. Given the efficient levels of up-front pricing and current reserve levels, the Company does not anticipate paying significant additional policyholder dividends on 1997 and prior policy years.
The following table reconciles the weighted average shares of common stock outstanding used in the EPS calculation to that used in the EPS - assuming dilution calculation. There is no difference in the earnings used in the two calculations.
Investments in fixed maturities are all held in investment grade securities. Fair values were obtained from published securities quotation services.
The amortized cost and estimated fair value of fixed maturities classified as available for sale at December 31, 1997 by the earlier of the pre-escrowed date or contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Unrealized investment gains (losses) on preferred stock at December 31, 1996 and 1997 are as follows:
Aggregate annual commitments under notes payable are as follows at December 31, 1997:
At December 31, 1996, the Company had an unsecured line of credit with a commercial bank of $10,500. As of December 31, 1996, the Company had drawn $7,490 on the line of credit. The interest rate on the line of credit was based on various indices. The average interest rate at December 31, 1996 was 7.8%. The line of credit required no principal payments during its term and matured December 31, 1998. The line of credit imposed certain financial covenants.
The following amounts have been deducted in the accompanying consolidated financial statements as a result of reinsurance ceded:
In August 1994, the Company completed a private placement of 941,177 shares of Series A - convertible preferred stock. Gross proceeds of $16,000 were received from three institutional investor groups which obtained the stock for their own portfolios or investment funds. In addition to a cash commission paid in connection with the private placement, the Company issued warrants to purchase 164,706 shares of common stock at the fair market value at the date of issuance of $8.50 per share to the placement agents.
On September 23, 1997, the Company declared a two-for-one stock split effected in the form of a dividend to stockholders of record on September 23, 1997. All data with respect to equity classification, earnings per share and share information, including price per share, where applicable, in the consolidated financial statements and notes thereto have been retroactively adjusted to reflect the split.
The Company maintains a defined contribution employee stock ownership plan (ESOP) covering all full-time employees, excluding hourly employees. The ESOP has assets principally comprised of 1,094,126 shares of the Company's common stock at December 31, 1996 and 1997. The Company can make annual contributions to the ESOP in cash or shares of the Company's common stock in amounts determined by the Company's Board of Directors, except that such contributions must be in cash to the extent the ESOP requires liquid funds to meet its obligations. The Company expensed cash contributions of $150, $150 and $125 in the years ended December 31, 1995, 1996 and 1997, respectively.
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 $208, $208 and $224 for the years ended December 31, 1995, 1996 and 1997, respectively.
Employees of the Company receive an annual year-end bonus based upon the profitability of the Company. Amounts expensed under bonus programs were $427, $1,053 and $1,068 for the years ended December 31, 1995, 1996 and 1997, 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 determined by the Executive Compensation Committee of the Board of Directors.
1,400 and 1,150 shares in 1995, 1996, and 1997, respectively, were forfeited based upon voluntary termination. No restricted stock was granted in the year ended December 31, 1997.
At December 31, 1997, 28,000 shares of common stock were available for issuance under the plan.
The fair value for these options 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 reflects only options granted in 1995 and 1996. During the initial phase-in period of Statement 123, the full impact of calculating compensation cost for stock options is not reflected
in the pro forma net income 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 insurance subsidiaries are required to file statutory financial statements with state insurance regulatory authorities. Accounting practices used to prepare these statutory financial statements differ from generally accepted accounting principles (GAAP). Such differences include the following: (1) reserves for losses and loss adjustment expenses must meet certain minimum requirements, (2) reserves for policyholder dividends are recorded as a restriction on surplus until declared, (3) Federal income taxes are recorded when payable, (4) fixed maturities are carried at admitted values, (5) certain assets are non-admitted and (6) acquisition expenses are expensed when incurred. Amounts reported to regulatory authorities as compared to amounts included in the accompanying consolidated financial statements on a GAAP basis for the years ended December 31, 1995, 1996 and 1997 follow:
Statutory accounting practices for the insurance subsidiaries are prescribed or permitted by the Department of Insurance of the State of California. Prescribed accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state and may change in the future. Furthermore, the National Association of Insurance Commissioners has a project to codify
statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project will likely change the definition of what comprises prescribed versus permitted statutory accounting practices and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory 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 2002. Certain of these leases contain renewal provisions. Certain of these leases are with related parties. Rent expense was $1,483, $1,657 and $1,613 for the years ended December 31, 1995, 1996 and 1997, respectively. Included in rent expense is rent paid to related parties of the Company totaling $230 and $149 and $52 for the years ended December 31, 1995, 1996 and 1997, respectively.
Approximate aggregate minimum rental commitments under operating leases at December 31, 1997 are as follows: