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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-23181
PAULA FINANCIAL
(Exact name of registrant as specified in its charter)
DELAWARE 95-4640368
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) identification number)
PAULA FINANCIAL
300 NORTH LAKE AVENUE, SUITE 300
PASADENA, CA 91101
(Address of principle executive offices)
(626) 304-0401
(Registrant's telephone number, including area code)
Securities Registered pursuant to Section 12(b) of the Act:
NONE
Securities Registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
(Title of Class)
RIGHTS TO PURCHASE PREFERRED STOCK, $0.01 PAR VALUE
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
--- ---
(Cover page 1 of 2 pages)
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
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The aggregate market value of the voting stock held by nonaffiliates of
the registrant was $36,635,594 as of March 15, 1999.
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
As of March 15, 1999, the registrant had outstanding 5,928,967 shares of
Common Stock, $0.01 par value.
DOCUMENTS INCORPORATED BY REFERENCE
1. The information called for by Part III, Items 10, 11, 12 and 13 of this
report are incorporated herein from the Company's Proxy Statement for its
1999 Annual Meeting of Stockholders.
2. A number of the exhibits to this Report called for by Part IV, Item 14 are
incorporated herein from the Company's Registration Statement on Form S-1
(Reg. No. 333-33159) filed on August 8, 1997, from Amendment No. 1 thereto,
and from the Company's Quarterly Report on Form 10-Q for the quarter ending
September 30, 1998.
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2
PART I
ITEM 1. BUSINESS
THE COMPANY
The Company is a California-based specialty underwriter and distributor of
commercial insurance products which, through its subsidiary PAULA Insurance
Company ("PICO"), is one of the largest underwriters specializing in workers'
compensation insurance products and services for the agribusiness industry. The
Company began operations in 1946 as an insurance agency providing workers'
compensation and group medical employee benefits to agribusiness employers in
underserved rural markets. In 1974, PICO was formed to underwrite the workers'
compensation portion of the business distributed by Pan American Underwriters,
Inc. ("Pan Am"), the Company's insurance agency. The Company's other principal
subsidiary is PAULA Assurance Company ("PACO"), a life and health carrier. The
Company transacts all of its business in the United States.
WORKERS' COMPENSATION SYSTEM
Workers' compensation is a statutory system under which an employer is
required to reimburse its employees for the costs of medical care and other
specified benefits for work-related injuries or illnesses. Most employers comply
with this requirement by purchasing workers' compensation insurance. The
principal concept underlying workers' compensation laws is that an employee
injured in the course of his employment has only the legal remedies for that
injury available under workers' compensation law and does not have any other
claims against his or her employer. Generally, workers are covered for injuries
which occur in the course and scope of their employment. The obligation to pay
such compensation does not depend on any negligence or wrong on the part of the
employer and exists even for injuries that result from the negligence or wrongs
of another person, including the employee.
Workers' compensation insurance policies obligate the carrier to pay all
benefits which the insured employer may become obligated to pay under applicable
workers' compensation laws. Each individual state has its own workers'
compensation regulatory system that determines the level of wage replacement to
be paid, the level of medical care required to be provided and the cost of
permanent impairment. For instance, there are four types of benefits payable
under California workers' compensation policies: (i) temporary or permanent
disability benefits (either in the form of short-term to life-term payments or
lump sum payments); (ii) vocational rehabilitation benefits; (iii) medical
benefits; and (iv) death benefits. The amount of benefits payable for various
types of claims is determined by regulation and varies with the severity and
nature of the injury or illness and the wage, occupation and age of the
employee.
BUSINESS STRATEGY
The Company believes that its differentiated approach as a provider of
insurance services to the agribusiness industry and its expertise with immigrant
employee groups, partial year workforces and businesses in rural communities
have been important to its success. The Company views its strengths as: (i) its
integrated distribution and underwriting activities; (ii) the distinctive labor
relations and cost containment services it provides; and (iii) its underwriting
and risk management expertise with respect to agribusiness risks.
1
The Company's target agribusiness market includes those employers who farm,
harvest, transport, pack and process tree fruit, vegetables, fiber, flowers,
vine fruit and dairy products. Labor intensive agribusiness employers rely on
their workforces performing to maximum productivity in order to deliver their
fresh product to market at the best price. Agribusiness insurance risks are
generally characterized by: (i) monolingual Spanish speaking workforces; (ii)
moving work sites and a relative lack of machinery and equipment, making loss
control engineering more difficult; (iii) large seasonal fluctuations and high
turnover in the employee pool, making timely and frequent safety training more
critical and increasing the opportunity for filing fraudulent claims; (iv) fewer
opportunities for discounts from health providers in rural locations; and (v) a
relatively young workforce performing physically demanding labor for low hourly
or piece-work wages.
The Company continues to grow outside of its historic California and
Arizona markets. Since 1994, the Company has become licensed in seven
additional states: Oregon, Idaho, Texas, Florida, Alaska, Nevada and New
Mexico. In addition, the Company has entered into a reinsurance fronting
arrangement allowing it to underwrite risks in most other states. The Company
has begun to use this facility to write agribusiness risks in the midwestern and
southeastern United States. In new states, the Company targets the same types
of small-to-medium-sized agribusiness operations that it has historically
served. With the addition of New Mexico and Texas, the Company is now licensed
in all states that share a border with Mexico. Migrant labor pools, however,
stretch into Oregon, Idaho and any other locations where fresh food is hand
harvested in the United States.
The Company has capitalized on its experience working in the agribusiness
industry by expanding into other industries with immigrant workforces, including
grocery stores, restaurants and garment manufacturers. Like agribusiness
employers, these business typically hire low-wage immigrant labor forces to
perform semi-skilled labor and have risk characteristics and service
requirements similar to those of the Company's agribusiness client base. PAULA
Trading Company ("PTC") member agencies with expertise in these industries have
been the key factor behind the Company's growth in non-agribusiness industries.
INTEGRATED DISTRIBUTION
The Company has developed an expertise in the agribusiness industry through
its long history of both distributing and underwriting insurance and through a
focus on the agent-customer relationship. PICO was formed by the owners of Pan
Am in 1974 to underwrite the workers' compensation portion of the business
distributed by Pan Am. The Company believes that Pan Am's direct interest in the
Company's success results in a cooperative relationship among the agent, the
underwriter, loss control consultants, claims management personnel and the
customer and its employees. Pan Am, which has 17 locations in California, Oregon
and Arizona, is the largest distributor for PICO.
To enhance the Company's presence in rural areas not served by Pan Am, the
Company affiliates with insurance agencies of similar size and operating
histories to Pan Am. In late 1996 and early 1997, the Company made minority
equity investments in two regional commercial insurance agencies and formed the
PTC to affiliate with other independent agencies. Typically, PTC member agencies
have extensive operating histories, a significant commercial insurance presence
in rural communities and historically high client persistency rates.
The Company believes it gains significant marketing benefits from the
endorsements Pan Am has developed for the Company. These endorsements by more
than 25 prominent trade associations have allowed the Company to be identified
with brand names significant to agribusiness customers. Trade associations
2
which have endorsed the Company have recommended the Company's products and
services to their members. Endorsements provide the Company with access to
large groups of potential customers without the usual sales process of
prospecting individual clients. The Company believes that solicitation of
association members results in a higher percentage of sales than do
individual unaffiliated solicitations.
DISTINCTIVE SERVICES TO AGRIBUSINESS EMPLOYERS
Throughout its history, the Company has tailored its labor relations and
cost containment services to the unique needs of the agribusiness employer. From
the initial reporting of a claim to the careful explanation of benefits to the
medical treatment delivery to the return of an employee to work, the Company's
capabilities are field-based, bilingual, cross-cultural and sensitive to the
unique fraud-prevention and cost-containment issues present in agribusiness. The
Company's safety training, early return to work efforts, case management and
case settlement operations are tailored specifically to the labor relations and
cost containment needs of agribusiness employers and to the needs of Hispanic
and other immigrant laborers.
LOSS PREVENTION. Since employee turnover is high among agribusiness
employers and labor intensive agribusiness requires little fixed equipment, the
Company's field representatives hold employee safety training, forklift training
and tail-gate sessions for the Company's clients and their employees. In
addition, the Company's field representatives train crew foremen and field
supervisors on safety practices, visit the workplace to help prevent fraudulent
claims and report safety concerns to the Company's loss control consultants and
underwriters. The Company's field representatives are a team of community-based
bilingual employees with agribusiness employment backgrounds.
CLAIMS REPORTING AND FRAUD DETECTION. The Company's Special Investigation
Unit reviews each claim for potential fraud as it is reported to the Company
rather than only those claims referred to the unit by claims adjusters after
they suspect fraud, as the Company believes is more typical in the industry. By
reviewing every claim at an early stage, the Company is able to take advantage
of its experience in identifying the principal indicators of fraud and thereby
mitigate its exposure to fraudulent claims. The Company has implemented a
toll-free injury reporting telephone number which allows employers and injured
workers to report claims more quickly.
CLAIMS MANAGEMENT EXPERTISE. The Company commits significant resources to
its claims operations. The Company's claims staff is bilingual, with many years
of claims experience and manages its number of open claims per examiner below
the industry average.
BENEFIT DELIVERY AND EXPLANATION OF BENEFITS TO FARM WORKERS. It has been a
long-standing and distinctive practice of the Company's field representatives to
hand deliver first-time benefit checks as often as possible and explain benefits
in the language of preference of the claimant. The Company believes this helps
to reduce the cost of claims, particularly by reducing the number of litigated
claims, and reduces the incidence of fraud. The Company's field representatives
also assist in returning employees to modified duty as part of the Company's
early return to work program.
MEDICAL DELIVERY IN MEXICO. The Company offers occupational medical
treatment options in Mexico in three approved clinics in Tijuana, Mexicali and
San Luis. The Company believes it is the only carrier to provide this service,
which allows covered employees to obtain culturally-compatible care in
sought-after private medical facilities in Mexico. The Company realizes
significant average cost savings from Mexico-based medical care compared with
comparable care in the United States.
3
AGRIBUSINESS UNDERWRITING EXPERTISE
KNOWLEDGE OF AGRIBUSINESS RISKS. The Company's proprietary loss experience
database, its trade association endorsements and its understanding of the risk
management needs of agribusiness employers are the key elements of its
underwriting capabilities. The Company's rate making process benefits
significantly from more than 50 years of claim experience in the agribusiness
industry and a proprietary database built over 25 years. This database includes
experience by class of business and by subclass within those business classes in
which the Company specializes. The information in the database has been
developed since PICO's inception and is relevant today in that the Company
continues to specialize in many of the same classes of business in which it has
historically focused. This experience has enabled the Company to differentiate
risks by creating many farm classes and subclasses, reflecting the unique
characteristics of job classifications and differences in farming operations.
TRADE ASSOCIATION ENDORSEMENTS AND SAFETY GROUPS. The Company enjoys the
endorsement of more than 25 trade associations and has promoted the formation
and operation of more than 40 other safety groups that purchase workers'
compensation insurance from the Company. Each employer participating in these
groups is pooled with other homogeneous employers for the purpose of rating
experience. These groups help the Company to achieve the actuarial benefit of
writing larger pools, to provide safety training and services to small accounts
more efficiently and to promote the selection of good risks and safety practices
by linking the self interest of each group member. The Company believes that the
loss ratios of its trade association and safety group customers have been lower
than those of its customers as a whole. The trade association endorsements, in
particular, are also a good source of marketing opportunities through access to
association mailing lists. Approximately one-third of the Company's policies are
in trade associations and safety groups.
RISK MANAGEMENT. Risk management is the process of identifying and
analyzing loss exposures and taking steps to minimize the financial impact of
those exposures. The Company's loss control consultants, most of whom are
bilingual and are trained and certified in various farm safety practices, assist
the underwriters in reviewing new accounts and in initiating safety programs
based on industry best practices for each type of customer.
CUSTOMERS
AGRIBUSINESS
The Company has served the insurance needs of western agribusiness
employers and other employers of immigrant workers for over 50 years. The
Company defines "agribusiness" to include those employers who farm, harvest,
transport, pack and process tree fruit, vegetables, fiber, flowers, vine fruit,
and dairy products. Because the Company focuses on clients in a limited number
of industries, it believes it has developed expertise in assessing the risks
associated with those industries.
The Company believes that the experience level required to be successful in
serving the agribusiness industry makes it difficult for competitors to enter
this market. In most states in which it operates, the Company's single largest
competitor for agribusiness is that state's workers' compensation insurance
fund. Due in part to the limited number of non-governmental carriers, state
funds have built substantial market share in the states where they exist.
4
TRADE ASSOCIATIONS AND SAFETY GROUPS
Two significant factors in the Company's insurance operations have been the
efforts of Pan Am to obtain endorsements from agricultural trade associations
and to promote the formation and operation of safety groups. The Company
believes that it gains significant marketing and underwriting benefits from
these relationships. Trade association endorsements are made and renewed on an
annual basis. As of December 31, 1998, no single trade association or safety
group accounted for more than 5% of the Company's estimated annual premium
("EAP"). The Company individually underwrites each policy and is not obligated
to offer insurance to any trade association member. The Company works with
significant independent employers or groups of employers in selected crops or
industries to form safety groups for group insurance purchasing and safety
training purposes. Safety groups are chartered business entities which are
registered with the applicable Department of Insurance and formed primarily to
encourage workplace safety among employer members of the group and to purchase
workers' compensation insurance as a group.
OTHER EMPLOYERS OF HISPANIC AND IMMIGRANT LABORERS
In recent years, the Company has leveraged its experience working with
non-English speaking immigrant workers into serving the needs of other
businesses employing low-wage, Hispanic workers and other immigrant populations.
Examples include Company programs focused on grocery stores, restaurants and
garment manufacturers.
DISTRIBUTION
DIRECT
The Company, operating through its wholly-owned subsidiary Pan Am,
distributes its workers' compensation products to employers in California,
Arizona and Oregon. Management believes Pan Am is one of the largest agency
operations specializing in offering employee benefit products to
agribusiness-related employers in California and Arizona. Pan Am primarily has
developed internally, to a current full-time sales force of approximately 32,
with commission revenues (before intercompany eliminations) of $8.7 million in
1998. Pan Am, as agent and broker, offers its customers a wide range of
insurance products tailored to agribusiness employers' specific needs.
Pan Am's revenues are derived from commissions from the placement of
insurance with insurance carriers, including PICO and PACO. In 1998, Pan Am
placed 53.5% of its total insurance premiums with PICO and PACO. The Company's
integration of the sales and underwriting elements of the workers' compensation
insurance business sold through Pan Am enhances the Company's ability to retain
this business. PICO's insurance business sold through Pan Am is not vulnerable
to being moved at the sole discretion of the agent, although PICO's insurance
sold through Pan Am is still subject to competition from other insurance agents.
For 1998, 30% of PICO's premiums written was sold through Pan Am.
Pan Am has approximately 59 full-time equivalent employees operating from
17 offices in California, Arizona and Oregon; these locations also house PICO
personnel and operations. This provides Pan Am sales personnel with direct
access to insurance company underwriting and claims personnel which, the Company
believes, improves the effectiveness of Pan Am's sales and servicing efforts.
5
PAULA TRADING COMPANY
To enhance the Company's presence in rural areas not served by Pan Am, the
Company affiliates with insurance agencies of similar size and operating
histories to Pan Am, primarily through the PTC membership arrangement. The
insurance agencies that have been selected to join the PTC are expected to
submit applications on risks where there is a high likelihood of PICO
successfully writing the business. PICO also typically expects the first and
last chance to quote agribusiness or Hispanic-focused workers' compensation
business written by a PTC member. The agencies also pay a membership fee to the
PTC. PTC members have access to PAULA's innovative product features such as an
employment practices liability insurance ("EPL") product and have the potential
to join an insurance agency marketing arrangement established by the founders of
the PTC. The Company believes the PTC allows the Company to receive better
quality insurance submissions, face less price competition and maintain
relatively lower insurance business acquisition costs.
INDEPENDENT INSURANCE AGENTS
The Company appoints a limited number of independent insurance agents, who
are not affiliated with the PTC, to sell its workers' compensation insurance,
primarily in states outside of California. The Company favors appointing
independent agents who will primarily represent the Company in its desired
agribusiness focused markets rather than presenting the Company as one of many
competing quotes together in a pricing comparison.
OTHER AGENCY OPERATIONS
Other products and services offered by Pan Am include group health
insurance, third party administration, managed care programs, property and
casualty insurance, crop insurance, life and disability insurance and other
financial services.
SCOPE OF OPERATIONS
The Company has operated successfully in California for more than 50 years
and in Arizona for more than 40 years. In 1994, the Company commenced operations
in Oregon to test whether its business formula would prove successful in other
jurisdictions. The Company wrote its first policy in Oregon on January 1, 1995.
The Company next commenced operations in Idaho, where it wrote its first policy
on July 1, 1996, just prior to the legislative requirement that workers'
compensation insurance become mandatory for agricultural employers for the first
time in January 1997. Most recently, the Company has expanded into Alaska,
Florida, New Mexico and Texas. The Company has been licensed to write insurance
in Nevada and expects to commence operations there in July 1999. The Company
also writes insurance risks in other states through a reinsurance fronting
facility put in place in late 1998. The Company has focused its expansion in
states with significant labor-intensive agribusiness insurance opportunities.
PRODUCTS AND SERVICES
The Company's principal product consists of workers' compensation insurance
policies sold primarily to agribusiness employers. For the year ended
December 31, 1998, workers' compensation premiums earned accounted for 88.8% of
the Company's revenues.
6
In order to differentiate its product from its competitors and provide the
members of the PTC with points of difference to aid them with the sale and
retention of business, the Company has developed a number of innovative product
features, including: (i) automatic coverage in California for discrimination
claims based on an employee's intent to file a workers' compensation claim;
(ii) available EPL insurance in California, which provides coverage for sexual
harassment, wrongful termination and discrimination; (iii) automatic benefits
for the provision of occupational medicine to workers' compensation claimants in
Mexico; and (iv) additional premium credit to the insured employer in California
when the agent provides both the workers' compensation and health insurance to
the employer client and its employees. The Company has entered into a
quota-share reinsurance agreement with Lloyds of London with respect to the
underwriting risk of its EPL product. The Company's EPL product was introduced
in April 1997 and generated gross premiums written of $632,000 for the year
ended December 31, 1998.
The Company sells "AmeriMex", a product underwritten by PACO, which is
typically sold alongside PICO's workers' compensation product in California, and
which provides group medical benefits for services rendered at three provider
hospitals in Mexico. PACO also offers low limit group term life and accidental
death and dismemberment insurance to employer groups. The Company's third party
administrator ("TPA") services consist of the independent administration of
claims and related matters for self-insured employers' health benefit plans. For
the year ended December 31, 1998, TPA, group medical and group life products
accounted for an aggregate of less than 2% of the Company's revenues. These
products are typically sold to the same employers that purchase the Company's
workers' compensation products.
As a general commercial agent, Pan Am distributes group health insurance,
property and casualty insurance, life and disability insurance and other
products underwritten by unaffiliated insurance companies to the Company's
agribusiness clients. The Company believes that the ability of Pan Am to offer
these products and the ability of Pan Am and the PTC member agencies to offer
the Company's distinctive products strengthen the relationship between the agent
and the Company's policyholders.
UNDERWRITING
RISK SELECTION
The Company's focus allows it to concentrate on agribusiness in rural areas
where litigation, fraud and abuse, which tend to increase the frequency of
claims as well as the Company's loss adjustment expense ("LAE"), are less
pronounced. The Company believes the historically lower claim frequency and LAE
in these areas are due in large part to the stronger work ethic and lower wage
level in these areas coupled with a lower density of attorneys and other
workers' compensation claimants' intermediaries.
Most of PICO's business is produced through Pan Am and a group of selected
independent agents which have a local presence in the major agricultural areas
throughout the Company's operating markets. The Company believes that this local
involvement in rural communities allows its agents to gain insight into the
insureds' financial stability, ability to run their business, attitudes toward
safety and loss control and willingness to work as partners with the Company in
the management of their workers' compensation program.
7
The Company focuses on small- to medium-sized accounts which make up the
broadest segment of agribusiness employers. PICO's average annual workers'
compensation policy premium, as measured by EAP, was $11,156 as of December 31,
1998. The Company has found that smaller businesses tend to be supervised by the
owner rather than management staff. The Company believes that an employer's
claims experience directly depends on the owner's commitment to workplace safety
and its hiring practices. By underwriting small- to medium-sized accounts, the
Company has an opportunity to assess directly the owners' commitment to
workplace safety rather than trying to assess such commitment through
interaction with management staff.
UNDERWRITING PROCESS
PICO's relationship with Pan Am and other agents allows the pre-screening
by such agents of new workers' compensation accounts according to criteria
established by PICO, including the employers' prior loss experience, hiring
practices, safety record, credit history, geographic location and types of job
assignments within employment classifications. The Company's agents also meet
with the employer's management to assess the extent to which management is
committed to safety in the workplace.
Once an account passes this initial screening process and prior to
approving an application, the Company's underwriting department reviews each
employer applicant's prior loss experience, safety record, operations,
geographic location and payroll classifications and the types of job assignments
within employment classifications. If necessary, more often for accounts with
EAP of $250,000 or greater, a pre-inspection is conducted by the Company's loss
control department to evaluate safety in the workplace, hiring practices,
industrial health hazards and the potential insured's enthusiasm for loss
control and workplace safety. The Company's underwriters evaluate the potential
profitability of each insurance application by analyzing the various potential
loss exposures related to that particular risk compared to the standard
exposures in that classification.
On accounts larger than $75,000 in EAP, the Company's underwriters
generally consult with the Company's senior claims management personnel during
the underwriting process. For new business submissions, this process improves
the Company's ability to estimate an employer's expected claims experience. For
renewing businesses, this process informs the underwriters of the Company's
experience handling claims for the particular employer and the employer's
attitude toward safety, cooperation in the claims settlement process, return to
work efforts and collection payment history.
Once an account is written, a service plan is put into place utilizing
appropriate members of the Company's team of bilingual field representatives and
certified loss control specialists and employer personnel to establish and
periodically review formal and informal safety programs, safety committees,
conformity with OSHA standards, procedures for reporting injuries, medical cost
containment, anti-fraud information, accident investigation, safety
incentive/rewards programs and claims review procedures. The Company's field
representatives provide a number of valuable services for the Company's
underwriting and claims personnel as well as to the Company's insured employers.
All of the field representatives speak English and Spanish. The field
representatives spend their working hours making periodic visits to the
Company's insured employers and their workers. Among other things, the field
representatives provide feedback to the Company's underwriting personnel about
particular accounts and their attitude toward, and actions to implement,
workplace safety. The Company uses its bilingual, state-certified loss control
personnel to hold safety seminars to train insureds' employees.
8
The Company has established an underwriting referral policy designed to
allow the Company's senior underwriting officer to review all large and unusual
underwriting opportunities. All accounts with (i) high EAP, (ii) high experience
modifications (indicating poor prior claims experience), (iii) a projected
overall rate reduction at renewal, or (iv) large variations from the Company's
standard rates are reviewed by the senior underwriting officer, often in
consultation with senior claims officers, loss control officers and/or the chief
operating officer.
The Company's underwriting department consists of 8 senior underwriters
with extensive experience in property/casualty underwriting and 17 other
underwriting staff members. Each of the senior underwriters is given
individually determined binding authority.
PRICING
The amount of premium the Company charges for workers' compensation
insurance is dependent on the size of an employer's payroll, the job
classifications of its employees and the application of the Company's rating
plan to each individual employer. The Company's rating plan varies from state to
state due to differences in regulatory environments. In certain states, the
premium rate charged to a particular employer may be affected by a risk premium
modifier if the employer is a member of a safety group or meets certain safety
or other requirements. Each employer's indicated premium is then adjusted based
on the employer's experience modification, which is determined by a third party
rating bureau. Application of the experience modification factor results in an
increase or decrease to the indicated premium rate based on the employer's loss
experience and, therefore, provides an incentive to employers to reduce
work-related injuries and illnesses.
In certain states, at the time the Company issues a policy to an employer,
the Company is paid a deposit premium, which is a percentage of the EAP of the
policy at the time of issuance. The percentage ranges from 10% to 100% of the
EAP depending, among other things, on the premium payment schedule, the
employer's credit history and employment classifications. The employer remits
its premiums either in installments based on a payment plan or in amounts
calculated from periodic reports of its payrolls. At the end of the policy term,
or when the policy is canceled, a final audit of the employer's records is
conducted by the Company to determine the correct amount of premium due to the
Company.
For a description of regulation of workers' compensation insurance premium
rates, see "Business-Regulation-Regulation of PICO's Business in Each State in
Which it is Licensed".
CLAIMS
The Company's policy is to protect injured workers or their dependents and
policyholders by promptly investigating each loss occurrence, administering
benefits in a prompt, efficient and cost effective manner and maintaining an
appropriate reserve estimate on each claim through closure. The Company expends
significant efforts to improve its insureds' claim experience. Because the
Company charges insurance rates based in part on an insured's claims experience
over a three-year period, improvements in an insured's claims experience are not
immediately reflected in lower rates, thereby providing an opportunity for the
Company's loss ratio to improve as each accounts' claims experience is reduced.
9
MANAGEMENT OF CLAIMS COSTS
The Company's Special Investigation Unit reviews each claim for potential
fraud as it is reported to the Company rather than only those claims referred to
the unit by claims adjusters after they suspect fraud, as the Company believes
is more typical in the industry. By reviewing every claim at an early stage, the
Company is able to take advantage of its experience in identifying the principal
indicators of fraud and thereby mitigate its exposure to fraudulent claims. The
Company believes its Special Investigation Unit's review of every claim
diminishes the number of fraudulent claims paid by the Company. The Company has
also established a separate litigation management unit, utilizing its own
administrative hearing representatives, which makes extensive use of alternative
dispute resolution techniques to settle claims prior to these claims going
before local workers' compensation appeals boards. The Company periodically
holds special one-day arbitration conferences with retired workers' compensation
judges to attempt to settle pending claims.
In addition, the Company has taken significant steps to reduce its outside
legal fee expenses when litigated claims cannot be resolved by the Company's
in-house litigation personnel. The Company has entered into capitation
arrangements with many of the members of its panel of outside law firms. These
arrangements limit the amount the Company will be charged by its attorneys for
given legal actions. The Company believes these capitation arrangements have
reduced its LAE.
As an integral part of its claims operations, PICO utilizes specially
trained personnel, both employees and independent contractors, to carry out cost
containment techniques in the areas of medical management, litigation
management, vocational rehabilitation management, subrogation management, fraud
investigation, bill review, utilization review and benefit delivery compliance.
The Company's medical management efforts are devoted to providing medical
utilization review and quality assurance with the objectives of controlling unit
cost, volume of services and lost work days due to work-related injury and
illness. In particular, due to its long experience in rural markets, the Company
understands how the delivery of occupational medical services varies in rural
areas from metropolitan areas, allowing the Company, it believes, to more
effectively utilize its rights to direct injured workers to medical providers
approved by the Company during the first weeks after an injury occurs.
The Company has implemented a toll-free injury reporting telephone
number which allows employers and injured workers to report claims more quickly.
Callers receive assistance reporting their claim and the Company's claims
personnel receive a "head start" on the management of the costs of that claim.
The head start allows the Company to investigate the circumstances of the injury
to determine the claim status, assist the injured worker in the selection of
medical providers approved by the Company and assist the injured party through
the claims process in a manner designed to reduce the likelihood that the
injured party will need to seek the assistance of legal counsel with the claims
process. The Company believes that there is a direct relationship between the
speed with which it learns of a claim and its ability to reduce the cost of the
claim to its lowest possible value.
The Company has created a panel of medical providers practicing in three
facilities in Mexico who are skilled in delivering occupational medicine in a
manner consistent with the requirements of the California workers' compensation
system at less cost than United States providers for those workers more
comfortable with Mexico clinics and hospitals.
10
CLAIMS PERSONNEL
The Company's claims management is conducted under the direction of 17
claims management personnel with extensive experience in the industry. The
Company's claims examiners are responsible for the management of caseloads per
examiner which are lower than the industry average. Due to the combination of
experience and more manageable caseloads, the Company's claims personnel can be
more effective at managing claims through more frequent contact with
policyholders, injured workers and medical providers. Moreover, the Company's
claims personnel are able to more quickly and cost effectively respond to
changes in mandated workers' compensation benefits.
LOSSES AND LOSS RESERVES
In many cases, significant periods of time may elapse between the
occurrence of an insured loss, the reporting of the loss to the insurer and the
insurer's payment of that loss. To recognize liabilities for unpaid losses,
insurers establish reserves, which are balance sheet liabilities representing
estimates of future amounts needed to pay claims with respect to insured events
that have occurred, including events that have occurred but have not yet been
reported to the insurer. Reserves are also established for LAE representing the
estimated expenses of settling claims, including legal and other fees, and
general expenses of administering the claims adjustment process.
Reserves for losses and LAE are based not only on historical experience but
also on management's judgment of the effects of factors such as future economic
and social forces likely to impact the insurer's experience relative to the type
of risk involved, benefit changes, circumstances surrounding individual claims
and trends that may affect the probable number and nature of claims arising from
losses not yet reported. Consequently, loss reserves are inherently subject to a
number of highly variable circumstances.
Reserves for losses and LAE are evaluated quarterly using a variety of
actuarial and statistical techniques for producing current estimates of expected
claim costs. Claim frequency and severity and other economic and social factors
are considered in the evaluation process. Since the Company relies on both
actual historical data, which reflect past inflation, and on other factors which
are judged to be appropriate modifiers of past experience, the Company uses an
implied, rather than explicit, provision for inflation in its calculation of
estimated future claim costs. Adjustments to reserves are reflected in operating
results for the periods in which they are made.
The Company sets an initial case reserve upon being notified of an insured
injury. Since 1992, the Company has employed automated computer technology
utilizing a database comprised of data from participating unaffiliated workers'
compensation carriers to assist the Company in setting such initial reserves. As
more facts regarding the loss become known, the Company reviews and, if
appropriate, revises the initial case loss reserve.
In addition to case reserves, the Company also establishes bulk reserves.
Bulk reserves are established on an aggregate basis to provide for losses
incurred but not yet reported to the insurer and to supplement the overall
adequacy of individual case reserves established by claims adjusters and
estimated expenses of settling such claims, including legal and other fees and
general expenses of administering the claims adjustment process. The Company
establishes bulk reserves by estimating the ultimate net liability for losses
and LAE by using actuarial reserving techniques. Such techniques are used to
adjust, in the aggregate, the amount estimated for individually established case
reserves, as well as to establish estimates for reserves
11
for unreported claims. Adjustments are made for changes in the volume and mix
of business, mix of claim categories, claims processing and other items which
affect the development patterns over time.
On the basis of the Company's internal procedures which analyze, among
other things, the Company's experience with similar cases and historical trends
such as reserving patterns, loss payments and pending levels of unpaid claims,
as well as court decisions, economic conditions and public attitudes, management
has made its best estimate of the Company's liabilities for unpaid losses and
LAE and believes that adequate provision has been made for such items. However,
because the establishment of loss reserves is an inherently uncertain process,
there can be no assurance that ultimate losses and LAE will not exceed the
Company's reserves. There can be no assurance that future loss development will
not require reserves for prior periods to be increased, which would adversely
affect earnings in future periods.
The Company employs an actuarial staff of two and also utilizes an outside
actuarial firm.
The following table sets forth a reconciliation of beginning and ending
reserves for losses and LAE after reinsurance deductions for the periods
indicated. There are no material differences between the Company's reserves for
losses and LAE shown below calculated in accordance with Generally Accepted
Accounting Principles ("GAAP") and those calculated in accordance with Statutory
Accounting Principles ("SAP"). The Company does not discount claim reserves on
either a GAAP basis or under SAP.
RECONCILIATION OF RESERVES FOR LOSSES AND LAE
(IN THOUSANDS)
1998 1997 1996
---- ---- ----
Unpaid loss and loss adjustment expenses beginning of year.............. $77,784 $55,720 $57,049
Less: reinsurance recoverable on unpaid losses and LAE.................. 6,394 6,427 6,775
PACO reserves.................................................. 343 533 292
------------ ------------ ------------
Net PICO balance, beginning of year.................................. $71,047 $48,760 $49,982
------------ ------------ ------------
Incurred related to:
Current period....................................................... 107,850 66,330 35,938
Prior periods........................................................ 6,268 1,586 (2,646)
------------ ------------ ------------
$114,118 $67,916 $33,292
------------ ------------ ------------
Paid related to:
Current period....................................................... 34,374 20,495 12,833
Prior periods........................................................ 39,989 25,134 21,681
------------ ------------ ------------
$74,363 $45,629 $34,514
------------ ------------ ------------
Net PICO balance, end of year........................................ 110,802 71,047 48,760
Plus: reinsurance recoverable on unpaid losses and LAE.................. 25,137 6,394 6,427
PACO reserves.................................................. 377 343 533
------------ ------------ ------------
Unpaid loss and loss adjustment expenses, end of year................... $136,316 $77,784 $55,720
------------ ------------ ------------
------------ ------------ ------------
12
The table below shows changes in historical workers' compensation net loss
and LAE reserves for PICO for each year since 1988. Reported reserve development
is derived from information included in PICO's statutory financial statements.
The first line of the upper portion of the table shows the net reserves as of
December 31 of each of the indicated years, representing the estimated amounts
of net outstanding losses and LAE for claims arising during that year and in all
prior years that are unpaid, including losses that have been incurred but not
yet reported to the Company. The upper portion of the table shows the restated
amount of the previously recorded net reserves for each year based on experience
as of the end of each succeeding year. The estimate changes as more information
becomes known about claims for individual years. The lower portion of the table
shows the cumulative net amounts paid as of December 31 of successive years with
respect to the net reserve liability for each year.
In evaluating the information in the table below, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
For example, if a loss determined in 1991 to be $10,000 was first reserved in
1988 at $8,000, the $2,000 deficiency would be included in the cumulative
redundancy (deficiency) for each of the years 1988 through 1991 shown below.
This table, unlike the table headed "Calendar Year Development by Accident Year"
that follows, does not present accident or policy year development data.
Conditions and trends that have affected the development of liability in the
past may not necessarily occur in the future. Accordingly, it may not be
appropriate to extrapolate future redundancies or deficiencies based on this
table.
13
CHANGES IN HISTORICAL NET RESERVES FOR LOSSES AND LAE
(IN THOUSANDS)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Unpaid losses and loss
adjustment expenses at
end of year............ $52,893 $49,994 $49,104 $57,909 $59,492 $56,792 $53,287 $49,982 $48,760 $71,047 $110,802
Reserve re-estimated as of:
One year later......... 47,061 47,833 52,209 58,618 57,000 52,837 49,403 47,335 50,346 77,315
Two years later........ 46,462 50,060 53,491 60,095 57,115 50,480 48,189 45,041 50,910
Three years later...... 47,725 49,970 54,316 60,733 55,305 50,647 46,855 45,814
Four years later....... 47,473 50,321 55,269 59,806 56,725 50,056 47,928
Five years later....... 47,064 51,095 54,808 60,286 56,813 50,707
Six years later........ 47,444 51,025 55,184 60,794 57,225
Seven years later...... 47,346 51,348 55,738 61,188
Eight years later...... 47,847 51,714 55,932
Nine years later....... 48,216 51,913
Ten years later........ 48,093
Cumulative redundancy
(deficiency).............. 4,800 (1,919) (6,828) (3,279) 2,267 6,085 5,359 4,168 (2,150) (6,268)
Cumulative paid as of:
One year later......... 16,761 19,757 21,736 25,543 23,464 21,711 21,742 21,680 25,133 39,989
Two years later........ 29,212 32,602 36,021 40,328 37,040 34,721 33,601 33,007 38,328
Three years later...... 36,832 40,456 43,482 48,429 45,529 41,855 39,372 38,784
Four years later....... 41,251 44,254 47,923 53,416 50,395 45,253 42,807
Five years later....... 43,271 46,682 50,713 56,250 52,941 47,231
Six years later........ 44,676 48,430 52,442 58,261 54,642
Seven years later...... 45,562 49,406 53,801 59,406
Eight years later...... 46,465 50,333 54,558
Nine years later....... 47,145 50,926
Ten years later........ 47,341
Net unpaid losses and loss
adj. expenses
December 31............ $49,982 $48,760 $71,047 $110,802
Reinsurance recoverable... 6,775 6,427 6,394 25,137
--------- -------- --------- -------
Gross unpaid losses and
loss adj. expenses
December 31............ $56,757 $55,187 $77,441 $135,939
------- ------- ------- --------
------- ------- ------- --------
(Continued)
14
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Re-estimated net unpaid
losses and loss
adjustment expenses.... $45,814 $50,910 $77,315
Re-estimated reinsurance
recoverable............ 7,659 8,190 9,172
--------- ---------- ---------
Re-estimated gross unpaid
losses and loss
adjustment expenses.... $53,473 $59,100 $86,487
--------- ---------- ---------
--------- ---------- ---------
Gross cumulative redundancy
(deficiency)........... $3,284 ($3,913) ($9,046)
--------- ---------- ---------
--------- ---------- ---------
The following table is derived from the table above and summarizes the
effect of reserve re-estimates net of ceded reinsurance on calendar year
operations for the same ten-year period ended December 31, 1998. The total of
each row details the amount of reserve re-estimates made in the indicated
calendar year and shows the accident years to which the re-estimates are
applicable. The total of each accident year column represents the cumulative
reserve re-estimates for the indicated accident year(s).
CALENDAR YEAR DEVELOPMENT BY ACCIDENT YEAR
(IN THOUSANDS)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 TOTAL
AND ---- ---- ---- ---- ---- ---- ---- ---- ---- CALENDAR
PRIOR YEAR
----- EFFECT
------
Calendar years
1998................ ($123) ($76) $5 ($200) ($18) ($239) ($422) $300 $209 ($5,704) ($6,268)
1997................ (369) 3 (188) 46 420 679 743 960 (3,880) (1,586)
1996................ (501) 178 (53) (104) (940) 1,253 1,381 1,433 2,647
1995................ 98 (28) 391 466 883 547 1,527 3,884
1994................ (380) (394) (179) 315 523 4,070 3,955
1993................ 409 (760) (474) (652) 3,969 2,492
1992................ 252 (162) (1,372) 573 (709)
1991................ (1,263) (964) (878) (3,105)
1990................ 599 1,562 2,161
1989................ 5,832 5,832
----------------------------------------------------------------------------------------------------------------
Cumulative
re-estimates
for each
accident year $4,554 ($641) ($2,748) $444 $4,837 $6,310 $3,229 $2,693 ($3,671) ($5,704) $9,303
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
15
PICO and the California workers' compensation industry as a whole
experienced relatively high incurred losses and LAE during accident years
1989 - 1992 as a result of laws enacted in 1989 which had the unintended effect
of permitting the filing of fraudulent and abusive workers' compensation claims.
PICO determined reserves for accident years 1993 and 1994, and to a lesser
extent, 1995, based on the relatively high incurred loss and LAE trends for the
1989 - 1992 accident years. PICO's actual incurred losses and LAE for the
1993 - 1995 accident years proved to be lower than anticipated and PICO's
original reserves for these periods were ultimately redundant. PICO determined
its reserves for the 1994 - 1996 accident years with the benefit of information
indicating favorable development in the immediate prior accident years.
Development of the 1994 and 1995 accident years has more closely approximated
the development anticipated when reserves for those years were initially
established. During 1994 and 1995, PICO experienced an aggregate of
approximately $7.8 million in reserve recoveries attributable primarily to
favorable development on losses and LAE for accident years 1990-1994. In 1996,
PICO experienced an aggregate of approximately $2.6 million in reserve
recoveries attributable primarily to favorable development on losses and LAE for
the 1993 - 1995 accident years, offset in part by mildly negative development
for the 1990 - 1992 accident years.
During 1997, PICO experienced an aggregate of approximately $1.6 million in
net reserve development. During 1997, reserve development of $3.9 million on
the 1996 accident year was partially offset by reserve recoveries of $2.4
million on accident years 1993 - 1995. PICO established its initial reserves on
the 1996 accident year based on the favorable trends for the 1993-1995 accident
years. The development for the 1996 accident year resulted from claims trends
less favorable than those experienced by the Company for the 1993-1995 accident
years.
During 1998, PICO experienced an aggregate of approximately $6.3 million
in net reserve development, principally related to the 1997 accident year.
In the first two quarters of 1998 the Company saw reserve development on the
1997 accident year for California business in excess of its expectations
given prior year reserving trends. The Company's second quarter reserve
adjustment, expressed as a percentage of related premiums, implied a pricing
deficiency for those periods. The Company began to address this pricing
deficiency early in 1998 through rate increases and non-renewal activity.
POLICYHOLDER DIVIDENDS
Workers' compensation policies can be written on a participating or
non-participating basis. Participating policies allow the Company to declare
and pay dividends to a policyholder after the expiration of the policy based
upon a policyholder's specific loss experience (or, if the policyholder is part
of a safety group, the group's specific loss experience), the Company's overall
loss experience and competitive conditions. Since January 1, 1997,
substantially all workers' compensation insurance underwritten by the Company in
California, Alaska and Texas has been written without the expectation that the
Company would pay policyholder dividends on such policies. Substantially all of
the insurance underwritten by the Company in Arizona, Oregon, Idaho and Florida
is written on participating policy forms. Currently, workers' compensation
insurers in Arizona and Florida generally use policyholder dividends to reward
favorable loss experience as a means of competitive pricing although with
increasing upfront price competition in Arizona, dividends are becoming less of
a competitive factor. In Oregon and Idaho, dividends are sometimes used as a
competitive pricing tool, although rates are more flexible in those states.
Dividends play little role in Alaska and Texas, due to the flexibility in the
rating plans in those states. The Company makes the determination of the amount
of the dividends it chooses to pay on its participating policies generally 12 to
30 months after policy expiration, and such payments require approval by PICO's
board of directors. The Company intends to continue to issue policies in
Arizona, Oregon, Idaho and Florida that are eligible for policyholder dividend
consideration.
16
REINSURANCE
Insurance risk is ceded primarily to reduce the liability on individual
claims and to protect against catastrophic losses. The Company follows the
industry practice of reinsuring a portion of its risks on an excess of loss
reinsurance basis. For this coverage, the Company pays the reinsurer a
portion of the premiums received on all policies. In return, the reinsurer
agrees to reimburse the Company for all losses in excess of a predetermined
amount, commonly referred to as the insurance company's retention. In
connection with a new reinsurance arrangement entered into in October 1998,
the Company has also chosen to quota-share a portion of its retained claims
exposure. In a quota-share reinsurance contract, the Company and the
reinsurer share premiums, losses and LAE on a proportional basis based on
each parties interest in the quota-shared risk.
The Company maintains excess of loss reinsurance treaties with various
reinsurers for workers' compensation. Since 1974, General Reinsurance
Corporation ("GenRe") has been the Company's primary excess of loss reinsurer.
GenRe is currently assigned a letter rating of "A++ (Superior)" by A.M. Best.
The Company's upper layers of reinsurance coverage (in excess of $10.0 million)
are currently provided by a large group of companies contracted through a
reinsurance intermediary owned by GenRe. All such carriers are currently
assigned a rating of "A-" or better by A.M. Best. Under the current workers'
compensation reinsurance treaties, various reinsurers assume liability on that
portion of the loss that exceeds $250,000 per accident, up to a maximum of $60.0
million per accident. An accident is defined as a single event, whether it
affects one or more persons. In July 1998, the Company modified its prior
existing excess of loss reinsurance treaty on the $250,000 excess of $250,000
layer to retain the first $2.0 million in annual aggregate losses, with a
corresponding reduction in the Company's reinsurance rate. In October 1998, the
Company entered into a two year excess of loss and quota-share reinsurance
arrangement with Reliance Insurance Company ("Reliance"). Under this
arrangement, the Company has ceded various portions of its exposure for claims
in excess of $10,000 and has quota-shared a portion of its risks under $10,000.
Reliance is rated A- (Excellent) by A.M. Best.
Although reinsurance makes the assuming reinsurer liable to PICO to the
extent of the reinsurance ceded, it does not legally discharge PICO from its
primary liability for the full amount of the claim. The Company has encountered
no disputes with its reinsurers and has not experienced any difficulty on the
part of reinsurers to fulfill their obligations under reinsurance treaties. The
Company believes that suitable alternative excess of loss reinsurance treaties
for the excess of $250,000 per accident layers are readily obtainable at the
present time. The Company does not expect to be able to replace or renew its
Reliance quota-share and $10,000 to $250,000 layer reinsurance treaty at current
terms upon expiration.
The Company has also entered into a quota-share reinsurance agreement with
the Venton Syndicate of Lloyds of London with respect to the underwriting risk
of its EPL product. The Company's EPL product was introduced in April 1997 and
generated gross premiums written of $632,000 for the year ended December 31,
1998.
17
INVESTMENTS AND INVESTMENT RESULTS
The Company employs a conservative investment strategy emphasizing asset
quality and the matching of maturities of its fixed maturity investments to the
Company's anticipated claim payments and expenditures or other liabilities. The
Company employs Conning Asset Management Company ("Conning Asset Management") to
act as its independent investment advisor for the bulk of the Company's
investment portfolio pursuant to the terms of a written agreement with Conning
Asset Management and the Company's written investment guidelines.
Conning Asset Management has discretion to enter into investment
transactions within the Company's investment guidelines. In practice, this
discretion is generally exercised only with respect to the reinvestment of
maturing securities in similar securities. In the case of sales of securities
prior to maturity, or the acquisition of securities which differ from the types
of securities already present in the portfolio, Conning Asset Management will
routinely consult with the Company's Chief Financial Officer, who chairs the
Company's investment committee, prior to entering into such transactions. Among
other things, Conning Asset Management seeks to match the average duration of
the portfolio's assets with the estimated average duration of the Company's
liabilities. Conning Asset Management's fee is based on the amount of assets in
the portfolio and is not dependent upon investment results or portfolio
turnover. Conning Asset Management is affiliated with one of the Company's
principal stockholders.
The amount and types of investments that may be made by the Company's
insurance subsidiaries are regulated under the California Insurance Code and
related rules and regulations promulgated by the California Department of
Insurance ("DOI"). Subject to such applicable state laws and regulations,
investment policies and investment decisions are approved by the Company's
investment committee and are reviewed by the Board of Directors. The Company
modifies its mix of tax-exempt and taxable securities from time to time based on
effective after-tax yield and tax planning considerations. Management intends
to hold all of the Company's fixed maturity investments for indefinite periods
of time but these investments are available for sale in response to changes in
interest rates, tax planning considerations or other aspects of asset/liability
management.
During the third quarter of 1998, the Company repositioned a substantial
portion of the investment portfolio from tax exempt to taxable securities. The
overall asset quality and duration of the portfolio was unchanged. The
repositioning was done for tax planning purposes.
18
As of December 31, 1998, the carrying value of the Company's investment
portfolio was approximately $177.6 million and amortized cost was approximately
$178.2 million. The diversification of the Company's investment portfolio as of
December 31, 1998 is shown in the table below:
CONSOLIDATED INVESTMENT POSITION
AS OF DECEMBER 31, 1998
---------------------------------------------
PERCENT OF
CARRYING AMORTIZED CARRYING
TYPE OF INVESTMENT VALUE (1) COST VALUE
- ------------------ --------- ---- -----
(DOLLARS IN THOUSANDS)
Fixed maturities: (2)
United States government agencies and authorities $13,766 $13,445 7.8%
States, municipalities and political subdivisions 24,346 24,082 13.7%
Corporate securities........................... 79,625 79,927 44.8%
Collateralized mortgage obligations
and other asset backed securities.......... 53,055 53,925 29.9%
--------------- ------------- --------------
Total fixed maturities......................... $170,792 $171,379 96.2%
Equity securities (3)............................. 4,259 4,251 2.4%
Invested cash..................................... 2,572 2,572 1.4%
--------------- ------------- --------------
Total investments.............................. $177,623 $178,202 100.0%
--------------- ------------- --------------
--------------- ------------- --------------
- -------
(1) All securities are carried at market value except invested cash is carried
at cost, which approximates market value.
(2) All fixed maturity securities have been designated as available for sale.
(3) Excludes the Company's minority investments in James G. Parker Insurance
Associates ("Parker") and CAPAX Management & Insurance Services ("CAPAX"),
which had a carrying value as of December 31, 1998 of $1.7 million.
It is the Company's practice to purchase almost exclusively investment
grade fixed maturity securities and mutual funds primarily holding such
securities for its insurance company portfolios. In addition, the Company
generally invests its parent company portfolio in similar investments, although
the Company selectively invests in unrated and below investment grade securities
in this portfolio. As of December 31, 1998, the Company owned one bond with a
carrying value of $1.6 million which was non-performing. In 1998, the Company
realized an other than temporary decline of $0.1 million on this bond. At this
time, the Company is unable to predict whether or not it will realize additional
other than temporary declines on this security. As of December 31, 1998 the
Company did not own any mortgages or real estate. As of December 31, 1998, 97.0%
of the Company's fixed maturity securities carried a NAIC Class 1 designation
(or a comparable rating agency designation).
19
At December 31, 1998, the Company owned a total of $53.9 million amortized
cost of mortgage backed and other asset backed securities. Mortgage backed
securities accounted for $31.4 million of the total. Approximately 84% of the
mortgage backed securities holdings were AAA-rated Agency pass through and
collateralized mortgage obligations ("CMO's"). The balance of the mortgage
backed securities holdings consisted of short maturity non-Agency mortgage
backed assets, also rated AAA. As of December 31, 1998, the average life of the
mortgage backed security portfolio was just over five years.
Asset backed holdings totaled $22.5 million at year end and primarily
consisted of traditional AAA rated automobile loan and credit card receivable
backed financings. In addition, the Company had modest exposures to AA-rated
Home Equity Loan and AAA-rated Collateralized Bond obligation debt issues. As
of December 31, 1998, the average life of the asset backed securities portfolio
was just over four years.
The primary objective of the mortgage and asset backed holdings is to
provide incremental investment income while controlling maturity extension and
prepayment risks.
The following table sets forth certain information regarding the investment
ratings of the Company's fixed maturity investment portfolio as of December 31,
1998:
LONG TERM FIXED MATURITY PORTFOLIO BY STANDARD & POOR'S RATING
CARRYING AMORTIZED PERCENTAGE OF
RATINGS (1) VALUE COST CARRYING VALUE
- ----------- ----- ---- --------------
(DOLLARS IN THOUSANDS)
AAA............................................................. $86,747 $86,945 50.8%
AA.............................................................. 26,326 25,875 15.4%
A............................................................... 44,848 44,000 26.3%
BBB to B........................................................ 11,321 12,659 6.6%
Not rated....................................................... 1,550 1,900 0.9%
--------------- ----------------- ------------------
Total........................................................... $170,792 $171,379 100.0%
--------------- ----------------- ------------------
--------------- ----------------- ------------------
- -------
(1) Ratings assigned by S&P when available, otherwise equivalent ratings
assigned by Moody's or Fitch. S&P assigns ratings ranging from "AAA" to "D"
reflecting its current opinion of the creditworthiness of the obligor with
respect to the specific security rated. The following ratings reflect S&P's
opinion of the obligor's capacity to meet its financial commitment on the
relevant obligation: AAA-Extremely Strong; AA-Very Strong; and A-Strong.
20
The following table sets forth certain information regarding the maturity
profile of the Company's fixed maturity securities as of December 31, 1998 based
on the earlier of the pre-escrowed date or the scheduled maturity date:
INVESTMENT PORTFOLIO BY YEARS TO MATURITY
PERCENTAGE OF
MATURITY CARRYING VALUE CARRYING VALUE
- -------- -------------- --------------
(DOLLARS IN THOUSANDS)
One year or less..................................................................... $7,541 4.4%
After one year through five years.................................................... 56,205 32.9%
After five years through ten years................................................... 48,590 28.4%
After ten years...................................................................... 5,401 3.2%
Mortgage and asset backed securities (1)............................................. 53,055 31.1%
--------------- ----------------
Total................................................................................ $170,792 100.0%
--------------- ----------------
--------------- ----------------
- -------
(1) Mortgage- and asset-backed securities generally are more likely to be
prepaid than other fixed maturity securities. Therefore, contractual
maturities are excluded from this table since they may not be indicative of
actual maturities.
The Company's investment results for each of the years in the three year
period ended December 31, 1998 were as follows:
INVESTMENT PORTFOLIO RESULTS
Years Ended December 31,
1998 1997 1996
---- ---- ----
(dollars in thousands)
Net pre-tax investment income (1).................................... $9,540 $5,582 $4,701
Average total invested assets (2).................................... 156,872 110,576 83,644
Annual pre-tax yield on average total invested assets (3)............ 6.1% 5.0% 5.6%
Net pre-tax realized investment gains................................ $1,706 $172 $444
- -------
(1) Calculated net of investment expenses and excluding capital gains and
losses and provision for income taxes.
(2) Calculated based on an average of the beginning and end of period total
investments. For the purpose of this calculation, investment balances were
at cost (fixed income securities at amortized cost). The Company's
investment portfolio materially increased in October 1997 following the
Company's initial public offering.
(3) Pre-tax yield is calculated as investment income (including dividend income
in the case of equities) divided by average total invested assets. The 1997
annual pre-tax yield as calculated above was diluted by the increase in the
Company's investment portfolio in October 1997. The increase in the
portfolio late in the year inflated the Company's average total invested
assets for 1997 as calculated above.
21
The following table summarizes net investment income from the Company's
portfolio for the years ended December 31, 1998, 1997 and 1996:
NET INVESTMENT INCOME BY INVESTMENT TYPE
YEARS ENDED DECEMBER 31,
------------------------
(DOLLARS IN THOUSANDS)
1998 1997
------------------------------------- -------------------------------------
PRE- PRE-
TAX REALIZED TAX REALIZED
YIELD GAINS YIELD GAINS
------ ------
INCOME (1) (LOSSES) INCOME (1) (LOSSES)
------ --- -------- ------ --- --------
Fixed maturity
securities:
Tax-exempt (2)..... $3,148 6.2% $1,846 $2,733 4.4% $(1)
Taxable............ 5,338 5.9 (362) 2,216 6.6 -
Equities (3).......... 500 7.8 222 121 2.3 173
Short-term............ 910 10.3 - 716 7.6 -
----------- ------------- ----------- ------------
Total.............. $9,896 6.3% $1,706 $5,786 5.2% $172
----------- ------------- ----------- ------------
Less investment expense
356 - 204 -
----------- ------------- ----------- ------------
----------- ------------- ----------- ------------
Total.............. $9,540 6.1% $1,706 $5,582 5.0% $172
----------- ------------- ----------- ------------
----------- ------------- ----------- ------------
YEARS ENDED DECEMBER 31,
------------------------
(DOLLARS IN THOUSANDS)
1996
-----------------------------------
REALIZED
PRE- GAINS
TAX
INCOME YIELD (1) (LOSSES)
------ --------- --------
Fixed maturity
securities:
Tax-exempt (2)..... $2,660 5.5% $248
Taxable............ 1,841 6.0 196
Equities (3).......... 62 5.8 -
Short-term............ 338 8.6 -
----------- ------------
Total.............. $4,901 5.9% $444
----------- ------------
Less investment expense
200 -
----------- ------------
Total.............. $4,701 5.6% $444
----------- ------------
----------- ------------
(1) Pre-tax yield is calculated as investment income (including dividend
income in the case of equities) divided by the average of the beginning
and end of year investment balances. For the purpose of this
calculation, investment balances were at cost (fixed income securities
at amortized cost).
(2) For purposes of comparison to yields on taxable securities, those yields
on tax-exempt securities are equivalent to average pre-tax yields of
8.0% for 1998, 5.7% for 1997, and 7.1% for 1996 assuming that the tax
rate was 34% and further assuming that 15% of a portion of the
tax-exempt interest was subject to federal income tax under certain
provisions applicable only to insurance companies.
(3) Excludes the Company's minority investments in Parker and CAPAX, which
had a carrying value as of December 31, 1998 of $1.7 million.
REGULATION
GENERAL
PAULA Financial and its subsidiaries are subject to regulation by the
departments of insurance in each jurisdiction in which they transact insurance.
These departments of insurance have broad regulatory, supervisory and
administrative powers over the insurance subsidiaries. Primary regulatory
authority, however, rests with the California DOI, the regulator in the
Company's insurance subsidiaries' state of domicile. While the exercise of their
authority may have company-wide ramifications, regulators in non-domiciliary
states focus primarily on the operation of an insurer within their respective
states.
22
State insurance regulation is generally intended for the benefit and
protection of policyholders and claimants under insurance policies rather than
stockholders. The nature and extent of such regulation varies from jurisdiction
to jurisdiction, but typically involve: (i) standards of solvency and minimum
amounts of capital and surplus which must be maintained; (ii) limits on types
and amounts of investments; (iii) restrictions on the size of risks which may be
insured by a single company; (iv) licensing of insurers and their agents;
(v) required deposits of securities for the benefit of policyholders;
(vi) approval of policy forms; (vii) establishment of statutory reporting
practices and the form and content of statutory financial statements;
(viii) establishment of methods for setting statutory loss and expense reserves;
(ix) review, and in certain instances prior-approval, of premium rates; (x)
limits on transactions among insurers and their affiliates; (xi) approval of all
proposed changes of control; (xii) approval of dividends; (xiii) setting and
collecting guarantee fund assessments; and (xiv) required filing of annual and
other reports with respect to the financial condition and operation of insurers.
In addition, state regulatory examiners perform periodic financial and
underwriting examinations of insurers.
DOMICILE AND LICENSING
PICO and PACO are domiciled in California. PICO is licensed to sell
insurance in Alaska, Arizona, California, Florida, Idaho, New Mexico, Nevada,
Oregon, and Texas. PACO is licensed to sell insurance in Arizona and
California.
RESTRICTIONS ON ACQUISITIONS OF CONTROL
The California Insurance Code provides that any direct or indirect
acquisition or change in "control" of a domestic insurer cannot be consummated
without the prior approval of the California DOI. The California Insurance Code
provides further that, unless the California DOI upon application determines
otherwise, a presumption of "control" arises from the ownership, control,
possession with the power to vote or possession of proxies with respect to 10%
or more of the voting securities of a domestic insurer or of a person or entity
that controls a domestic insurer.
Any person who purchases shares of the Common Stock which, when combined
with all other voting securities owned or otherwise controlled by that person,
total 10% or more of the voting securities of the Company, will be deemed to
have acquired control of the insurance subsidiaries unless the California DOI,
upon application, determines otherwise. Any such acquisition of control is
prohibited under the California Insurance Code unless prior approval of the
California DOI is obtained or the California DOI does not disapprove the
acquisition within 60 days after a complete application has been filed. The
California DOI is authorized to disapprove any acquisition which (i) would cause
the insurance subsidiaries to cease to qualify for their licenses to transact
insurance, (ii) would substantially lessen competition or tend to create a
monopoly, (iii) might, due to the financial condition of the acquiring person,
jeopardize the financial stability of the insurance subsidiaries or prejudice
the interests of their policyholders, (iv) would result in a major change in the
insurance subsidiaries' business or corporate structure or management which is
not fair and reasonable to policyholders, or (v) would result in control over
the insurance subsidiaries by persons whose competence, experience and integrity
indicate that it is not in the interest of policyholders or the public to permit
them to assume control.
23
The need for such action, and the possibility of disapproval by the
California DOI, could deter, delay or prevent certain transactions affecting the
control of the Company or the ownership of the Company's Common Stock. Since the
statutory disapproval criteria focus primarily on policyholder, rather than
stockholder interests, these requirements could deter, delay or prevent
transactions which could be advantageous to the stockholders of the Company.
RESTRICTIONS ON STOCKHOLDER DIVIDENDS PAYABLE BY THE INSURANCE SUBSIDIARIES
TO THE COMPANY
PAULA Financial, as a non-insurer, is generally not restricted directly
under applicable insurance laws with respect to the payment of dividends to
stockholders or the acquisition of non-regulated businesses. PAULA Financial,
however, is subject to regulation with respect to all transactions involving the
insurance subsidiaries. Additionally, as a nonoperating holding company, a
principal source of the PAULA Financial's liquidity is cash dividends received
from its subsidiaries, including the insurance subsidiaries.
California law places significant restrictions on the ability of the
insurance subsidiaries to pay dividends to PAULA Financial. All dividends from
PICO and PACO, as California-domiciled insurers, require prior notice to the
California DOI. All "extraordinary" dividends must be approved in advance by the
California DOI. A dividend is deemed "extraordinary" if, when aggregated with
all other dividends paid within the preceding twelve months, the dividend
exceeds the greater of (i) PICO's statutory net income or PACO's statutory net
gain from operations (both excluding unrealized capital gains) for the preceding
calendar year or (ii) 10% of policyholder surplus as of the preceding December
31st. Additionally, unless approved in advance by the California DOI, no
dividend may be paid by PICO or PACO except from earned surplus. Dividends paid
from earned surplus which do not exceed the definition of "extraordinary" must
be reported to the California DOI within five business days after declaration.
Insurers are prohibited from paying such dividends until ten business days after
the California DOI's receipt of such notice. The California DOI may disallow
payment of any dividend if, in the California DOI's opinion, the payment would
in any way violate the California Insurance Code or be hazardous to
policyholders, creditors or the public. Based on these limitations and statutory
results, as of December 31, 1998, PAULA Financial would be able to receive $5.4
million in dividends in 1999 from its insurance subsidiaries without obtaining
prior regulatory approval from the California DOI.
RESTRICTIONS ON TRANSACTIONS AMONG AFFILIATES OF THE INSURANCE SUBSIDIARIES
In addition to dividend restrictions, California law restricts the ability
of the insurance subsidiaries to make other types of payments to their
affiliates, including PAULA Financial. Certain material transactions between an
insurance company and its affiliates, including sales, loans or investments
which in any twelve month period aggregate at least 3% of its admitted assets or
25% of policyholders' surplus, whichever is less, are subject to thirty day
prior notice to the California DOI during which period the California DOI may
disapprove the transaction. All management, administrative, cost-sharing and
similar agreements between an insurance company and its affiliates are also
subject to thirty day prior notice and non-disapproval by the California DOI.
The California Insurance Code requires that all affiliate transactions be fair
and reasonable to the insurer, that such transactions be documented according to
specified standards, and that the insurer's surplus after the transaction
remains reasonable in relation to the insurer's liabilities and adequate to its
financial needs.
24
EXAMINATIONS
The accounts and businesses of PICO and PACO are subject to periodic
statutory examination by the California DOI and by the Departments of Insurance
in each jurisdiction in which they transact business. The California DOI has
completed its examination of PICO and PACO for the three-year period ended
December 31, 1996. The report disclosed no material problems or adjustments to
statutory surplus.
NAIC STATUTORY ACCOUNTING INITIATIVE
The NAIC's project to codify accounting practices was approved by the NAIC
in March 1998. The approval included a provision for commissioner discretion in
determining appropriate statutory accounting for insurers in their state.
Consequently, prescribed and permitted accounting practices may continue to
differ from state to state. The California DOI has indicated that codification
will become effective on January 1, 2001. The Company has not determined how
implementation will affect its insurance subsidiaries' statutory financial
statements and is unable to predict how insurance rating agencies will interpret
or react to any such changes. No assurance can be given that future legislative
or regulatory changes resulting from such activities will not adversely affect
the Company and its subsidiaries.
RISK-BASED CAPITAL AND IRIS RATIOS
California, as well as numerous other states, uses analytical tools
developed by the NAIC in the course of its financial surveillance of insurers.
Among these is a methodology for assessing the adequacy of statutory surplus of
property/casualty insurers and life/health insurers using a risk-based capital
("RBC") formula. The RBC formula attempts to measure statutory capital and
surplus needs based on the risks in a company's mix of products and investment
portfolio. The formula is designed to allow state regulators to identify
potentially under-capitalized companies. Under the formula, a company determines
its RBC by taking into account certain risks related to the insurer's assets
(including risks related to its investment portfolio and ceded reinsurance) and
the insurer's liabilities (including underwriting risks related to the nature
and experience of its insurance business). The RBC rules provide for different
levels of regulatory attention depending upon the ratio of the company's total
adjusted capital to its "authorized control level" of RBC. An insurer is
obligated to submit a detailed financial plan to regulators if its RBC falls
below 2.0 times its authorized control level. Enhanced regulatory scrutiny,
including possible corrective orders, are required if an insurer's RBC falls
below 1.5 times its authorized control level, with mandatory regulatory
intervention, including possible seizure, if an insurer's RBC falls below its
authorized control level (seizure is mandatory if RBC falls below 0.7 times
authorized control level). As of December 31, 1998, PICO's RBC was $34.1 million
in excess of the threshold requiring the least regulatory attention, which
amount was $15.7 million. As of December 31, 1998, PACO's RBC was $4.6 million
in excess of the threshold requiring the least regulatory attention, which
amount was $0.1 million. Neither PICO nor PACO has ever triggered any RBC level
requiring a financial plan or regulatory action.
California and other states also utilize the NAIC Insurance Regulatory
Information System ("IRIS"). IRIS identifies eleven ratios for property/casualty
insurance companies and twelve ratios for life/health insurance companies. IRIS
specifies a range of "usual values" for each ratio. No statutory requirements
exist which determine regulators' response to unusual IRIS ratios. Regulators
generally allow insurers to provide written explanations for any unusual values.
If the explanations are accepted as reasonable, no regulatory action is
generally taken. If regulators remain concerned, an insurer may be subject to
regulatory examination, corrective orders, and possible seizure. Departure from
the "usual value" range on four or more
25
ratios may lead to increased regulatory oversight from individual state
insurance commissioners. For 1998, PICO has two ratios outside the usual
values. The two ratios are change in net writings and two-year overall
operating ratio. The usual range for the change in net writings ratios is
(33%) to 33%. PICO experienced 38% growth in 1998. PICO's two-year overall
operating ratio was 101% and a ratio in excess of 100% is considered
unusual. For 1998, PACO has two ratios outside its usual value, one of which
is caused by more than adequate investment income and the other related to
change in premium. PICO and PACO are unaware of any increased regulatory
scrutiny as a result of their 1998 IRIS values.
REGULATION OF PICO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED
PICO's transaction of workers' compensation insurance is closely regulated
by departments of insurance in Alaska, Arizona, California, Florida, Idaho,
Nevada, New Mexico, Oregon and Texas. In each of these states, the workers'
compensation system is a mechanism to promptly compensate and rehabilitate
injured workers without regard to fault. In each state where PICO is licensed,
other than New Mexico (with respect to agricultural workers) and Texas, employer
participation in the workers' compensation system is compulsory. Employers are
required by law either to obtain workers' compensation insurance from a licensed
insurer or to comply with specific requirements to self-insure.
Workers' compensation benefits are established by law in each of the states
where PICO is licensed. While benefit levels vary from state to state, they fall
generally into three categories: (1) medical benefits for treatment of covered
injuries or diseases; (2) disability benefits that indemnify covered claimants
for loss of income, and (3) death benefits to compensate statutorily enumerated
dependents of workers who have died because of covered accidents or diseases.
Individual state statutes, regulations, administrative rulings and judicial
opinions have created a complex body of law to determine when an injury, disease
or death is employment related, when and to what extent it is compensable, and
whether employees may sue employers, coworkers or other parties for damages
outside of the no-fault workers' compensation system.
Workers' compensation has been the subject of significant reform efforts in
recent years, particularly in the areas of cost management and fraud detection.
For example, legislation enacted in California in 1993 significantly reformed
many areas of the workers' compensation system. Among other things, the 1993
legislation (i) granted employer's rights regarding disclosure of insurer claims
information; (ii) required insurers to provide minimum levels of occupational
safety and health loss control consultation services; (iii) increased benefits,
phased in over a three-year period commencing July 1, 1994; (iv) tightened
standards relating to stress-related claims; (v) limited post-termination
claims; (vi) placed restrictions, including payment limitations, on vocational
rehabilitation claims, (vii) increased measures to reduce fraudulent claims;
(viii) increased the ability of insurance companies and employers to contract
with managed care organizations and to direct claimants' medical care; and
(ix) changed procedures for medical-legal evaluations. Similarly, legislation
adopted in Oregon in 1995, among other things, reformed requirements pertaining
to pre-existing conditions, vocational rehabilitation, payment of death
benefits, review of benefit awards and dispute resolution.
To protect persons covered under policies of workers' compensation
insurance, several states impose special deposit requirements on insurers. In
the event of an insurer insolvency, special deposits made by insurers are
utilized by the relevant department of insurance to provide a pool of funds upon
which workers' compensation claimants domiciled exclusively in that state
possess a first priority claim and can be used by the regulators to pay those
claimants. Under these requirements, PICO maintains special deposits in Arizona,
California, Idaho, Oregon, Nevada and New Mexico. Additional special deposits
may be required if PICO becomes licensed in additional states, or if Alaska,
Florida or Texas enact deposit requirements.
26
While deposit requirements vary somewhat, they generally require insurers
to deposit cash or securities with each states' treasurer, or an approved
depository, in an amount based on a company's loss and loss expense reserves
plus a percentage of its unearned premium reserves on workers' compensation
insurance business transacted in each individual state. Thus, the size of the
required deposit correlates positively with the amount of workers' compensation
insurance sold by PICO in such state. PICO maintains deposits of securities in
California, Arizona, Oregon, Idaho, New Mexico and Nevada, having a book value
as of December 31, 1998 of $55.8 million, $16.1 million, $7.2 million, $0.3
million, $3.7 million and $0.2 million, respectively.
An important aspect of workers' compensation insurance regulated by
individual states is the setting of premiums. Among the states where it is
currently licensed, PICO is allowed to establish its own rates under a "file and
use" system in Alaska, California and Texas. Prior approval by insurance
regulators is required for workers' compensation insurance rates in Florida,
Nevada, New Mexico and Oregon. Hybrid systems exist in Arizona and Idaho, where
workers' compensation insurance rates are determined initially by the National
Council on Compensation Insurance ("NCCI"), a rating organization. Upon the
request of an individual insurer, the Arizona or Idaho DOI, as applicable, may
approve rates that deviate from those recommended by the NCCI.
Prior to January 1, 1995, California had required workers' compensation
insurers to adhere to minimum rates approved by the California DOI. Under this
system, price competition among insurers had been generally restricted to the
payment of dividends under participating policies. This system was replaced with
a file and use system, in which insurers may use any rate within 30 days after
filing it with the California DOI unless such rate is specifically disapproved.
The repeal of the former minimum rate system in California has resulted in
increased competition among workers' compensation insurers in California and has
caused a material decrease in average rates charged by PICO.
Competition among workers' compensation insurers is also affected in
several states by the presence of quasi-public workers' compensation insurance
funds, which compete against private insurers and which frequently serve as
insurers of last resort to employers unable to secure coverage elsewhere. Among
the states where PICO is licensed, active state funds exist in Arizona,
California, Idaho, Nevada, New Mexico, Oregon and Texas.
REGULATION OF PACO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED
PACO, a California-domiciled insurer, is licensed in California and
Arizona. The transaction of life and health insurance is closely regulated in
these states. Such regulation includes statutorily mandated benefits, sales
disclosures, and claims settlement requirements. In 1998, PACO wrote $0.8
million in life and health premiums in California and Arizona combined.
MEMBERSHIP IN INSOLVENCY FUNDS AND ASSOCIATIONS
The Company's insurance subsidiaries, like other insurers, are required to
participate in insolvency funds and associations and may be subject to
assessments from time to time to cover unpaid policyholder claims of insolvent
insurers participating in the same lines of business as the Company. The maximum
assessment required by law in any one year has varied between 1% and 2% of
annual premiums written in that state. Most of these payments are recoverable
through future policy surcharges and premium tax
27
reductions. No material assessments have been made on the Company's insurance
subsidiaries since prior to December 31, 1990. The Company was assessed 2%
of gross written premium in the state of Florida in 1998.
COMPETITION
The workers' compensation insurance industry is highly competitive. In most
states in which the Company operates, the Company's single largest competitor in
its targeted agricultural markets is the applicable state fund. More recently,
the Company has faced increased competition from alternative risk funding
arrangements such as self-insurance or captive insurance programs. Captive
insurance companies are insurance or reinsurance companies in which an insured,
a group of insureds or an insurance agent holds significant ownership. Employers
have the option of self insuring against workers' compensation liabilities.
Normally, those companies who choose to self insure are very large employers and
are not among the targeted insurance underwriting prospects of the Company.
In those states without minimum premium laws, such as California, Oregon,
Idaho, Alaska and Texas, the Company faces competition on the basis of price as
well as on the services which it delivers to policyholders. Arizona's single
deviated rating plan has resulted in price competition among firms with
different rating plans, but not among firms with the same rating plan as PICO.
As a result of Florida's minimum rate law, there has been no significant price
competition in that state in terms of premiums charged. Competition among
workers' compensation insurance carriers in Arizona and Florida has been based
to varying degrees on emphasizing dividends to policyholders, loss control and
claims management services and maintaining relations with and varying commission
rates paid to brokers and agents. When the Company commences operations in
Nevada in July 1999, rates will be set by the Nevada DOI and the Company expects
competition to be based on service and dividends to policyholders. The Company
believes that its ability to compete successfully with larger carriers and to
obtain and retain its accounts is due to its claims expertise, extensive
experience in the agribusiness market and emphasis on service to policyholders.
The Company has entered into arrangements with two nationwide reinsurance
companies which enable the Company to cause those companies to write qualifying
workers' compensation insurance in states where the Company is not licensed and
cede virtually all of the premiums and related risk to the Company. Under the
arrangements, the Company is responsible for ensuring the writing carrier's
compliance with its filed rating plans and the payment of claims in accordance
with applicable state insurance laws. In this regard, the Company operates
under the indirect regulation of the Departments of Insurance in these several
states.
CERTAIN EXECUTIVE OFFICERS OF THE COMPANY
Information concerning the Company's executive officers who serve as
members of the Company's Board of Directors will be set forth in the Company's
definitive proxy materials. See "Item 10. Directors and Executive Officers of
the Registrant." Mr. Victor Gloria III, Mr. James M. Hannah and Mr. James J.
Muza also serve as executive officers of the Company.
Mr. Gloria is Senior Vice President of PICO and is responsible for PICO's
risk management operations including claims administration, loss control and
field representative operations. Mr. Gloria has been with the Company since
1972 and has served in PICO's claims department for a majority of that time. He
has served as Manager of that Department since 1987 and was appointed Senior
Vice President in 1987. Mr. Gloria is 44.
28
Mr. Hannah is a Senior Vice President and Chief Underwriting Officer of
PICO and is responsible for PICO's underwriting operations. Mr. Hannah joined
the Company in March 1995. Mr. Hannah is 50.
Mr. Muza is a Vice President and Chief Actuary of PICO and is responsible
for rate making and reserve setting functions. Mr. Muza joined the Company in
July 1998 following 15 years with California Casualty Insurance Company. Mr.
Muza is 45.
EMPLOYEES
As of December 31, 1998, the Company employed 309 full-time employees
including 61 in its agency and TPA operations, 222 in its underwriting
operations and 26 in corporate administration and finance. The Company considers
its relationship with its employees to be excellent. All employees with at least
one year of service are eligible to participate in the Company's Employee Stock
Ownership Plan except for those employees employed on an hourly basis.
ITEM 2. PROPERTIES.
The Company's principal executive offices, comprised of approximately
35,000 square feet of office space leased through April 2000, are located in
Pasadena, California. The Company is currently evaluating various alternatives
for its headquarters office after its current lease expires. In addition, the
Company maintains 22 branch offices in various locations in the western United
States and Florida in leased facilities with various lease terms. Management
believes that the Company's facilities are suitable and adequate for their
intended uses.
ITEM 3. LEGAL PROCEEDINGS
Except for ordinary, routine litigation incidental to the Company's
business, there are no pending material legal proceedings to which the Company
is a party or which any of its properties are subject. The nature of the
Company's business subjects it to claims or litigation relating to policies of
insurance it has issued. Management believes that the Company is not a party to,
and none of its properties is the subject of, any pending legal proceedings
which are likely to have a material adverse effect on its business, financial
conditions or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter of 1998.
29
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET INFORMATION
The Company's Common Stock has traded on the Nasdaq Stock Market under the
symbol "PFCO" since the consummation of the Company's initial public offering of
its Common Stock on October 24, 1997. The high and low closing prices of the
Common Stock on the Nasdaq Stock Market during the fourth quarter of 1997 and
1998 were as follows:
High Low
---- ---
Fourth Quarter 1997 (1) 25.250 21.250
First Quarter 1998 24.250 22.625
Second Quarter 1998 25.625 19.375
Third Quarter 1998 22.000 6.750
Fourth Quarter 1998 11.875 6.875
- ------------
(1) From October 24, 1997 through December 31, 1997
HOLDERS OF RECORD
As of March 15, 1999, the Common Stock was held of record by 216 holders.
The Company estimates that the number of beneficial holders of the Common Stock
as of such date exceeded 800.
DIVIDENDS
The Company did not pay cash dividends to its stockholders prior to the
first quarter of 1998. Since the first quarter of 1998, the Company has
declared and paid quarterly dividends of $0.04 per share of Common Stock. The
most recent dividend is payable to stockholders of record on March 15, 1999.
Although the Company currently intends to continue to pay quarterly
dividends, the declaration and payment of dividends is subject to the discretion
of the Company's Board of Directors and will depend upon, among other things,
the Company's results of operations, financial condition, cash requirements,
future prospects and capital requirements, regulatory restrictions on the
payment of dividends by the Company's insurance company subsidiaries, general
economic and business conditions and other factors deemed relevant by the Board
of Directors. There can be no assurance that the Company will continue to
declare and pay any dividends. The ability of the Company's subsidiaries to pay
dividends to the Company is subject to substantial regulation. In addition, the
Company's line of credit restricts the payment of dividends under certain
circumstances. See Management's Discussion and Analysis of Financial Condition
and Results of Operation-Liquidity and Capital Resources", "Business-Regulation"
and Note 10 of Notes to Consolidated Financial Statements.
30
ITEM 6. SELECTED FINANCIAL DATA.
The selected data presented below under the captions "Income Statement
Data" and "Balance Sheet Data" as of and for each of the years in the five-year
period ended December 31, 1998, are derived from the consolidated financial
statements of the Company, which financial statements have been audited by KPMG
LLP, independent certified public accountants. The consolidated financial
statements as of December 31, 1998 and 1997 and for each of the years in the
three-year period ended December 31, 1998, and the report thereon are included
elsewhere herein. The information presented below under the caption "Other Data"
is unaudited. The selected financial data set forth below should be read in
conjunction with Management's Discussion and Analysis of Financial Condition and
Results of Operations and the Consolidated Financial Statements and notes
thereto appearing elsewhere herein.
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
INCOME STATEMENT DATA:
Gross premiums written....................... $152,448 $100,797 $63,606 $46,762 $53,545
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Net premiums earned:
Workers' compensation..................... $127,997 $91,957 $54,563 $44,224 $50,977
Group medical and life.................... 773 878 941 307 312
Commissions.................................. 3,234 3,434 4,213 3,964 4,299
Net investment income........................ 9,540 5,582 4,701 4,817 4,536
Net realized investment gains................ 1,706 172 444 37 -
Other........................................ 842 1,047 896 1,569 1,712
--------------------------------------------------------------------------
Total revenue............................. $144,092 $103,070 $65,758 $54,918 $61,836
Losses and loss adjustment expenses incurred.
114,483 68,107 33,900 29,363 28,618
Dividends provided for policyholders......... 677 (2,713) 1,628 3,438 6,221
Operating expenses........................... 37,636 30,741 25,480 22,608 20,720