The Company's principal executive offices, comprised of approximately 34,000 square feet of office space leased through April 2003, are located in Pasadena, California. In addition, the Company maintains 16 branch offices in various locations in the western United States in leased facilities with various lease terms. Management believes that the Company's facilities are suitable and adequate for their intended uses.
of Operations and the Consolidated Financial Statements and notes thereto appearing elsewhere herein.
Revenue Recognition. Commission income is recorded on the effective date of the policy or the billing date, whichever is later. Premiums are earned by the insurance subsidiaries on a monthly pro rata basis over the terms of the policies.
Unpaid Losses and Loss Adjustment Expenses. 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. 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.
De-consolidation of PICO. As a result of the continued adverse loss experience, PICO recorded an additional provision for prior accident year loss reserves of $37 million in the fourth quarter of 2001. This reserve increase caused PICO's RBC to fall into the "Mandatory Control Level." As a result PICO and the California DOI entered into the Oversight Agreement which effectively transferred control of the underwriting operations to the California DOI. As a result, beginning in the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, PICO's balance sheet amounts are excluded from the consolidated financial statements at year-end and the consolidated operating results of the Company only reflect the result of PICO's operation in the individual income and expense line items for the first nine months of 2001 while the fourth quarter activity is reflected as equity in net loss of PICO. As of December 31, 2001, PAULA Financial is carrying its investment in PICO at $-0-.
The Company's expenses have consisted of losses and LAE 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. LAE 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 LAE are offset in part by estimated recoveries from reinsurers under 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.
PICO's revenues have been seasonal, and have tended to be highest in the second and third quarters of each year. This is due primarily to the seasonality of the size of the workforce employed by PICO's agribusiness clients.
The following table sets forth selected information relating to PICO's workers' compensation insurance book of business:
(1)Beginning in the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, gross premiums written and net premiums earned in the above table only reflect PICO's premium volume for the first nine months of 2001. The following combined ratio information is derived from the insurance subsidiaries, PICO and PACO, GAAP operating results:
The "Adjusted" column excludes the impact of low layer reinsurance treaties which were not in effect in 2001 or 2000.
Gross premiums written. The Company's gross premiums written for 2001 decreased 45.4% to $53.1 million from $97.4 million in 2000. The decrease in gross premiums written is due to a number of factors: (1) 2001 results only reflect nine months' activity for the underwriting operation (2) PICO ceased writing business in the state of Texas in November 2000 which accounts for $16.4 million of the decline and (3) California writings declined 33.9% due to PICO's pricing stance in the state. Since mid-1998, the Company aggressively pursued rate increases on its California book of business. Rate increases on business retained by the Company averaged 19% in 2001 and 25% in 2000.
Net realized investment gains and losses. The Company had net realized investment gains of $1.0 million for 2001 compared to net realized losses of $5.6 million for 2000. The 2001 results only include PICO net realized investment gains for the first nine months of 2001 compared to twelve months of activity in 2000. In 2001, PICO elected to realize a significant portion of the gain imbedded in its fixed income portfolio. In 2000, the Company recorded an impairment loss of $3.3 million related to its investment in Montlake.
Losses and LAE incurred. The Company's net loss ratio for calendar year 2001 decreased to 86.8% from 98.2% in 2000. The consolidated financial statements do not include the operations of PICO for the fourth quarter of 2001. In that period, PICO recorded a $37 million increase to prior year reserves.
Net income (loss). Net loss for 2001 was $31.3 million compared to $19.2 million in 2000. The 2001 net loss was due to the write down of PAULA Financial's investment in PICO to $-0- while the 2000 net loss was primarily attributable to actions taken to increase loss reserves on the prior accident years.
Commission income. Commission income increased 32.1% to $6.3 million for 2000 from $4.8 million for 1999. The increase is due to a full year's operating results for the two new California offices which were acquired effective April 30, 1999, rate increases on underlying workers' compensation and accident and health policies as well as increased premiums placed with insurance
carriers other than PICO and PACO. Commission income paid by PICO and PACO to Pan Am is eliminated in consolidation.
No dividends were paid by PICO to PAULA Financial during 2001. The Oversight Agreement restricts PICO's ability to pay dividends to PAULA Financial.
Since December 31, 2001, the Company has been out of compliance with certain of its debt covenants related to PICO matters. However, PAULA Financial has been and remains current on the term loan's scheduled principal and interest payments. On March 22, 2002, the Company received a waiver of the breach of covenants from the lender. According to the waiver the lender has waived all now existing and hereafter arising events of default resulting solely from PICO being placed on supervised status by the California DOI and the subsequent winding down of PICO's business. The Company believes that it will be able to maintain compliance with the revised covenants throughout 2002.
The Credit Agreement limits the Company's ability to (i) enter new lines of business; (ii) incur or assume debt; (iii) pay dividends and repurchase or retire capital stock; and (iv) make acquisitions, investments and capital expenditures. Under the terms of the Second Amendment, in the event of default in 2002, the interest rate would increase by 2.0%. Each of PAULA Financial's non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement. Additionally, the Company has pledged as collateral its stock in PICO.
On August 12, 1998, the Company announced the approval of the Board of Directors of a 500,000 share stock repurchase program. On October 29, 1998, the Board authorized an additional 500,000 shares bringing the total authorization under the program to 1,000,000 shares. As of December 31,
2001, the Company had repurchased 873,500 shares at an average price of $6.73 per share. Additionally, PICO holds 121,600 shares of PAULA Financial common stock in its investment portfolio.
The following is a summary of the Company's contractual obligations as of December 31, 2001:
PICO's major uses of funds were claim payments and underwriting and administrative expenses and maintaining the required surplus to expand its insurance business. In recent years, cash flows at PICO have been negatively impacted by declines in premium volume and increases in claim payments for prior accident years. In 2001, 2000 and 1999, PICO made claim payments on prior accident years totaling $83.1 million, $85.9 million and $53.3 million, respectively. The increase in prior year claims payments in recent years is related to increased premium volume in 1997 and 1998. 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. PICO's operating cash flows in 2000 were positively impacted by the receipt of a $42.0 million reinsurance settlement. Operating cash flows and the portion of the investment portfolio consisting of cash and liquid securities have historically met PICO's liquidity requirements. In the future, PICO believes that its liquidity needs will be met through investment income and releases of securities on deposit.
*Quarters do not add to full year due to changes in shares outstanding. New Accounting Standards
In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting and requires separate recognition of intangible assets that meet certain criteria. This statement applies to all business combinations after June 30, 2001. SFAS No. 142 requires that an acquired intangible asset be initially recognized and measured based on its fair value. This 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. SFAS No. 142 is effective for fiscal periods beginning after December 15, 2001. The Company continued to amortize existing goodwill through 2001, beginning in 2002 amortization will cease and the Company will perform a transitional goodwill impairment test. The Company has completed an analysis of the impact of the adoption of SFAS No. 142 and does not believe the adoption will have a material impact on the Company's consolidated financial statements.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. As the Company's decision to exit underwriting workers' compensation business was made in February 2002, the accounting for this decision is governed by SFAS No. 144. Application of the standard precludes the presentation of PICO's operations as discontinued operations due to the continuing involvement with PICO. (PICO continues to settle and pay claims.) Prior to the application of SFAS No. 144, PICO could have qualified as a discontinued operation allowing reclassification of prior year's financial statements to separate PICO's operating results and balance sheet accounts from those of the continuing operations.
We have audited the accompanying consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 2001 and 2000 and the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2001. 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.
On February 28, 2002, the Company announced that it would voluntarily cease underwriting workers' compensation insurance. The decision came as a result of claims reserve development primarily from claims relating to accident years 1997-1999 on California workers' compensation business. In the fourth quarter of 2001, PICO posted an increase to prior year reserves of $37 million. This reserve increase caused PICO's Risk Based Capital ("RBC") to fall into the "Mandatory Control Level." Consequently, on March 12, 2002, the Company and the California Department of Insurance ("California DOI") entered into an agreement of regulatory oversight ("Oversight Agreement"). See Note 2.
Invested cash consisted primarily of treasury and agency instruments with short durations.
Depreciation and amortization is provided over the estimated useful lives of the respective assets, primarily using the modified accelerated cost recovery system (which approximates the double-declining-balance method). Principal estimated useful lives used in computing the depreciation provisions are five years for automobiles and five to seven years for furniture and equipment.
Certain direct costs associated with the development of software for internal use were capitalized by PICO. Amortization on such amounts was provided on a straight-line basis over the estimated useful life of the software, generally five to seven years. Amortization began when the related project was substantially complete.
in Montlake using the equity method and as such recognizes its share of the net earnings or loss of the unconsolidated affiliate in its consolidated statement of operations.
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 $1,374 and $2,728 at December 31, 2001 and 2000, respectively.
recorded as a liability based on estimates of ultimate amounts expected to be declared by PICO's Board of Directors, at their discretion.
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. A valuation allowance is recorded to reduce deferred tax assets to the amount that is more likely than not to be realized.
The fair values of notes payable and note payable to bank are estimated using discounted cash flow analyses based on current market interest rates. The estimated fair values approximate the related carrying values.
excluded from the calculation of EPS-assuming dilution as the inclusion of such options would have an antidilutive effect.) There is no difference in the earnings used in the two calculations.
As a result of the continued adverse loss experience, PICO recorded an additional provision for prior accident year loss reserves of $37 million in the fourth quarter of 2001. This reserve increase caused PICO's RBC to fall into the "Mandatory Control Level." As a result, PICO and the California DOI entered into the Oversight Agreement which effectively transferred control of the underwriting operations to the California DOI. Consequently, beginning in the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. As a result, PICO's balance sheet amounts are excluded from the consolidated financial statements at year-end and the consolidated operating results of the Company only reflect the result of PICO's operation in the individual income and expense line items for the first nine months of 2001 while the fourth quarter activity is reflected as equity in net loss of PICO. As of December 31, 2001, PAULA Financial is carrying its investment in PICO at $-0-.
As of December 31, 2001, PICO's adjusted capital fell within the Mandatory Control Level. Consequently, on March 12, 2002, the Company and the California DOI entered into the Oversight Agreement. The Oversight Agreement generally provides that all of the ongoing operations of PICO are subject to California DOI under regulatory control. More specifically the Oversight Agreement provides, most significantly, that the California DOI will appoint a Special Deputy Examiner to provide supervision and regulatory oversight, limits PICO's ability to enter transactions with any affiliated company without the prior approval of the California DOI, restricts PICO's ability to pay dividends to PAULA Financial without prior approval of the California DOI and restricts PICO's ability to consummate transactions outside the normal course of business or to incur debt without prior approval of the California DOI. Additionally, PICO cannot write any new or renewal business of any type without the prior approval of the California DOI. The agreement remains in effect until PICO either receives written notice that it is released from the agreement or the agreement is superseded by an Administrative or Superior Court Order. Under the terms of the agreement, the California DOI can amend or supplement the agreement at its sole discretion.
In the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. As the Company has no further obligation to fund the deficit at PICO, PAULA Financial wrote down its investment in PICO to $-0- as of year end 2001.
The amortized cost and estimated fair value of fixed maturities classified as available for sale at December 31, 2001 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.
For the year ended December 31, 2001, California accounted for 56% of premiums earned.
Activity in the liability for unpaid losses and loss adjustment expenses for the year ended December 31, 2001 is summarized as follows:
The continued reserve development on prior accident years relates primarily to the 1998-2000 accident years. The adverse development relates primarily to the California operations. Similar to the claims development experienced by the California workers' compensation insurance industry in general, PICO has seen ongoing expansion in incurred claims values, primarily related to medical inflation and litigation activity. Also contributing to the adverse loss reserve development on the 1999 and 2000 accident years are the Texas operations.
At December 31, 2000, the gross unrealized investment loss on common stock is $573.
The consolidated financial statements do not include the operations of PICO in the individual income and expense line items for the fourth quarter of 2001. In that period, PICO recorded a $37 million increase to prior year reserves.
Since December 31, 2001, the Company has been out of compliance with certain of its debt covenants related to PICO matters. However, the Company has been and remains current on the term loan's scheduled principal and interest payments. On March 22, 2002, the Company received a waiver of the breach of covenants from the lender. According to the waiver the lender has waived all now existing and hereafter arising events of default resulting solely from PICO being placed on supervised status by the California DOI and the subsequent winding down of PICO's business.
Management believes that funds currently available and expense reimbursements and dividends from its non-regulated operating subsidiaries will be sufficient to meet the required principal and interest payments except for a portion of its January 1, 2003 balloon payment. The Company has plans to refinance the remaining portion of the obligation. Management believes that such financing is available and can be obtained under appropriate and reasonable terms.
The Company and its subsidiaries file a consolidated Federal income tax return. Income tax benefit for the years ended December 31, 2001, 2000 and 1999 is shown as follows:
In the ordinary course of business, PICO cedes insurance for the purpose of obtaining greater risk diversification and minimizing the maximum net loss potential arising from large claims. PICO, however, is contingently liable in the event that its reinsurers become unable to meet their contractual obligations.
Effective July 1, 2000, PICO entered into a variable rate quota share agreement with the Insurance Corporation of Hannover (ICH). For the years ended December 31, 2001 and 2000, PICO ceded 10% of policy year 2001 and 2000 earned premium to ICH. The contract with ICH was terminated effective January 1, 2002.
Effective January 1, 2001, PICO entered into a quota share agreement with Everest Reinsurance Company (Everest Re). Under the terms of the agreement, PICO will cede a minimum of 30% and has the option to cede up to a maximum of 50% of policy year 2001 earned premium to Everest Re. During the first six months of 2001, PICO ceded 50% of policy year 2001 earned premium to Everest Re. For the last six months of 2001, the quota share was adjusted to 30% of policy year 2001 earned premium. Effective January 1, 2002, the contract with Everest Re was canceled.
In September 1998, the Board of Directors adopted a Stockholder Rights Plan ("Rights Plan"). The Rights Plan provided for the distribution of one Right for each share of common stock outstanding on October 1, 1998. The Rights Plan provides that if any person acquires 10% or more of the Company's common stock, each Right (other than the Rights held by the 10% stockholder) will become exercisable to purchase PAULA common stock with a value equal to two times the Right's exercise price. In addition, if on or after such event the Company is merged out of existence or 50% or more of its assets or earning power are sold, each Right (other than Rights held by the 10%
stockholder) will become exercisable to purchase common shares of the acquiring corporation with a value equal to two times the Right's exercise price. The Rights expire in ten years unless previously triggered and are subject to redemption by the Board of Directors prior to being triggered.
Employees of the Company receive an annual year-end bonus. Amounts expensed under bonus programs were $569, $280 and $432 for the years ended December 31, 2001, 2000 and 1999, respectively.
In 1998, the Company implemented a key employee/consultant loan program which provides funds exclusively for the borrowers' purchase of Company stock. The Company has authorized loans of up to $1,000. The loans are full recourse, bear interest at the rate of 8.5% per annum, payable quarterly, have a three year maturity and are secured by the stock purchased. The loan program was reviewed and approved by the Compensation Committee of the Board of Directors. As of December 31, 2001 and 2000, the Company had extended loans in the principal amount of $570. Beginning in the second quarter of 2001 and extending through the end of 2002, the Company has granted an interest holiday to loan program participants. The carrying value of the related notes has been adjusted to reflect the discounted value of the loans. Loan balances under this program are reflected in the equity section of the accompanying consolidated financial statements.
In addition, 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 outside the plans 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 restricted stock generally vests over a two year period with one-third of the grant vesting immediately. The unvested portion of the restricted stock grant is included in unearned compensation in the accompanying consolidated financial statements.
The fair value for options granted in 2001, 2000, 1999 and 1998 was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions: risk free interest rate of 3.0% in 2001, 6.0% in 2000 and 1999 and 5.3% in 1998, 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 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 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.
Statutory accounting practices for the insurance subsidiaries are prescribed or permitted by California DOI. Prescribed accounting practices include a variety of publications of the National
Approximate aggregate minimum rental commitments under operating leases at December 31, 2001 are as follows:
In April 1999, the Company agreed to purchase the insurance agency assets of the Sacramento and Stockton, California offices of CAPAX Management & Insurance Services ("CAPAX") for $3,100. The Company funded the transaction with $1,470 in cash plus $1,156 in CAPAX securities held by the Company. The balance of $474 was due May 1, 2001 and was subject to a downward earnout adjustment. The acquisition was accounted for as an asset purchase.
A cost reimbursement allocation agreement among affiliates has been in effect since March 1, 1992 for administration, human resources, data processing services and facility utilization. Additionally, in 2001 the Company's TPA began providing operational services to PICO. Services performed by the TPA include claims adjudication, underwriting, policyholder services, business development and loss control. Under the terms of the agreement, in the fourth quarter of 2001 PICO made payments to affiliates totaling $1,899. In addition, PICO received reimbursements from affiliates of $73.
Additionally, the Company's agencies place business with PICO. Commissions received by affiliate agencies in the fourth quarter of 2001 totaled $761.
The following table provides information as to the Company's operating segments:
The "Other" column primarily includes information related to third party administration and parent company operations.