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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2000

OR

For the Transition Period from                to                
Commission file number 0-23181

PAULA FINANCIAL
(Exact name of registrant as specified in its charter)

PAULA FINANCIAL
300 North Lake Avenue, Suite 300
Pasadena, CA 91101
(Address of principal 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 / /

    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.

    The aggregate market value of the voting stock held by nonaffiliates of the registrant was $6,368,827 as of March 21, 2001.

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

    As of March 21, 2001, the registrant had outstanding 5,341,979 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 2001 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, from the Company's Annual Reports on Form 10-K for the years ending December 31, 1999 and 1998 and from the Company's Quarterly Reports on Form 10-Q for the quarters ending September 30, 1998, March 31, 1999, September 30, 1999 and September 30, 2000.

PART I

Item 1. BUSINESS

The Company

    PAULA Financial and subsidiaries (collectively, "the Company") is a California-based specialty underwriter and distributor of commercial insurance products which, through its subsidiary PAULA Insurance Company ("PICO"), underwrites 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 also owns Pan Pacific Benefit Administrators ("PPBA"), a third party administration ("TPA") operation.

Scope of Operations

    The Company has operated 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 with significant labor-intensive agribusiness operations. The Company wrote its first policy in Oregon on January 1, 1995. The Company's experience in Oregon indicated that the business formula could be successful in other states. Subsequently, the Company expanded into Alaska, Florida, Idaho, Nevada, New Mexico and Texas. In 2000, the Company elected to scale back operations in states where the environment made it difficult to produce profits. Consequently, the Company is running off its books of business in Florida, Texas and Nevada and does not anticipate writing new business in these jurisdictions for the foreseeable future.

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, 2000, workers' compensation net premiums earned accounted for 88.7% of the Company's revenues.

    In order to differentiate its workers' compensation product from its competitors, 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 employment practices liability ("EPL") insurance in California, which provides coverage for sexual harassment, wrongful termination and discrimination; and (iii) automatic benefits for the provision of occupational medicine to workers' compensation claimants in Mexico.

    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. See also "Distribution."

    PPBA is a licensed TPA which has historically provided independent administration of claims and related services for self-insured employers' health benefit plans. Prospectively, the Company anticipates using the PPBA platform to provide a broad range of managing general agency services.

    The Company, through Pan Am, also sells "AmeriMex", a product which, until November 2000, was underwritten by PAULA Assurance Company ("PACO"), a wholly owned subsidiary of PAULA Financial. AmeriMex is typically sold alongside PICO's workers' compensation product in California and provides group medical benefits for services rendered at three provider hospitals in Mexico. Additionally, until November 2000, PACO offered low limit group term life and accidental death and dismemberment insurance to employer groups. For the year ended December 31, 2000, group medical

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and group life products accounted for an aggregate of less than 1.5% of the Company's revenues. The Company is in the process of liquidating PACO. The liquidation is expected to be completed in early 2001.

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'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 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 businesses 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.

Technology

    The Company believes that a key success factor going forward will be the effective use of technology to leverage resources. In recent years, the Company has taken various initiatives to improve its technology assets. Along those lines, effective January 2001, the Company entered into a service agreement with InsureTrade.com. InsureTrade.com is a subscription based, Internet enabled, supply chain management solution that facilitates property and casualty insurance transactions. In 2001, the Company plans to expand its California distribution network to selected rural agencies utilizing the InsureTrade.com platform. The use of the InsureTrade.com platform allows the Company to develop additional agency relationships without incurring the usual infrastructure development and maintenance costs. The Chairman and Chief Executive Officer of the Company is also the founder and Chairman of InsureTrade.com.

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. 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 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

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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 trade association endorsements allow the Company to be identified with brand names significant to agribusiness customers. Trade associations which have endorsed the Company recommend 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.

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.

    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.

Customers

Agribusiness

    The Company has served the insurance needs of agribusiness employers and other employers of immigrant workers for over 50 years. 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.

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Trade Associations and Safety Groups

    The Company believes that it gains significant marketing and underwriting benefits from the efforts of Pan Am to obtain endorsements from agricultural trade associations and to promote the formation and operation of safety groups. Trade association endorsements are made and renewed on an annual basis. As of December 31, 2000, one trade association or safety group accounted for 5.4% 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 entities which are registered with the applicable Department of Insurance ("DOI") and formed primarily to encourage workplace safety among employer members of the group and to purchase workers' compensation insurance as a group.

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 had commission revenues (before intercompany eliminations) of $10.6 million and $9.2 million in 2000 and 1999, respectively. 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 2000 and 1999, Pan Am placed 29% and 37%, respectively, 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 2000 and 1999, 32% and 30%, respectively, of PICO's premiums written was sold through Pan Am.

    Pan Am has 77 full-time equivalent employees operating from 17 offices in California, Arizona and Oregon; most of 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.

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. PTC members have access to PAULA's innovative product features such as an EPL product and have the potential to join various insurance agency marketing arrangements. Commission structures are negotiated separately with each agency; however, the majority of PTC agencies receive the Company's standard commission rate.

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 other than California. The Company favors appointing independent agents who will primarily represent the Company in its desired

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agribusiness focused markets rather than presenting the Company as one of many competing quotes together in a pricing comparison.

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 or her 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.

Underwriting

Agribusiness Underwriting Expertise

    Knowledge of Agribusiness Risks.  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. Over half of the Company's policies are in trade associations and safety groups.

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

5

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.

    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 $8,309 as of December 31, 2000. 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 $100,000 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

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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.

    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, the chief actuary and/or the chief financial officer.

    The Company's underwriting department personnel has extensive experience in property/casualty underwriting. 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.

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

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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, 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 order to mitigate the trend towards higher claim values on permanent disability claims, in the second quarter of 1999, the Company established new claims units, internally referred to as "Ranger" units. The Ranger units, which are in place in California, are based on a model of proactive claims management. Ranger team members are charged with developing action plans for each case using best practices data. Ranger team members are also subject to daily monitoring and feedback by Ranger supervisors. The Company believes that this results in increased accountability and improved oversight and ultimately allows the Company to manage claims to efficient outcomes.

    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 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.

Claims Personnel

    The Company's claims management is conducted under the direction of a management team with extensive experience in the industry. The Company believes that the combination of experience and manageable caseloads allows claims personnel to be more effective at managing claims through frequent contact with policyholders, injured workers and medical providers.

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

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losses not yet reported. Consequently, loss reserves are inherently subject to a number of highly variable circumstances.

    Reserves for losses and LAE are evaluated periodically 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 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 in-house actuary and also utilizes an outside actuarial firm to determine its reserving levels.

    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.

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Reconciliation of Reserves for Losses and LAE
(in thousands)

    The table below shows changes in historical workers' compensation net loss and LAE reserves for PICO for each year since 1990. 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 1993 to be $10,000 was first reserved in 1990 at $8,000, the $2,000 deficiency would be included in the cumulative redundancy (deficiency) for each of the years 1989 through 1993 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.

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Changes in Historical Net Reserves for Losses and LAE
(in thousands)

    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, 2000. 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).

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Calendar Year Development by Accident Year
(in thousands)

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    PICO and the California workers' compensation industry as a whole experienced relatively high incurred losses and LAE during accident years 1990-1992 as a result of laws enacted in 1989 which had the unintended effect of permitting the filing of fraudulent 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 1990-1992 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 redundant. During the three year period ended December 31, 1996, PICO experienced an aggregate of approximately $10.5 million in reserve recoveries attributable primarily to favorable development on losses and LAE for accident years 1993-1995.

    During 1997, PICO experienced an aggregate of approximately $1.6 million in net reserve development. Adverse 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 in mid-1998 through rate increases and non-renewal activity. The Company continued to pursue rate increases in 1999 and 2000.

    During 1999, PICO experienced an aggregate of approximately $17.2 million in net reserve development, $12.6 million of which related to the 1997 and 1998 accident years. The reserve development in those accident years was largely related to the California book of business and was generally attributable to longer claim durations, principally on litigated claims.

    During 2000, PICO experienced an aggregate of approximately $21.2 million in net reserve development, $11.3 million of which related to continued development on the 1998 accident year, largely attributable to extended claim durations for the California book of business. Additionally, the 1999 accident year had adverse development of $4.2 million. The reserve development for the 1999 accident year as well as a contributing factor to the 1998 development can be attributed to the Texas operations. In late 1999, the Company transitioned its portfolio of open claims from an independent TPA to PICO's in-house claim staff. Consistent with the Company's claims approach, the in-house staff took a more proactive approach to claim settlement resulting in an increase in estimated claim costs.

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, Texas and New Mexico 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, Florida and Nevada is written on participating policy forms. However, increasing upfront price competition in Arizona has led to dividends becoming less of a competitive factor in recent years. In Oregon, Idaho and Nevada, dividends are sometimes used as a competitive pricing tool, especially for trade association

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and safety groups. Workers' compensation insurers in Florida use policyholder dividends to reward favorable loss experience as a means of competitive pricing.

    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 and Idaho that are eligible for policyholder dividend consideration.

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. Occasionally, 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 party's interest in the quota-shared risk. Many times quota-share reinsurance is used as a means to manage a company's premium to surplus leverage ratio.

    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 $10.3 million) are currently provided by a 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 $60.3 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. Effective July 1, 2000, the deductible structure was changed from a fixed $2.0 million to 2.0% of earned premium.

    Effective July 1, 2000, PICO entered into a variable rate quota share agreement with the Insurance Corporation of Hannover ("ICH"). Under the terms of the agreement, PICO may cede no less than 10% and no more than $12.5 million of premiums earned in 2000 on policies with an effective date on or after January 1, 2000. The selection of the quota share percentage is at PICO's discretion. For the year ended December 31, 2000, PICO ceded 10% of policy year 2000 premiums earned in the last six months of the year to ICH. In 2001, PICO may cede not less than 10% and up to 25% of earned premiums to ICH.

    Effective January 1, 2001, PICO entered into a quota share agreement with Everest Reinsurance Company ("Everest Re"). Under the terms of the agreement, PICO will cede a minimum of 35% and has the option to cede up to a maximum of 75% of policy year 2001 earned premium to Everest Re.

    Under this combined quota share program, the Company has the ability to cede up to 75% of policy year 2001 earned premium.

    The Company has also entered into a 90% 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 generated gross premiums written of $325,000 for the year ended December 31, 2000.

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    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 ceded various portions of its exposure for claims in excess of $10,000 and quota-shared a portion of its risks under $10,000. The treaties with Reliance were settled and commuted effective September 30, 1999. The Company received the cash settlement of $42.0 million from Reliance on January 27, 2000. The settlement amount included the return of net premiums ceded during the twelve months the treaties were in effect plus a substantial break-up fee. The difference between the break-up fee and the economic benefits derived from the treaties while they were in effect was a loss of $0.8 million, pre-tax. The Company has accounted for this transaction as a commutation.

    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.

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. In 2000, the Company changed its investment advisor from Conning Asset Management Company to General Re—New England Asset Management, Inc. ("New England Asset Management"). New England Asset Management acts as an independent investment advisor for the bulk of the Company's investment portfolio pursuant to the terms of a written agreement and the Company's written investment guidelines.

    New England 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, New England Asset Management will routinely consult with the Company's Chief Investment Officer prior to entering into such transactions. Among other things, the investment advisor seeks to match the average duration of the portfolio's assets with the estimated average duration of the Company's liabilities. New England Asset Management's fee is based on the amount of assets in the portfolio and is not dependent upon investment results or portfolio turnover.

    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 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.

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    As of December 31, 2000, the carrying value of the Company's investment portfolio was approximately $148.3 million and amortized cost was approximately $150.0 million. The diversification of the Company's investment portfolio as of December 31, 2000 is shown in the table below:

Consolidated Investment Position

(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.

    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.

    In early 1999, PAULA Financial made an investment in the recently formed Montlake Insurance Holdings, LLC ("Montlake"), the parent company of Montlake Casualty, a specialty workers' compensation insurance company. The Company invested $5.5 million and has the option to acquire additional equity. The Company is accounting for its investment in Montlake using the equity method. The Company recognized its equity in the net loss of Montlake of $0.5 million and $1.3 million for the years ended December 31, 2000 and 1999, respectively. Based on Montlake's unfavorable 2000 operating results, specifically adverse loss development at their Bermuda captive, which is in run-off, in December 2000 the Company recorded a $3.3 million impairment loss to reduce the carrying value of its investment in Montlake to $0.

    As of December 31, 2000 the Company did not own any mortgages or real estate. As of December 31, 2000, 99.3% of the Company's fixed maturity securities carried a National Association of Insurance Commissioners ("NAIC") Class 1 designation (or a comparable rating agency designation).

    At December 31, 2000, the Company owned a total of $36.7 million amortized cost of mortgage backed and other asset backed securities. Mortgage backed securities accounted for $13.5 million of the total. All of the mortgage backed securities holdings were AAA-rated Agency pass through and collateralized mortgage obligations ("CMO's"). As of December 31, 2000, the average life of the mortgage backed security portfolio was just over 6 years.

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    Asset backed holdings totaled $23.2 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 and automobile loans and AAA-rated collateralized bond obligation debt issues. As of December 31, 2000, the average life of the asset backed securities portfolio was just over 2 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, 2000:

Fixed Maturity Portfolio by Standard & Poor's ("S&P") Rating

(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.

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    The following table sets forth certain information regarding the maturity profile of the Company's fixed maturity securities as of December 31, 2000 based on the earlier of the pre-escrowed date or the scheduled maturity date:

Fixed Maturity Portfolio by Years to Maturity

(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, 2000 were as follows:

Investment Portfolio Results

(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).

(3)

Pre-tax yield is calculated as investment income (including dividend income in the case of equities) divided by average total invested assets. The 2000 annual pre-tax yield as calculated above is skewed by the receipt of a $42.0 reinsurance settlement from Reliance in January 2000. The increase in the portfolio early in the year understated the Company's average total invested assets for 2000 as calculated above. The actual return is closer to historical levels.

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    The following table summarizes net investment income from the Company's portfolio for the years ended December 31, 2000, 1999 and 1998:

Net Investment Income by Investment Type

(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 6.4% for 2000, 6.8% for 1999, and 8.0% for 1998 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.

A.M. Best

    A.M. Best publishes ratings on insurance companies based on a comparative analysis of the financial condition and operating performance as determined by their publicly available reports and meetings with management. On March 9, 2001, A.M. Best announced that they were lowering PICO's rating from a "B" (Fair) to a "B-" (Fair). In its announcement, A.M. Best indicated that the downgrade reflected PICO's increased premium leverage, but also noted that recent underwriting results have improved significantly. The Company believes it has addressed A.M. Best's premium leverage concerns by putting into place prospective quota share arrangements. A.M. Best reviews its ratings periodically and there can be no assurance that PICO's current rating will be maintained in the future.

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Regulation

General

    The Company is subject to regulation by the DOI's in each jurisdiction in which they transact insurance. These DOI's 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.

    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 vary 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

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and integrity indicate that it is not in the interest of policyholders or the public to permit them to assume control.

    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, 2000, PICO would not be able to dividend any funds to its parent in 2001 without obtaining prior regulatory approval. However, PAULA Financial would be able to receive $0.3 million in dividends in 2001 from PACO without obtaining prior regulatory approval from the California DOI. The Company is in the process of liquidating PACO. The liquidation is expected to be completed in early 2001.

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.

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Examinations

    The accounts and businesses of PICO and PACO are subject to periodic statutory examination by the California DOI and by the DOI's in each jurisdiction in which they transact business. The California DOI has completed its fieldwork of PICO and PACO for the three-year period ended December 31, 1999 and is in the process of finalizing its report. Based on discussions with the California DOI, it is the Company's understanding that the draft report discloses an adjustment to loss reserves as of December 31, 1999 which was less than the amount of adverse development recorded by PICO in 2000. Consequently there is no impact to statutory surplus as of December 31, 2000.

NAIC's 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 commissioners' discretion in determining appropriate statutory accounting for insurers in their states. Consequently, prescribed and permitted accounting practices may continue to differ from state to state. Codification became effective on January 1, 2001. The implementation of codification resulted in an increase in PICO's statutory surplus of $1.2 million. There was no material impact to PACO's statutory surplus. However, the Company is unable to predict how insurance rating agencies will interpret or react to these changes. No assurance can be given that future legislative or regulatory changes resulting from NAIC activities will not adversely affect the Company.

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.

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    The following table sets forth the different levels of RBC that may trigger regulator involvement and the actions that may be triggered:

    The comprehensive plan required at the Company Action Level and certain other levels must: (i) identify the conditions in the insurer that contribute to the failure to meet the capital requirements; (ii) contain proposed corrective actions that the insurer intends to make and that would be expected to result in compliance with capital requirements; (iii) provide certain projections of the insurer's financial results for the current year and at least the four succeeding years; (iv) identify key assumptions impacting the insurer's projections and the sensitivity of the projections to the assumptions; and (v) identify the quality of, and problems associated with, the insurer's business, including but not limited to its assets, anticipated business growth and associated surplus strain, extraordinary exposure to risk, mix of business, and use of reinsurance in each case.

    As of December 31, 2000, PICO's adjusted capital fell within the Company Action Level. Consequently, the Company is required to file a detailed financial plan with the California DOI. The Company has had ongoing discussions with the California DOI. In the course of those discussions, the Company has provided the California DOI with much of the information required in the comprehensive plan. The California DOI has informed the Company that it is currently not contemplating any action other than requesting the formal comprehensive plan. The Company plans to file the formal action plan within the allotted time frame.

    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 ratios may lead to increased regulatory oversight from individual state insurance commissioners. For 2000, PICO has six ratios outside the usual values. The ratios are net premium to surplus, two-year overall operating ratio, change in surplus, one-year reserve development to surplus, two-year reserve development to surplus and estimated current reserve deficiency to surplus. Driving these results outside of the expected ranges is the fourth quarter reserve strengthening. For 2000, PACO has two ratios outside their ranges of usual values, which are caused by more than

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adequate investment income and a change in investment mix. PICO and PACO are unaware of any increased regulatory scrutiny as a result of their 2000 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 DOI's 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, 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 DOI 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.

    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

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Nevada, having a book value as of December 31, 2000 of $109.6 million, $11.4 million, $10.9 million, $0.4 million, $3.1 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 and Texas. Prior approval by insurance regulators is required for workers' compensation insurance rates in California, 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 prior approval system, in which insurers must obtain the California DOI approval of any requested rate change.

    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 2000, PACO wrote $0.7 million in life and health premiums in California. PACO wrote no business in Arizona during 2000. The Company is in the process of liquidating PACO. The liquidation is expected to be completed in early 2001.

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 the applicable state. Most of these payments are recoverable through future policy surcharges and premium tax reductions.

    The Company was assessed 2% of gross written premium in the state of Florida in 2000, 1999 and 1998.

    In 2000, the Company received a notice of assessment of 1% of subject 2001 premium by the California Insurance Guarantee Association ("CIGA"). The maximum assessment available to CIGA in any given year is 1% of related California premiums. However, California law requires that such assessments be surcharged to policyholders. Given the recent failures of a number of California workers' compensation carriers, it is likely that such assessments will continue for the foreseeable future.

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

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applicable state fund. In those states without minimum rate 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. 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.

    In the years immediately following the beginning of open rating in California on January 1, 1995, a number of companies attempted to expand their market share through merger and acquisition activity as well as competitive pricing structures. In recent years, the California marketplace has seen unprecedented negative operating results, followed by a number of highly publicized insurance company failures. Consequently, competition in recent periods has come from a more limited number of sources.

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 and Mr. James M. Hannah 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 47.

    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 52.

Employees

    As of December 31, 2000, the Company employed 252 full-time employees including 75 in its agency and TPA operations, 157 in its underwriting operations and 20 in corporate administration and finance. The Company considers its relationship with its employees to be excellent.

Item 2. PROPERTIES.

    The Company's principal executive offices, comprised of approximately 34,000 square feet of office space leased through April 2003, are located in Pasadena, California. In addition, the Company maintains 21 branch offices in various locations in the western United States in leased facilities with various lease terms. Management believes that the Company's facilities are suitable and adequate for their intended uses.

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.

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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 2000.

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PART II

Item 5. MARKET FOR REGISTRANT'S 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 1999 and 2000 were as follows:

Holders of Record

    As of March 21, 2001, the Common Stock was held of record by 212 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. From the first quarter of 1998 through the fourth quarter of 1999, the Company declared and paid quarterly dividends of $0.04 per share of Common Stock. In 2000, the Board of Directors elected not to declare any cash dividends. The decision was largely based on the Company's operating results.

    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 declare and pay dividends in the future. The ability of the Company's subsidiaries to pay dividends to the Company is subject to substantial regulation. In addition, the Company's bank loan restricts the payment of dividends. 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.

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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, 2000, 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, 2000 and 1999 and for each of the years in the three-year period ended December 31, 2000, 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.

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