In September 1996, the Company subleased approximately 3,574 square feet of its Woodland Hills office space to a third party for a period of five years and eight months. In August 1995, the Company subleased approximately 3,000 square feet of its Woodland Hills office space to a third party for one year, subject to an additional one-year option. In May 1994, the Company subleased an additional 1,000 square feet of its Woodland Hills office to a third party for a period of three years, which was extended by an additional five years in 1996. Also, in March 1994, the Company subleased an additional 12,000 square feet of its Woodland Hills office to a third party for a period of five years.
In 1992, the Company started a project to design a new computer system. This system, which was completed in 1993, provides a more sophisticated, economical, and a better managed flow of information, as well as efficient insurance processing. This project included investment in electronic data processing equipment, as well as the development of proprietary software.
In 1995, the Company started a project to design a system to create electronic files of claim and policyholder information that would substantially decrease the need to access paper files. This system was completed in 1996. It allows for more efficient handling of claims and underwriting activities. The project included an investment in electronic data processing equipment, as well as software.
The Company increased its 1996 premium revenue base, through increased premium rates in California, and continued expansion into additional geographic areas. The Company managed underwriting expenses in 1996, to a level below 1995. As a result of continued negative cash flow during 1996, due to an overall erosion of premium rate levels in California from the 1995 beginning of statewide open premium rating, the Company sold investments during 1996 to meet cash flow needs, and realized capital gains from those sales.
During the fourth quarter of 1996, subsequent to the Company's November 20 distribution of a proxy statement to stockholders announcing a December 11 special meeting of stockholders to approve the acquisition by Superior, the California Department of Insurance ("Department") linked its approval of the acquisition with the completion of its triennial examination of Pacific Rim Assurance as of December 31, 1995. After taking into account the volatility of claims experience in prior accident years, due to the significant changes in legislative, economic, managed medical care, and other significant factors affecting loss and LAE reserves, Pacific Rim Assurance, in conjunction and consultation with its internal and independent actuaries, reached agreement with the Department to increase its loss and LAE reserves by a further amount of approximately $12,000,000 for accident years 1995 and prior, in its fourth quarter 1996 operating results. As a result of the increases to strengthen reserves, the Company reported significant losses in its results of operations for the third and fourth quarters of 1996 and the year ended December 31, 1996.
Net investment income decreased 13.3%, to $7,013,000 in 1996, from $8,089,000 in 1995. The amount of average invested assets decreased 12.4% to $118,400,000 for the year ended December 31, 1996, compared to 1995. This decrease in invested assets was the result of the Company experiencing negative cash flow from operations during 1995 and 1996. As a result, the Company sold securities, or utilized maturing securities, to meet its cash flow needs. The average yield on average invested assets was 5.9% for 1996, as compared to 6.0% for 1995.
Losses and LAE incurred increased by $28,933,000 during 1996, compared to 1995. The loss and LAE ratio increased to 92.4% during 1996, compared to 67.0% during 1995. During the nine months ended September 30, 1996, the Company increased total losses and LAE related to 1995 and prior accident years by approximately $5,600,000, including approximately $4,500,000 recognized during the third quarter of 1996. Based on the Company's internal actuarial analysis and input from its independent actuaries, the Company believed that its recorded loss and LAE reserves at September 30, 1996 were adequate and within the independent actuaries' reasonable range as of that date.
During the fourth quarter of 1996, the Department, in connection with its statutory triennial examination of Pacific Rim Assurance as of December 31, 1995, and its regulatory review prior to granting approval of the pending acquisition of the Company by Superior, undertook studies of the Company's loss and LAE reserves. Following extensive review by, and meetings with the Department, and giving recognition to the combined impacts on loss and LAE development patterns of the volatility in legislative, economic, managed medical care, litigation expense, and other significant factors, the Company, in conjunction and consultation with its internal and independent actuaries, reached agreement with the Department to increase its loss and LAE reserves by approximately $12,000,000 for accident years 1995 and prior in its fourth quarter 1996 operating results. The $12,000,000 increase was greater than the amount that was needed to be within the reasonable range of the Company's independent actuaries; but the Company believes the pending transaction with Superior could no longer be delayed, and Department approval was and is essential to completion of the transaction.
The reason for recognizing such adverse development was that during 1996, despite experiencing favorable trends in the overall frequency and severity of claims for the 1995 and 1996 accident years, the Company and its internal and independent actuaries observed development patterns in the 1990-1994 accident years that were volatile when compared to previous historical patterns. In particular, 1990-1992 were very difficult accident years, due to the impact of fraud and stress claims from adverse economic conditions, although the 1992 accident year began the transition to improved claims experience during the second half of the year. The 1993-1994 accident years were very favorable transition years, following legislative reforms to the workers' compensation benefits system. Nevertheless, it was unclear how each of those years ultimately would develop, and how subsequent accident year patterns would thus be affected, given paid loss and case reserve activity during 1996.
The Company has filed with the Department an independent actuarial opinion that states that the Company's loss and LAE reserves make reasonable provision for loss and LAE obligations of the Company as of December 31, 1996. While no assurance can be given, the Company believes that, given the inherent variability in any such estimates, its reserve for losses and LAE is within a reasonable range of adequacy. If the assumptions on which the estimates are based prove to be incorrect and reserves are insufficient based on the Company's actual experience, future results of operations and the financial condition of the Company would be adversely affected.
Total underwriting expenses decreased $2,086,000, or 6.9%, during 1996, compared to 1995. The decrease was primarily the result of a decrease in commissions paid to agents and brokers. The average commission rate to agents and brokers decreased to 14.1% for 1996, compared to 21.6% for 1995.
The general and administrative expense component of the Company's underwriting expenses increased by $1,708,000, or 14.6%, to $13,370,000 during 1996, from $11,662,000 during 1995. The increase in general and administrative expense was primarily due to the Company's recent expansion into other geographical areas and the related increased premium levels, as well as increased legal expenses related to certain industry lawsuits (see Legal Proceedings), and actuarial expenses related to the pending acquisition of the Company by Superior and the triennial examination by the Department. The ratio of general and administrative expenses to net premiums earned was 15.5% for 1996, compared to 15.3% for 1995.
The net loss for the year ended December 31, 1996 was $15,900,000, compared to net income of $575,000 for 1995.
1995 Compared to 1994 Net premiums earned during 1995 were $76,016,000, which represents a decrease of 18.2%. This decrease is the result of a state-mandated premium rate decrease of 16% on October 1, 1994, which affected earned premium revenues generated during 1995 from business originally written during the fourth quarter of 1994. Further, the beginning of statewide open premium rating for California workers' compensation insurance, effective January 1, 1995, created an intense level of price competition and an overall erosion of premium rate levels.
$787,000 through December 31, 1995. During August 1995, the Company received a Certificate of Authority to write workers' compensation insurance in the State of Texas, and it commenced operations in October. The Company's net premiums earned in Texas were $20,000 through December 31, 1995. In March 1996, the Company received a Certificate of Authority to write workers' compensation insurance in the State of Georgia. In addition, during September 1995, Pacific Rim Assurance filed an application to write workers' compensation insurance in the State of Florida. The Company also is considering the filing of applications in certain other states. The Company believes that geographic expansion will enable it to increase its premium revenues and operate regionally in more, and potentially less volatile, markets. However, there can be no assurance that such expansion will ultimately increase revenues or prove to be profitable.
Losses and LAE incurred decreased $12,831,000 for the year ended December 31, 1995 as compared to 1994. The loss and LAE ratio decreased to 67.0% in 1995 from 68.7% in 1994. The improvement in the losses and LAE was attributable to the continued favorable decline in the frequency of new claims during the first half of 1995, offset in part by higher frequency of new claims in the second half of 1995; a reduction in the overall number of outstanding claims; and a continued stable trend in the severity of claims.
Total underwriting expenses decreased 3.8% to $30,309,000 for the year ended December 31, 1995, from $31,492,000 for 1994. This decrease is primarily due to a decrease in premium volume. Commissions paid to agents and brokers during 1995 decreased by $614,000. However, the average commission ratio to agents and brokers increased to 21.6% for the year ended December 31, 1995 from 18.3% for 1994, due to the impact of highly competitive conditions on business written in the California workers' compensation insurance market during the third and fourth quarters of 1994 on premiums earned during 1995. New business written during 1995 was at a lower average commission rate than premiums written in the third and fourth quarters of 1994.
The general and administrative expense component of underwriting expenses decreased $265,000 or 2.2% to $11,662,000 in 1995 from $11,927,000 in 1994. This decrease is due to reduced employee staff costs and related expenses. The general and administrative expense ratio increased to 15.3% in 1995 from 12.8% in 1994 reflecting the Company's position to maintain a high quality of service personnel and agents, despite a decrease in premium volume.
The differences in the GAAP and statutory loss ratios, underwriting expense ratios, policyholder dividend ratios, and combined ratios for the periods presented are due primarily to GAAP permitting, but statutory accounting practices prohibiting or delaying, certain accruals. The statutory loss ratios differed from the GAAP loss ratios in 1994 primarily as a result of the cession of amounts under the Company's quota share and aggregate excess of loss reinsurance treaties. The statutory underwriting expense ratios are different than the GAAP underwriting expense ratios primarily as a result of the amortization of policy acquisition costs. The statutory policyholder dividend ratios differ from the GAAP policyholder dividend ratios because policyholder dividends are recognized for statutory purposes when declared and are accrued for GAAP purposes based on anticipated future declarations as the related premiums are earned.
assessing a property/casualty insurance company's financial condition. The lower the ratio, the less leveraged is the company.
In August 1994, the Company completed a capital-raising transaction and issued $20,000,000 of convertible debentures to PRAC, Ltd. ("PRAC"). As a result of the capital transaction, the Company increased the policyholders' surplus of Pacific Rim Assurance by $16,800,000. At December 31, 1996, the statutory-basis policyholders surplus of Pacific Rim Assurance was $27,215,652. Pacific Rim Assurance's ratio of net premiums written to policyholders' surplus for 1996, as determined on the basis of statutory accounting practices, was 3.22 to 1.
In the event that the Company is unable to complete the pending merger with Superior or raise additional capital from another party, a reduction in premium writings might be necessary, in order to meet regulatory leverage guidelines. If such premium reduction is necessary, the Company would have to substantially alter the nature and scope of its operations. Such changes might include staff and expense reductions, a change in the level of service provided to policyholders, and a change in the number and type of policyholders and agents with whom it currently does business. In addition, the Company likely would seek capital from other sources. No assurance can be given that such a plan can be successfully accomplished.
A workers' compensation insurance company must maintain sufficient liquid assets to meet its contractual obligations to policyholders, in addition to maintaining funds to meet ordinary operating expenses. The Company typically has several sources of funds to meet obligations, including cash flow from operations, interest from fixed-income securities, recoveries from reinsurance contracts, as well as the ability to sell portions of its investment portfolio. The Company has an investment portfolio of high quality, highly liquid, U.S. Treasury, other governmental agency, and corporate obligations. The Company's cash flows provided by (used in) operating activities for the years ended December 31, 1996, 1995, and 1994 were $(13,189,000), $(22,819,000), and $15,905,000, respectively. In light of the reduced level of premiums currently being written, due to state-mandated reductions in premium rates, and the repeal of the minimum rate law, coupled with claim payments required on premiums previously written, should further reduction in premium be necessary in the event that the Company is unable to complete the pending acquisition by Superior or obtain additional capital from another party, it is probable that the Company will experience a continued period of negative cash flow, until the level of loss payments decreases to the level proportionate to the level of premiums collected.
As a result of its ownership of debentures of Pac Rim Holding, PRAC, together with certain affiliated entities, is entitled to vote the equivalent of 55.2% of the Company's voting securities with respect to certain matters, and will be entitled to vote the equivalent of approximately 61.6% of the Company's voting securities as to those matters on exercise of Warrants. These voting rights, together with PRAC's right to designate certain members of the Board of Directors, give PRAC effective control of the Board of Directors and over all major corporate matters and transactions. It may also have the effect of discouraging certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of the Company's shares might otherwise receive a premium for their shares over then current market prices. These actions will have the effect, among other things, of limiting the ability of the Company to enter into certain significant transactions without the support of PRAC, and allowing PRAC to cause the Company to enter into certain transactions. These transactions may include transactions between PRAC, or its affiliates, and the Company, as well as transactions for the sale of the Company or the sale of control of the Company. PRAC may have interests that diverge from or conflict with those of the Company. Although such conflicts may arise, Directors designated by PRAC to the Board of Directors have a fiduciary responsibility to act in the Company's best interest.
In October 1995, FASB issued Statement No. 123, "Accounting For Stock-Based Compensation" which established a fair value based method of accounting for stock-based compensation plans. This statement is effective for financial statements with fiscal years beginning after December 15, 1995. The Company elected to continue accounting for stock-based compensation based on Accounting Principles Board (APB) No. 25; and thus, the Company adopted only the disclosure provision of FASB Statement No. 123.
Information with respect to this Item is incorporated by reference to the financial statements and supplementary data listed in Item 14 of Part IV of this report.