These changes are a result of the November 20, 1996 merger of Physicians Insurance Company of Ohio and a subsidiary of Citation Insurance Group, in which Physicians Insurance Company of Ohio was the surviving corporation. Upon consummation of the Merger, Citation Insurance Group changed its name to PICO Holdings, Inc. For accounting purposes the transaction has been treated as a reverse acquisition with Physicians Insurance Company of Ohio being the acquiror. As a result, these financial statements reflect prior years data of Physicians Insurance Company of Ohio and its subsidiaries and affiliates only. Citation Insurance Group's information for 1995 and operating results and account balances prior to the Merger have not been included in these financial statements. See Note 3 to the Consolidated Financial Statements entitled "Acquisitions" for further information on the accounting treatment of the reverse acquisition.
On August 1, 1995, Physicians purchased Sequoia, a California property and casualty insurance company writing light commercial and multiple peril insurance in northern and central California. Sequoia does not write MPL insurance.
On September 5, 1995, Physicians purchased 38.2% of the common stock of GEC, a Canadian company operating in portfolio investments, agricultural services, and other business segments. Through acquisitions on July 30 and August 19, 1997, the Company increased its ownership in GEC to an aggregate of approximately 51.17%. As a result of such acquisition, GEC's financial statements have been consolidated with those of the Company for 1997.
On November 20, 1996, Physicians and its subsidiaries merged with a subsidiary of CIG and CIG then changed its name to PICO Holdings, Inc. This reverse acquisition brought another California property and casualty insurance company, CIC, into the affiliated group and provided a non-insurance holding company structure.
Shareholders' equity per share increased $0.12 during 1997, principally as a result of the $19.5 million net income, partially offset by a $14.6 million reduction in unrealized appreciation of investments, net of taxes from January 1, 1997 through December 31, 1997. Shareholders' equity per share calculated on an undiluted basis at December 31, 1997 was $3.73, compared to $3.61 and $3.04 at December 31, 1996 and 1995, respectively. Prior years per share amounts have been adjusted to reflect the November 1996 merger. Shareholders' equity of $112.2 million increased $1.9 million, or 1.8% compared to $110.2 million at December 31, 1996.
Much of the 1997 decline in unrealized appreciation of investments resulted from the sale of appreciated securities during the year. Realized investment gains provided $21.4 million in revenues and income before taxes and minority interests in 1997, compared to $27.1 million and $5.0 million in 1996 and 1995, respectively. Realized investment gains during 1997 included a gain of approximately $2 million from the sale of the Company's holdings in AmVestors Financial Corporation common stock during the first quarter; approximately $27 million from the sale of the Resource America common stock during the third quarter; and a realized investment loss of approximately $8 million, before minority interests, resulting from the write down of GEC's investments in Korean securities, including a foreign currency loss of approximately $3.8 million (See "PORTFOLIO INVESTING--GLOBAL EQUITY CORPORATION" following).
Revenues of $87.6 million increased $10.9 million over 1996 and $46.5 million over 1995. Property and casualty insurance revenues increased $21.7 million over 1996 and nearly $55 million over 1995. CIC added $21.0 million and $6.5 million to revenues in 1997 and 1996, respectively, following the Merger. Sequoia's 1997 revenues were $35.4 million, up $6.7 million from 1996 and up $33 million from the five-month period of inclusion in 1995. GEC provided $1.5 million in revenues during 1997 which was more than offset by approximately $8.0 million in realized investment losses. GEC was not consolidated with the Company in 1996 and 1995. MPL revenues decreased $8.3 million during 1997 as compared to 1996 and more than $25 million compared to 1995 due to the reduction in earned premiums associated with the wind down of the business.
The Company's ongoing operations are organized into five segments: portfolio investing: surface, water, geothermal and mineral rights; property and casualty insurance; medical professional liability insurance, and other operations. GEC's portfolio investing results are shown separately below for consistency of presentation and to simplify analysis since GEC's results were not consolidated with those of PICO until the effective date of the Company's majority ownership of GEC. In addition, as a result of the acquisition of the majority ownership of GEC and management's strategic initiatives, the surface, water, geothermal and mineral rights activities of PICO and GEC have been disclosed as a segment in this annual report. Life and health insurance operations and certain of GEC's operations are shown as discontinued operations based upon the sale or pending sale of those operations. See Note 6 of Notes to Consolidated Financial Statements, "Discontinued Operations" for additional information.
Portfolio investing operations are principally conducted by PICO, Physicians and GEC. GEC's portfolio investing results are shown separately in the following section. Investment revenues and realized investment gains or losses generated by Physicians are first allocated to MPL equal to the amount of loss reserve discount accretion recorded during the period. The remainder is shown as portfolio investing revenue.
Excluding GEC, which is stated separately below, portfolio investing revenues for 1997 of $30.6 million increased $3.6 million over the $27 million recorded in 1996 and $22.6 over the $8 million of 1995. Excluding realized investment gains, portfolio investing increased approximately $700,000 over 1996 and decreased $1.7 million as compared to 1995. The increase in 1997 investment income over 1997 principally reflects investment income earned by PICO on dividends from Physicians. The decline in 1996 investment income compared to 1995 was principally due to a significant shift in the mix of the Company's investment portfolio from interest bearing fixed maturity and cash equivalent securities toward equity securities. See "PART 1 - BUSINESS-HISTORY OF THE COMPANY-Physicians."
At December 31, 1997, the consolidated investment portfolio was in a net unrealized loss position of approximately $2.7 million, net of taxes. This compares to net unrealized investment gains at December 31, 1996 of approximately $11.8 million. Much of this decline resulted from the conversion of unrealized investment gains to realized investment gains resulting from the sale of the Company's holdings in Resource America common stock during the third quarter of 1997 and AmVestors Financial Corporation ("AmVestors") common stock at a gain of $1.3 million, net of tax, during the first quarter of 1997. Unrealized investment gains, net of taxes, at December 31, 1996 attributable to Resource America and AmVestors were approximately $9.4 million and $1.2 million, respectively. PC Quote, one of the Company's technology stocks and a provider of real time and delayed stock market quotes continued to decline in value during 1997. The Company has provided a loan of $2.5 million and a line of credit of approximately $2 million, and received certain warrants for the purchase of PC Quote common stock as an inducement, to provide working capital and other funds necessary for PC Quote to continue to develop and market its products.
Most of GEC's $6.5 million in combined revenues and realized investment losses and $10.1 million loss before taxes and minority interest resulted from an approximate $8 million write down of GEC's investments in Korean securities. This permanent write down reflects management's opinion that the decline in the market value of these securities is "other than temporary" and includes a loss on foreign currency exchange of approximately $3.8 million. These Korean investments were heavily impacted by the recent downturn in the Korean and Asian financial markets. GEC's investment in these Korean securities as of December 31, 1997, subsequent to the write down, is less than $1.0 million.
See "DISCONTINUED OPERATIONS" below regarding GEC's contribution to income from discontinued operations.
Sequoia and CIC account for all of the ongoing property and casualty ("P & C") insurance revenues. These companies write predominately light commercial and multiple peril insurance coverage in central and northern California. CNIC is no longer a part of the group following the sale of CNIC on June 30, 1997 along with CIC's workers compensation business.
As shown below, earned premiums made up most of the P & C revenues. Premiums are earned pro-rata throughout the year according to the coverage dates of the underlying policies.
P&C income before taxes for 1997 amounted to $5.6 million, an increase of $2.3 million or 67% over the 1996 level of $3.3 million. CIC added approximately $300,000 to the 1997 increase due to its inclusion for a full year. Sequoia's income before taxes increased $2.0 million from 1996 to 1997. Most of Sequoia's improvement was attributable to greatly improved claims experience. As shown below, Sequoia's GAAP industry combined ratio declined 5.5 percentage points during 1997. The P&C loss before taxes for 1995 of $3.7 million included only five months of Sequoia's income and none of CIC's. Much of Sequoia's five-month 1995 loss was attributable to expenditures that may provide benefits in future years through improved operating efficiencies. These expenses included, among others, those associated with development of a new policy quoting and processing system and integrated claims processing and accounting systems. Software was developed and is now in use which allows underwriters and agents to decentralize, rate policies in the field, and download the information via modem to the home office, allowing them to spend much more time in the field inspecting risks and servicing policies.
Sequoia's direct premium writings for 1997 were $41.0 million, up $3.3 million from the $37.7 million reported for 1996 and down slightly from the $42.0 million reported by Sequoia for the full year 1995. The $42.0 million of 1995 direct written premium included seven months of activity prior to Physicians' purchase of Sequoia on August 1, 1995. This reduction in premium writings in 1997 and 1996 reflects, in part, the increased underwriting selectivity of Sequoia's management team. Sequoia and CIC stress quality of business over quantity. As policies came up for renewal in 1995 and through much of 1996, they were reviewed carefully by underwriting management for excessive loss experience and unwanted risks. New policy writings have been less than expected, largely due to increased competition, and have not offset renewal policies cancelled or non-renewed. The loss of renewal policies with higher loss ratios and greater exposures to risk may improve Sequoia's loss ratios in the future. Nevertheless, there can be no assurance that Sequoia and Citation will be successful in reducing their policies with higher loss ratios or that their loss ratios will improve in the future.
Physicians' and PRO's MPL insurance business was sold to Mutual on August 28, 1995. Except for a few minor policy coverage extensions and adjustments which are 100% reinsured by Mutual, for all intents and purposes, the Company ceased writing MPL policies effective January 1, 1996. The Company continues to administer and adjust the remaining claims and LAE reserves. Based upon careful analysis of various alternative scenarios for handling the runoff of the remaining claims reserves, the Company determined that the best option was to process the existing claims internally with existing staff, rather than through a third party administrator or through an outright sale of the claims and LAE reserves. In addition, it is expected that shareholders' equity may be better served by retaining the investments necessary to fund the payment of these claims and LAE reserves, managing them along with the rest of the Company's investment holdings, as opposed to selling or fully reinsuring these reserves and giving up the corresponding funds. However, there can be no assurance that funds generated by such retained investments will exceed claims. Accordingly, although the Company ceased writing MPL insurance, MPL is treated as a separate business segment of continuing operations due to the continued management of claims and associated investments.
Revenues and pre-tax income or loss from MPL operations included the following:
Since the withdrawal of Physicians and PRO from their personal automobile and homeowners lines of business in the late 1980's, MPL has, for all intents and purposes, been these two companies' only sources of insurance premiums. Earned premium steadily declined from $17.1 million in 1995 to $7.4 million in 1996 and slightly less than $240,000 in 1997.
The following table shows the decline in Physicians' and PRO's direct written premiums over the past five years:
MPL operations produced pre-tax operating income of approximately $765,000 in 1997 compared to income of $8.5 million and $6.0 million during 1996 and 1995, respectively. Results for 1997 were negatively impacted by a $2 million addition to loss and LAE reserves. This addition to reserves during the third quarter of 1997 was based upon an actuarial analysis as of June 30, 1997 which indicated some unfavorable loss experience had occurred during the first six months of 1997. Pre-tax operating results for 1996 were aided by a $1.4 million reduction in MPL death, disability and retirement unearned premium reserves related to the Mutual transaction, and loss and LAE reserve reductions of approximately $6.0 million due to continued favorable development of MPL reserves. The $6.0 million pre-tax operating income recorded during 1995 was equal to the $6.0 million realized on the sale of Physicians' and PRO's MPL businesses. Investment income was also higher in 1996 and 1995 due to greater reserve levels and higher loss reserve discount accretion.
Greatly reduced earned premiums, somewhat lower investment income, and certain non-recurring expense accruals associated with the MPL claims runoff were responsible for the remainder of the decline in pre-tax MPL income from 1996 to 1997.
Although MPL reserves are certified annually by two independent actuaries, as required by Ohio insurance regulations, significant fluctuations in reserve levels can occur based upon a number of variables used in actuarial projections of ultimate incurred losses and LAE.
Other operations consists principally of Summit's investment management operations, the wind down of Raven Development Company's ("Raven") real estate development projects, and various other activities as summarized below:
Revenues from other operations decreased from $2.2 million in 1996 and $1.6 million in 1995 to approximately $100,000 in 1997. Nearly all this decline resulted from the wind down of real estate operations of Physician's subsidiary, Raven, which saw virtually no activity in 1997. The remainder of Raven's real estate holdings was sold in early 1998. Raven's real estate activity is minimal, generally consisting of wind down costs.
Other operations produced an approximate $700,000 pre-tax loss for 1997 compared to pre-tax losses of $1.1 million and $0.5 million in 1996 and 1995, respectively.
APL, Physicians' wholly-owned life insurance subsidiary, produced revenues of $5.3 million and a pre-tax loss of $112,000 during 1997. This compares to $9.0 million and $6.8 million in revenues and $4.0 million and approximately $859,000 million in pre-tax income in 1996 and 1995, respectively. Revenues and income before tax for 1996 included realized investment gains of approximately $3.9 million from the sale of APL's investment in Fairfield Communities common stock.
On June 16, 1997, Physicians announced the signing of a binding agreement to sell APL subject to certain closing conditions including regulatory approval, which are still pending. See "HISTORY OF THE COMPANY--Developments Since the Merger" regarding the pending sale of APL and its wholly owned subsidiary.
GEC has elected to treat its Sri Lankan operations as discontinued in recognition of their sale in November and December 1997. These operations produced approximately $3.3 million in pre-tax income during 1997 as recorded in GEC's financial results, prior to the elimination of minority interests when consolidated with PICO. This included approximately $3.5 million of realized pre-tax gain in 1997 on the sale and reversal of a foreign currency translation adjustment relating to those operations of approximately $2.3 million, prior to recognition of minority interest. See Note 6 of Notes to the Consolidated Financial Statements, "Discontinued Operations."
PICO's principal sources of funds are its available cash resources, bank borrowings, public financings, repayment of subsidiary advances, funds distributed from its subsidiaries as tax sharing payments, management and other fees, and borrowings and dividends from its subsidiaries.
It is expected that each of PICO's major subsidiaries currently within the group will be able to stand on its own and cover its own cash flow needs without the need for long-term borrowing or additional capital infusions, with the possible exceptions of additional capital requirements of Sequoia and CIC to maintain or improve their Best ratings or to meet minimum capital requirements. Physicians contributed an additional $5.5 million to Sequoia in 1997 for this purpose. However, from time to time funds may be needed to cover short-term operating shortfalls (i.e. timing differences) or to expand the Company's operations (principally through investments and/or acquisitions) both at the subsidiary level and at the parent company level. Additional funding may be generated through, among other avenues, disposition or transfer of existing assets, issuance of additional capital stock through a public offering, or through a public debt offering or other borrowing.
Disregarding any appreciation or depreciation of Physicians' investment portfolio and the results of the operations of its subsidiaries and affiliates, on a stand alone basis Physicians should experience a decline in total assets and total liabilities as a result of the payment of claims, loss adjustment expenses and operating expenses. Absent unfavorable loss experience and operating and other expenses in excess of investment income, shareholders' equity should remain relatively unaffected. Income in excess of expenses, favorable claims experience, appreciation of investments and increases in the equities of subsidiaries and affiliates all would increase shareholders' equity and, ultimately, total assets.
PICO management hopes to maximize the return of all assets, including those needed to fund the eventual wrap-up of the MPL reserves through, among other things, value investing and managing the invested assets internally rather than liquidating assets to pay a third party to oversee the runoff of the existing claims. Management also elected to handle the runoff of the MPL claims internally to continue to maintain a high standard of claims handling and to maximize shareholder values. While management expects that certain of the Company's current and future investments may increase in value, offsetting some of the decline in assets during the period of runoff and increasing shareholder value, the impact of future market fluctuations on the value of the Company's invested assets cannot be accurately predicted. Although assets will be managed to mature or liquidate according to expected payout projections, at times, in response to abnormal funding demands, some invested assets may need to be sold at inopportune times during periods of decline in the stock market or declines in the market values of the individual securities. Such forced sales are expected to occur infrequently and only under extreme circumstances; however, this cannot be guaranteed.
As previously mentioned, reinsurance recoveries (reimbursement of covered losses from reinsurers) will be a significant source of incoming funds in upcoming years as claims are settled. As shown in the accompanying financial statements, consolidated reinsurance receivables amounted to $75.0 million at December 31, 1997 compared to $97.0 million at December 31, 1996. Physicians' and PRO's reinsurance receivables were $38.0 million at December 31, 1997 and at December 31, 1996. Of the $37 million difference between the $75.0 million consolidated total at December 31, 1997 and the $38.0 million of Physicians and PRO, $30.3 million was recorded on Sequoia's financial statements, most of which is due from SRC and guaranteed by QBE. See "ITEM 1 - -BUSINESS--HISTORY OF THE COMPANY." Of the remainder, $6.7 million resulted from the inclusion of CIC.
As an additional source of funding, PICO's subsidiaries as they grow and accumulate increasing amounts of retained earnings may be able to return some of PICO's investment in the form of dividend distributions; however, this cannot be assured. On December 30, 1997, Physicians paid a dividend of $13.2 million to PICO in the form of GEC stock. This dividend was the maximum dividend that could be paid under Ohio insurance regulations without specific approval by the Ohio department.
As shown in the accompanying Consolidated Statements of Cash Flows, the Company used cash flows of $62.1 million for operations in 1997 and $10.8 million in 1996, compared to $15.1 million in 1995. Cash consumed by operations in 1997 increased $51.2 million over 1996 and $46.9 million over 1995. The increase in cash used for operations as compared to 1996 and 1995 included increased MPL claims and expense payments, federal, foreign and state income tax payments, and the inclusion of CIC in the consolidated group. Net cash used for operating activities consisted of $49.3 million from Physicians, $2.2 million from PRO, $13.7 from CIC, $1.6 million from PICO, and $11.8 million from others, including a $9.7 million reclassification of APL's cash and cash equivalents to discontinued operations on the balance sheet at December 31, 1997. Net cash provided by operating activities included $9.2 million from Sequoia and $7.3 million from GEC.
Cash provided by investing activities in 1997 of $68.1 million principally reflects fixed income securities maturities and sales and investment gains realized from the sale of Resource America, Inc. and AmVestors. Cash provided from investing activities was $31.4 million and $37.6 million in 1996 and 1995, respectively
The Company continues to address the issue of the compatibility of systems software with the year 2000. Insurance premium, loss and statistical systems are particularly critical to the successful operation of the insurance companies. It is believed that the majority of these systems, which are different among the various insurance companies, currently accept the year 2000 logic. The MPL insurance systems are known, however, to be incompatible. Projects are under way to test all insurance systems and correct the logic of these systems to make them compatible with the year 2000. Other operating systems consist of various accounting, billing, disbursement, and tracking systems which may or may not be compatible with the year 2000. For the most part, these systems are in the process of being updated by their vendors. Tests will be run to ensure the compatibility of these systems, also. Management expects these projects to be completed by the end of 1998. In addition to resources expended in researching and correcting systems, additional outlays may be necessary to purchase and install new software that is compatible with the year 2000. The estimated costs of this project are undetermined at this time.
The Company's principal sources of funds are its available cash resources, operating cash flow, liquidation of non-essential investment holdings, bank borrowings, public debt and equity offerings, advances and repayment of balances between subsidiaries and PICO, funds from consolidated tax savings, investment management and other fees, and borrowings. During August 1997, GEC issued new common stock of 25 million shares, raising more than $44.0 million in funds, net of costs. At December 31, 1997, the Company had $56.4 million in cash and cash equivalents compared to $64.6 million and $44.0 million at December 31, 1996 and 1995, respectively.
In addition to the risks and uncertainties discussed in the preceding sections of "Management's Discussion and Analysis of Financial Condition and Results of Operations," the following risk factors are also inherent in the Company's business operations:
Application of Physicians' new strategy since 1995 has resulted in a greater concentration of equity investments held by Physicians, and, consequently, the Company. Market values of equity securities are subject to changes in the stock market, which may cause the Company's shareholders' equity to fluctuate from period to period. At times, the Company may come to hold securities of companies for which no market exists or which may be subject to restrictions on resale. As a result, periodically, a portion of the Company's assets may not be readily marketable.
INTEGRATION OF CERTAIN OPERATIONS. CIG and Physicians completed the Merger with the expectation that the Merger would result in certain benefits for the combined company. Achieving the anticipated benefits of the Merger will depend in part upon whether certain of the two companies' business operations can be integrated in an efficient and effective manner. There can be no assurance that this will occur or that cost savings in operations will be achieved. The successful combination of the two companies will require, among other things, integration of the companies' respective product offerings, medical management of health care claims and management information systems enhancements. The difficulties of such integration may be increased by the necessity of coordinating geographically separated organizations. The integration of certain operations following the Merger will require the dedication of management resources which may temporarily distract attention from the day-to-day business of the combined companies. There can be no assurance that integration will be accomplished smoothly or successfully. Failure to effectively accomplish the integration of the two companies' operations could have an adverse effect on the Company's results of operations and financial condition following the Merger.
DEPENDENCE ON KEY PERSONNEL. The Company has several key executive officers, the loss of whom could have a significant adverse effect on the Company. In particular, Ronald Langley, PICO's Chairman, and John R. Hart, PICO's President and Chief Executive Officer, play key roles in the Company's and GEC's investment decisions. Messrs. Langley and Hart have entered into employment agreements with PICO and a wholly-owned subsidiary of GEC as of December 31, 1997. Messrs. Langley and Hart are key to the implementation of the Company's new strategic focus, and the ability of the Company to implement its current strategy is dependent on its ability to retain the services of Messrs. Langley and Hart.
Under Ohio law the statute of limitations is one year after the cause of action accrues. Also under Ohio law there is a four-year statutory time bar; however, this has been construed judicially to be unconstitutional in situations where the plaintiff could not have reasonably discovered the injury in that four-year period. Claims of minors must be brought within one year of the date of majority.
The future financial results of the insurance subsidiaries could be adversely affected by disputes with their respective reinsurers with respect to coverage and by the solvency of such reinsurers. None of the Company's insurance subsidiaries is aware of actual or potential disputes with any of their respective reinsurers that could materially and adversely impact the financial results of the Company, or is aware of any insolvent reinsurer whose current obligations to CIC, Physicians, PRO, APL, or Sequoia are material to such companies.
GLOBAL DIVERSIFICATION OF INVESTMENTS. As a result of global diversification, investment decisions already made and which may be made in the future, particularly with regard to GEC, the Company's revenues may be adversely affected by economic, political and governmental conditions in countries where it maintains investments or operations, such as volatile interest rates or inflation, the imposition of exchange controls which could restrict the Company's ability to withdraw funds, political instability and fluctuations in currency exchange rates.
FLUCTUATIONS IN HISTORICAL OPERATING RESULTS, P & C RESERVES. PICO's operating results over the past five years have been volatile. During the past several years, the levels of the reserves for PICO's insurance subsidiaries have been very volatile. As a result of its claims experience and the level of existing reserves with respect to its P & C insurance business, CIC has had to significantly increase these reserves in four of the past six years.
There can be no assurance that significant increases with respect to the reserves for the P & C business will not be necessary in the future, that the level of reserves for PICO's insurance subsidiaries will not be volatile in the future, or that any such increases or volatility will not have an adverse effect on PICO's operating results and financial condition.
A.M. BEST RATINGS. A.M. Best ("Best") has assigned Sequoia a rating of B++ (Very Good) and APL has had a Best rating of B+ (Very Good) since 1983. CIC was recently upgraded from a B- (Adequate) to a B+ (Very Good) by Best. Physicians and PRO are currently rated, and have been for a number of years, NR-3 (rating procedure inapplicable). Best's ratings reflect the assessment of A.M. Best and Company of the insurer's financial condition, as well as the expertise and experience of management. Therefore, Best ratings are important to policyholders. Best ratings are subject to review and change over time. Failure to maintain or improve their Best ratings could have a material adverse effect on the ability of the insurance companies to write new insurance policies, as well as potentially reduce their ability to maintain or increase market share. Management believes that many potential customers will not insure with an insurer that carries a Best rating of less than B+, and that customers who do so will demand lower rate structures. There can be no assurance that any of the insurance companies' ratings will be maintained or increased.
The Company's financial statements as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997 and the independent auditors' reports are included in this report as listed in the index on page 45 of this report.
We have audited the accompanying consolidated balance sheet of PICO Holdings, Inc. and subsidiaries as of December 31, 1997, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for the year ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We did not audit the 1997 consolidated financial statements of Global Equity Corporation (all expressed in Canadian dollars), a 51.17% owned consolidated subsidiary, which constitutes 42% of consolidated total assets as of December 31, 1997. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Global Equity Corporation (all expressed in Canadian dollars), is based solely on the report of such other auditors. The consolidated balance sheet of the Company as of December 31, 1996, and the related consolidated statements of income, shareholders' equity, and cash flows for the years ended December 31, 1996 and 1995 were audited by other auditors whose report, dated April 7, 1997, expressed an unqualified opinion on those statements.
We have audited the consolidated balance sheet of PICO Holdings, Inc. and subsidiaries as of December 31, 1996 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the two years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
PICO Holdings, Inc. and subsidiaries (the "Company") is predominately an insurance and investment company specializing in commercial property and casualty insurance; portfolio investing; surface, water, geothermal and mineral rights; medical professional liability insurance and other services (Note 19). Surface, water, geothermal and mineral rights has been added as a segment for this annual report based on recent acquisitions and management's strategic initiatives. As discussed in Note 3, Physicians Insurance Company of Ohio consummated a reverse merger transaction on November 20, 1996 with a wholly owned subsidiary of Citation Insurance Group, with Physicians Insurance Company of Ohio being the accounting acquirer. Pursuant to the merger, each outstanding share of the Common Stock of Physicians Insurance Company of Ohio was converted into the right to receive 5.0099 shares of Citation Insurance Group common stock. Upon the consummation of the merger, Citation Insurance Group changed its name to PICO Holdings, Inc. ("PICO"), which is the continuing registrant. Any references to "the Company" herein as of dates or for periods prior to the merger, refer to Physicians Insurance Company of Ohio and its subsidiaries, which included Summit Global Management, Inc. prior to the consummation of the merger. The Company's principal subsidiaries as of December 31, 1997 are as follows:
- Global Equity Corporation ("GEC"). GEC is a publicly held corporation and is listed on the Toronto Stock Exchange and The Montreal Exchange under the symbol "GEQ". The Chairman of the Board of Directors ("Chairman") and the Chief Executive Officer ("CEO") of the Company are the Chairman and CEO of GEC, respectively. The Company acquired an approximate 38% ownership in GEC on September 5, 1995. The Company increased its ownership in GEC to approximately 49.9% on July 30, 1997 and to approximately 51.17% on August 19, 1997 (Note 3). As a result, GEC has been included in the consolidated accounts of the Company for 1997. The Company previously accounted for GEC utilizing the equity method of accounting wherein the Company's share of GEC's net income or loss was included in the equity in earnings (losses) of investee on the statements of income.
APL provides life and health insurance coverage in a number of states and is shown as discontinued operations due to a definitive agreement entered into on June 16, 1997 to sell APL and its wholly owned subsidiary, Living Benefit Administrators Agency, Inc.
CIC and its wholly-owned subsidiary, CNIC, were acquired November 20, 1996 through a reverse acquisition (Note 3). CIC writes commercial property and casualty insurance in Arizona, California, Colorado, and Utah. Prior to July 1997, CIC wrote workers compensation insurance. However, as discussed in Note 3, the Company entered into a Letter of Intent in January 1997 and sold CNIC and all of the net assets related to CIC's workers' compensation business effective June 30, 1997. Such net assets are reflected in the accompanying consolidated balance sheet as of December 31, 1996 as "Net Assets of Acquired Business Held for Sale." CNIC previously wrote commercial property and casualty insurance primarily in the state of California, but ceased writing new business effective December 1994. For the years ended December 31, 1997 and 1996, approximately 72% and 89%, respectively, of CIC's direct written premiums were in California. Consequently, CIC's and Sequoia's operating results are expected to be largely dependent on their ability to write profitable insurance in California.
GEC is a Canadian corporation engaging in strategic investment; surface, water, geothermal and mineral rights; and other services, operating primarily in the United States, but also with operations in Canada, Asia, Europe, and the Caribbean. At times, GEC may come to hold securities of companies for which no market exists or which may be subject to restrictions on resale. As a result, a portion of GEC's assets may not be liquid. Furthermore, as a result of its global diversification with respect to existing investments, GEC's revenues may be adversely affected by economic, political and governmental conditions in countries where it maintains investments or operations, such as volatile interest rates or inflation, the imposition of exchange controls which could restrict or prohibit GEC's ability to withdraw funds, political instability and fluctuations in currency exchange rates.
Raven Development Company is a real estate development company in Ohio. It is in the process of withdrawing from all real estate development activities and is currently involved in only one development in Ohio.
The following is a description of the significant accounting policies and practices followed in the preparation of the Company's consolidated financial statements:
The estimated fair value of fixed maturity and equity securities other than those carried at equity is based upon quoted market prices or dealer quotes for comparable securities
A decline in the market value of any available for sale security below cost that is deemed other than temporary is charged to earnings and results in the establishment of a new cost basis for the security (Note 4).
Surface, Water, Geothermal and mineral rights are carried at cost. This cost includes, when applicable, costs directly related to acquisition, and interest and other costs directly related to developing the assets for their intended use.
Premiums on ordinary and group life contracts, including critical illness, are recognized when due, and premiums on accident and health contracts are recognized over the contract period. Unearned premiums have been principally calculated using the monthly pro rata method, resulting in the earning of premiums evenly over the terms of the policies.
The Company's income tax expense includes deferred income taxes arising from temporary differences between the tax and financial reporting bases of assets and liabilities. The liability method of accounting for income taxes also requires the Company to reflect the effect of a tax rate change on accumulated deferred income taxes in income in the period in which the change is enacted.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions 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 for each reporting period. The significant estimates made in the preparation of the Company's consolidated financial statements relate to the assessment of the carrying value of unpaid losses and loss adjustment expenses, future policy benefits, deferred policy acquisition costs, deferred income taxes and contingent liabilities. While management believes that the carrying value of such assets and liabilities are appropriate as of December 31, 1997 and 1996, it is reasonably possible that actual results could differ from the estimates upon which the carrying values were based.
Certain amounts in the financial statements for prior periods have been reclassified to conform with the 1997 presentation.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". SFAS No. 131 establishes standards for disclosure about operating segments in annual statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise". The new standard becomes effective for the Company for the year ending December 31, 1998, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. The Company does not expect this pronouncement to materially change the Company's current reporting and disclosures.
On November 20, 1996, Physicians consummated a transaction (the "Merger") pursuant to which Citation Holdings, Inc. ("Holdings"), a wholly owned subsidiary of Citation Insurance Group ("CIG"), merged with and into Physicians pursuant to an Agreement and Plan of Reorganization dated as of May 1, 1996 with Physicians being the accounting acquiror. Pursuant to the Merger, each outstanding share of the common stock of Physicians was converted into the right to receive 5.0099 shares of CIG's common stock. CIG's other significant direct and indirect subsidiaries just prior to the merger were CIC and CNIC. Upon the consummation of the merger, CIG changed its name to PICO Holdings, Inc., which is the continuing registrant.
As a result of the Merger, the former shareholders of Physicians own approximately 80% of the outstanding common stock of the Company and control the Board of Directors of the Company. Accordingly, for accounting purposes, the merger has been treated as a recapitalization of Physicians with Physicians as the acquirer (i.e., a reverse acquisition). Therefore, the statements of income, changes in shareholders' equity and cash flows of the year ended December 31, 1995 represent the historical results of Physicians and its subsidiaries, which is the predecessor entity. Physicians' equity as of December 31, 1995 and the changes in its equity for the year ended December 31, 1995 have been retroactively recapitalized for the equivalent number of shares of PICO Holdings, Inc.'s common stock received in the merger transaction. The difference between the par value of Physicians' and PICO Holdings, Inc.'s common stock has been added to additional paid-in capital.
The allocation of the purchase price was adjusted as of December 31, 1997 to reflect changes from the estimates made as of December 31, 1996. These changes in estimates did not affect the purchase price; however, the net result was a decrease in negative goodwill from $6,293,084 estimated at December 31, 1996 to $5,679,853 recorded as of December 31, 1997.
The difference between the carrying amount of the net assets of CIC's workers compensation line of business at the date of sale and the actual proceeds from such sale resulted in a reallocation of the purchase price of CIG of $3,652,894. This amount differed from the $2,864,092 estimated as of December 31, 1996 by $788,802.
The unaudited pro forma results for 1996 have been prepared for comparative purposes and do not purport to be indicative of the results of operations which actually would have resulted had the combinations been in effect on January 1, 1996 or of future results of operations of the consolidated entity.
On August 26, 1997 CIC purchased 113,743 newly issued shares of The Physicians Investment Company ("PIC") and Sequoia purchased 40,162 newly issued shares of PIC. The purchase price was $56.26 per share.
On July 1, 1997, Sequoia purchased all of the outstanding shares of MacCready & Gutmann Insurance Services Nevada, Inc., a licensed Nevada insurance agency, for $550,000 in cash and other considerations.
Included above are fixed maturity investments with an estimated fair value of $52,467,790 that have been classified as net assets of acquired business held for sale on the consolidated balance sheet as of December 31, 1996.
The amortized cost and estimated fair value of investments in fixed maturities at December 31, 1997, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Approximately $26.8 million of the total gross realized gains for the year ended December 31, 1997 were generated from the conversion of the Company's Resource America, Inc. warrants and the immediate sale of the converted common stock. As of December 31, 1997, GEC recorded a permanent write down of $8.0 million (of which approximately $3.8 million represented the realization of accumulated foreign currency translation adjustments recorded by GEC) in the value of its investment in Korean securities in recognition of what is expected to be an other than temporary decline in the market value of those securities. The value of these securities was sharply impacted by the recent decline in the Korean financial market This write down has been recorded as a realized loss. In 1996, approximately $26.0 million of the total gross realized gains for the year resulted from the sale of the Company's Fairfield Communities, Inc. common stock in November 1996.
The GAAP book value assigned to such net assets at December 31, 1997 of $15,949,989 was based upon the net book value of APL as of December 31, 1997 as determined on the basis of generally accepted accounting principles. The primary remaining assets and liabilities of APL as of that date were investments, cash and cash equivalents, and accident and health insurance reserves. The Company expects to realize a small gain on the sale.
Following is an unaudited summary of APL's stand alone financial results for the periods included in the statements of income as discontinued operations in the accompanying financial statements:
Because these subsidiaries represent a major segment of GEC's business, in accordance with Accounting Principles Board Opinion No. 30 "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business," these companies' operations for the year ended December 31, 1997 have been classified as discontinued operations. Operating results for 1996 and 1995 are not shown since these periods were prior to the effective date of consolidation of GEC and PICO.
Income tax expense (benefit) from continuing operations consists of the following for each of the years ended December 31:
Depreciation expense was $872,969, $751,000, and $589,000 in 1997, 1996, and 1995, respectively.
The difference between the December 31, 1996 ending balance of $7,921,570 and the January 1, 1997 beginning balance of $5,377,339 is equal to the amount of deferred policy acquisition costs attributable to 1997 discontinued operations of APL.
11. SHAREHOLDERS' EQUITY (ALL SHARE AMOUNTS HAVE BEEN RESTATED TO GIVE EFFECT TO THE STOCK EXCHANGE RATIO UTILIZED IN CONNECTION WITH THE REVERSE ACQUISITION OF CIG (NOTE 3):
In December 1993, the Company issued 7,156,997 common shares (adjusted for the merger exchange rate) to Guinness Peat Group plc for $5,000,000. In accordance with their original stock purchase agreement, Guinness Peat Group plc was entitled to purchase additional common shares at a price based upon the average closing bid price of the stock for a period prior to the date of notice of intent to buy up to an aggregate purchase price of $5,000,000. In June 1994, the Company issued 3,164,147 common shares (adjusted for the merger exchange rate) to Guinness Peat Group plc for $3,000,000, increasing their ownership to approximately 40%.
The Company sponsors various stock-based incentive compensation plans (the "Plans"). The Company applies APB Opinion No. 25 and related interpretations in accounting for the Plans and, therefore, does not recognize any compensation cost related to such plans. In 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation . Adoption of the cost recognition provisions of SFAS No. 123 is optional and the Company has decided not to elect these provisions of SFAS No. 123. However, pro forma disclosures of the impact on the Company's net income and earnings per share for the years ended December 31, 1997, 1996 and 1995 as if the Company adopted the cost recognition provisions of SFAS 123 are presented below.
Unsecured reinsurance risk is concentrated in the companies shown in the table below. The Company remains contingently liable with respect to reinsurance contracts in the event that reinsurers are unable to meet their obligations under the reinsurance agreements in force.
As more fully described in Note 3, immediately prior to the sale of Sequoia to Physicians by SRC, Sequoia and SRC entered into a reinsurance treaty whereby all policy and claims liabilities of Sequoia prior to the date of purchase by the Company are the responsibility of SRC. Payment of these reinsurance liabilities has been unconditionally and irrevocably guaranteed by QBE Insurance Group Limited.
The following is a summary of the net effect of reinsurance activity on the consolidated financial statements for 1997, 1996, and 1995:
The method of discounting utilized by Physicians is based on historical payment patterns and assumes an interest rate at or below Physicians' investment yield, and is the same rate used for statutory reporting purposes. Physicians uses a discount rate of 4%. The carrying value of MPL reserves gross as to reinsurance was approximately $108.7 million, net of discounting of $12.5 million at December 31, 1997 and $141.8 million, net of discounting of $15.5 million at December 31, 1996.
The regulations of the Departments of Insurance in the states where the Company's insurance subsidiaries are domiciled generally restrict the ability of insurance companies to pay dividends or make other distributions. Based upon statutory financial statements filed with the insurance departments as of December 31, 1997, $16.0 million was available for distribution by the Company's wholly-owned insurance subsidiaries to the parent company without the prior approval of the Department of Insurance in the states in which the Company's insurance subsidiaries are domiciled, through December 29, 1998. The total eligible distributions in 1998 are approximately $29.2 million. On December 17, 1997, PRO paid a dividend of approximately $5.5 million to Physicians in cash. A dividend payment of $13,212,593 was made on December 30, 1997 from Physicians to PICO Holdings, Inc. in the form of GEC common stock.
The Company leases some of its offices under noncancellable operating leases which expire through February 2001. Total rental expense for the years ended December 31, 1997, 1996 and 1995 was $1,470,301, $1,714,265 and $395,239, respectively. Future minimum rental payments required under the leases are as follows:
The Company is subject to various litigation which arises in the ordinary course of its business. Based upon information presently available, management is of the opinion that such litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company.
Summit is a Registered Investment Advisor providing investment advisory services to managed accounts including the Company's subsidiaries. Although dormant for several years, Summit commenced active operations on January 1, 1995. On January 1, 1995, Summit's President and CEO was granted an option expiring December 31, 2004 to purchase 49% of Summit's common shares for a nominal amount, which represented the fair value of such options on the grant date. No options have been exercised under this agreement. Two of the Company's directors were instrumental in establishing the operations of Summit and are entitled to receive 50% of the first $1,000,000 of profits attributed to Physicians' ownership of common stock. No compensation was paid to each of those directors under this arrangement in 1997, 1996, or 1995. Effective January 1, 1996, Summit entered into a contract to provide investment management services to Physicians, PRO, Sequoia, APL, and Separate Accounts A and B of APL. Summit also entered into a contract to provide investment management services to CIC on December 1, 1996.
On September 26, 1995, the same two directors of the Company, who are also officers and directors of GEC, were granted options by GEC to purchase up to 1,549,833 shares of common stock of GEC at an exercise price of $2.50 (Cdn.) per share, which was the closing market price of GEC shares on the Toronto Stock Exchange on the date of grant. Such options are immediately exercisable. In addition, on October 24, 1995, each was granted options by GEC to purchase 950,167 additional shares of common stock of GEC at an exercise price of $2.45 (Cdn.) per share. All of these options are exercisable.
On December 30, 1996, Physicians paid a dividend of approximately $13.2 million to its sole shareholder, PICO. On April 14, 1997, Physicians paid a dividend of approximately $8.6 million to PICO. With the approval of the Ohio Department, on November 19, 1997, PRO amended its license to delete the authority to write MPL insurance and on December 17, 1997 paid a dividend of approximately $5.5 million to its sole shareholder, Physicians. On December 17, 1997, Physicians contributed an additional 5.5 million to Sequoia. On December 30, 1997, Physicians paid a dividend of approximately $13.2 million to PICO in the form of 5,557,347 shares of GEC common stock.
The Company and its insurance subsidiaries are subject to regulation by the insurance departments of the states of domicile and other states in which the companies are licensed to operate and file financial statements using statutory accounting practices prescribed or permitted by the respective Departments of Insurance. Prescribed statutory accounting practices include a variety of publications of the NAIC, as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Physicians has received written approval from the Ohio Department of Insurance to discount its MPL unpaid loss and loss adjustment expense reserves, including related reinsurance recoverables using a 4% discount rate. Statutory practices vary in certain respects from generally accepted accounting principles. The principal variances are as follows:
The Company and its wholly owned insurance subsidiaries' net income (loss) for the years ended December 31, 1997, 1996 and 1995 and policyholders' surplus as of December 31, 1997, 1996, and 1995 on the statutory accounting basis are as follows:
Certain insurance subsidiaries are owned by other insurance subsidiaries. In the table above, investments in such subsidiary-owned insurance companies are reflected in statutory surplus of both the parent and subsidiary-owned insurance company. As a result, at December 31, 1997, 1996, and 1995, statutory surplus of approximately $37,768,506, $38,423,146 and $25,937,298, respectively, is reflected in both the parent and subsidiary-owned insurance companies.
At December 31, the principal industry segments are as follows (in thousands):
Summarized unaudited financial data for 1997 and 1996 are shown below. In management's opinion, the interim financial data contains all adjustments, consisting of only normal recurring accruals, necessary for a fair presentation of results for such interim periods. Prior period amounts have been adjusted to conform to the current period presentation, including reclassification for discontinued operations, and adjustment to shares and net income (loss) per share values due to the Merger.