The Company’s principal executive offices, comprised of approximately 4,500 square feet of office space leased through May 2005, are located in Pasadena, California. In addition, the Company maintains 14 branch offices in various locations in California and Arizona in leased facilities with various lease terms. Management believes that the Company’s facilities are suitable and adequate for their intended uses.
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 of America. 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.
Amounts related to discontinued operations in 2002 primarily relate to the write off of PICO receivables and employee severance costs associated with the discontinuance of PICO operations.
Net investment income. Net investment income is comprised of interest income on various trustee savings accounts. Net investment income decreased 89.2% to $17,000 for 2002 from $158,000 for 2001. The decline is due to a combination of a lower interest rate environment and less funds being held in these interest bearing accounts.
Salaries and related expenses. Salaries and employee benefits increased 24.8% to $8.0 million for 2002 from $6.4 million for 2001. The increase is due to two primary factors: the transfer of selected employees from PICO’s payroll to Pan Am in early to mid-2002 and the addition of new employees beginning in July 2002.
Operating expenses. Operating expenses decreased 8.8% to $4.2 million for 2002 from $4.6 million for 2001. The decrease is primarily due to a decline in amortization expense as the related intangible was fully amortized at the end of 2001.
The net deferred tax asset is the amount the Company believes is more likely than not to be realized and is adjusted based on anticipated future operating results and various tax planning strategies. In 2002, changes in the tax law made available for recovery certain alternative minimum tax payments made for years which were previously closed.
Salaries and related expenses. Salaries and related expenses increased 7.2% to $6.4 million for 2001 from $6.0 million for 2000. The increase is due to increased compensation costs under Pan Am’s variable compensation structure, as commission income increases, the associated compensation costs increase.
Interest expense. Interest expense decreased 55.9% to $672,000 for 2001 from $1.5 million for 2000. The decrease is due to a decline in the outstanding balance of the related notes payable. As of the beginning of 2000, note payables had a balance of $16.6 million which was reduced to $12.9 million at the beginning of 2001 and further reduced to $4.1 million by the end of 2001.
Net income (loss). Net loss for 2001 was $31.3 million compared to $19.2 million in 2000. The net loss in both years was primarily due to loss from discontinued operations.
Historically, the sources of funds of the agency operations are cash flows from operating activities and the major use of funds is operating expenses. In the most recent years, operating cash flows at Pan Am have met the agency subsidiaries’ liquidity requirements as well as a substantial portion of the parent company’s cash flow requirements, including debt service requirements.
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 $1.3 million, $1.1 million and $1.0 million for the years ended December 31, 2002, 2001 and 2000, 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 forStock Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock basedemployee 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 2002, approximately 93% of the Company’s agency commission revenue was generated in the state of California compared to 89% in 2001. In 2002, approximately 45% of commission revenue was derived from the workers’ compensation line of business compared to 52% in 2001.
As discussed further in Note 9 - Discontinued Operations, prior to 2002 the Company also underwrote workers’ compensation insurance through its subsidiary PAULA Insurance Company (“PICO). Additionally, in 2001, the Company liquidated its investment in PAULA Assurance Company (“PACO”) and surrendered its insurance license to the state of California. Prior to the liquidation, the Company wrote limited group medical products through PACO. Agri-Comp Insurance Agency, Inc. and PAULA Mexico S.A. de C.V. are inactive subsidiaries.
Where necessary, prior years’ information has been reclassified to conform to the 2002 presentation.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and revenues and expenses for the period. Actual results could differ significantly from those estimates.
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 when known.
In early 1999, the Company made an investment in Montlake Insurance Holdings, LLC (“Montlake”), the parent company of Montlake Casualty Company, Ltd., a specialty workers’ compensation insurance company. The Company made an initial investment of $5,500 for a 21% equity position. The Company accounted for its investment in Montlake using the equity method. Based on Montlake’s unfavorable 2000 operating results, the Company recorded an impairment loss of $3,273 to reduce the carrying value of its investment in Montlake to $-0- as of December 31, 2000. In 2002, Montlake was liquidated.
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.
As required by SFAS 142, the Company has completed an annual goodwill impairment test on its reporting units and has determined that each of its reporting units has a fair value in excess of its carrying value. Accordingly, no goodwill impairment has been recorded.
Beginning on January 1, 2002, the Company ceased recording goodwill amortization in accordance with SFAS 142. The following table reconciles reported net earnings and net earnings per share to adjusted net earnings and net earnings per share:
Other intangible assets, which consist mainly of contracts not to compete and expiration lists, are amortized on a straight-line basis over periods not to exceed seven years. At December 31, 2002 and 2001, other intangible assets were $2,739 and $2,816, respectively, less accumulated amortization of $1,683 and $1,294, respectively. Aggregate amortization expense for the years ended December 31, 2002 and 2001 was $389 and $725, respectively. Estimated amortization expense for the next five years is $332 in 2003, $288 in 2004, $288 in 2005, $266 in 2007 and $10 in 2008.
The fair values of financial instruments are estimates of the fair values at a specific point in time using appropriate valuation methodologies. These estimates are subjective in nature and involve uncertainties and significant judgment in the interpretation of current market data. Therefore, the fair values presented are not necessarily indicative of amounts the Company could realize or settle currently. The Company does not necessarily intend to dispose of or liquidate such instruments prior to maturity.
Comprehensive income (loss) includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. In 2001 and 2000, 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.
Stock options to purchase 20,000 shares that were outstanding as of December 31, 2002 were not included in the computation of earnings per share for 2002 and 2001 as inclusion of such shares would be antidilutive.
In December 2002, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123”. (“SFAS 148”) SFAS 148 amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock based employee compensation. In addition, SFAS 148 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 above.
In the accompanying consolidated financial statements, operating activity related to workers’ compensation underwriting have 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 Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets” (“SFAS 144”).
On March 31, 1997, the Company entered into a $15,000 unsecured line of credit with a commercial bank. On December 31, 1999, the Company elected to convert all of the borrowings into a term loan maturing on December 31, 2000. At the date of conversion, the line of credit had an outstanding balance of $15,000.
On December 31, 2001, the Company and the lender completed negotiations and signed a second Amendment to the Credit Agreement (the “Second Amendment”). Under the terms of the Second Amendment, the Company made principal payments totaling $1,300 during 2002 with the remaining principal balance of $2,750 due on January 1, 2003.
On December 31, 2002, the Company and the lender completed negotiations and signed a third Amendment to the Credit Agreement (the “Third Amendment”). Under the terms of the Third Amendment, the loan balance will be paid over the next two years with the final principal payment due January 1, 2005. Balances outstanding under the term loan bear interest at the lender’s reference rate plus 2.0%. As of March 7, 2003, the interest rate was 6.25%.
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:
The Company received Federal income tax refunds of $92, $672 and $326 during the years ended December 31, 2002, 2001 and 2000, respectively.
At December 31, 2002, the Company had a tax net operating loss carry forward of $82,341 that begins to expire in 2018.
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 for continuing operations under the plan were $154, $177 and $103 for the years ended December 31, 2002, 2001 and 2000, respectively.
Employees of the Company receive an annual year-end bonus. Amounts expensed under bonus programs related to continuing operations were $95, $360 and $33 for the years ended December 31, 2002, 2001 and 2000, 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, 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, 2002 and 2001, the Company had outstanding loans in the principal amount of $450 and $570, respectively. 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 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, 2002, 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, 2002, 313,310 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.
There were no changes in the status of options granted under the 1994 plan for 2002. Changes in the status of options granted under the 1994 plan for 2001 and 2000 are summarized as follows:
There were no changes in the status of options granted outside the plans for 2002. Changes in the status of options granted outside the plans for 2001 and 2000 are summarized as follows:
Subsequent to the liquidation order, the Company provided limited operational support to PICO. For example, the Company provided payroll and human resource department support into the third quarter of 2002 and Pan Am had inforce premiums on PICO’s books until all policies were cancelled in July 2002. Subsequent to that date there was on-going involvement with PICO related to the separation of previously commingled locations. Given the continued activity with PICO through the third quarter of 2002, the Company was precluded from treating PICO as a discontinued operation for accounting purposes. In the fourth quarter of 2002 the requirements of SFAS 144 for treating a segment as a discontinued operation were met. Consequently, the accompanying consolidated financial statements for current and prior periods have been adjusted to reflect the operations of PICO as discontinued operations.
Realized gains and losses on sales of investments were computed on the specific-identification basis.
There was 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 also caused actual developments to vary from the past.
As previously discussed, PICO was de-consolidated in the fourth quarter of 2001, consequently, the above schedule only includes activity through September 30, 2001. In the fourth quarter of 2001, PICO recorded a $37 million increase to prior year reserves.
The unfavorable incurred development for prior periods in 2000 in the liability for unpaid losses and loss adjustment expenses was principally due to reserve development on the 1998 accident year. The continued development on the 1998 accident year was largely attributable to extended claim durations for the California book of business. To a lesser extent, the 1999 accident year also had adverse reserve development, principally related to experience in Texas.
Participating workers’ compensation policies represented approximately 25% of net written premium for the years ended December 31, 2001 and 2000. Dividends were recorded as a liability based on estimates of ultimate amounts expected to be declared by PICO’s Board of Directors, at their discretion.
The maximum retention for each loss occurrence on workers’ compensation policies was $250 subject to $2,000 in annual aggregate losses on the $250 excess $250 layer. In July 2000, PICO modified the terms of the deductible from a fixed $2,000 to 2.0% of earned premium.
Additionally, the Company’s agencies placed business with PICO. As of December 31, 2002 the agencies had commissions receivable from PICO totaling $481. The Company intends to pursue all available avenues for recovering such balances but given the nature of the receivable the Company has established a valuation allowance for the full amount of the outstanding balance. The expense associated with this allowance is included in discontinued operations for the year ended December 31, 2002.
In 2001, the shareholders elected to the Company’s board of directors Mr. James G. Parker, III who also has a significant ownership interest in an agency that placed business with PICO. Commissions paid by PICO to this agency were $603 and $814 for the years ended December 31, 2001 and 2000, respectively.
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 and $185 for the years ended December 31, 2001 and 2000, respectively.