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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2001

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 ý    No o

(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. o

        The aggregate market value of the voting stock held by nonaffiliates of the registrant was $1,955,190 as of March 22, 2002.

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

        As of March 22, 2002, the registrant had outstanding 6,092,679 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 2002 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, 2000, 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 distributor of commercial insurance products. The Company's agency operations, Pan American Underwriters, Inc., Pan American Underwriters Insurance Agents and Brokers and Agri-Comp Insurance Agency (collectively "Pan Am"), place a full array of commercial insurance products for their customers. In addition, the Company owns Pan Pacific Benefit Administrators ("PPBA"), a third party administration ("TPA") operation whose sole client is PAULA Insurance Company ("PICO"). The Company also underwrote workers' compensation insurance products through its underwriting subsidiary, PICO until its February 28, 2002 announcement. See "Scope of Operations" for additional discussion.

        Additionally, in 2001, PAULA Financial liquidated its investment in PAULA Assurance Company ("PACO") and surrendered its insurance license to the state of California.

        The Company began operations in 1946 as an insurance agency providing workers' compensation and group medical employee benefits to agribusiness employers. In 1974, PICO was formed to underwrite the workers' compensation portion of the business distributed by Pan Am.

Scope of Operations

        The Company's agency business has operated in California for more than 50 years and in Arizona for more than 40 years.

        Until recently, the Company also had underwriting operations in six states: California, Arizona, Oregon, Idaho, Alaska and New Mexico. In 2000, PICO began a systematic exit from jurisdictions where the environment made it difficult to both produce profits and establish a differentiated franchise. These states included Texas, Florida and Nevada.

        On February 28, 2002, the Company announced that it would voluntarily cease underwriting workers' compensation insurance in all jurisdictions. The decision came as a result of claims reserve development primarily relating to accident years 1997-1999 on California workers' compensation business. In the fourth quarter of 2001, PICO posted an increase to prior year reserves of $37 million. This reserve increase caused PICO's Risk Based Capital ("RBC") to fall into the "Mandatory Control Level." As a result, on March 12, 2002, the Company and the California Department of Insurance ("California DOI") entered into an agreement of regulatory oversight ("Oversight Agreement"). See "Regulation" for additional discussion.

        PICO will continue to collect premium and provide coverage on policies currently inforce until expiration.

Products and Services

        Pan Am is an agency with commission revenue derived from the placement of group health, property and casualty (including workers' compensation), and some life and disability insurance products. Pan Am had commission revenues (before intercompany eliminations) of $11.4 million, $10.6 million, and $9.2 million in 2001, 2000 and 1999, respectively.

        PICO's principal source of premium was workers' compensation policies sold primarily to agribusiness employers.

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Business Strategy

Agency Operations

        The sales competency of Pan Am is not limited to employee benefits, workers' compensation and group medical sales, but these two lines predominate. There is significant share growth opportunity in its customer area of focus, agribusiness and rural markets in California and Arizona.

        Average commissions per producer have increased steadily since 1996. Maintaining this momentum through product refinement and market retention (keeping the best underwriting relationships), with ongoing sales training is fundamental to protecting margins and growing top line. It is also important to avoid sales activity in areas that place downward pressure on agency margins. Certain forms of TPA services sales can be an example of small margin activity.

        The Company has effectively identified, closed and integrated acquisitions of agencies in previous periods. Current plans allow the Company to be opportunistic in this area but it is not expected to be a critical factor to agency business development in 2002.

        In 2002 Pan Am will focus on the transition initiated by PICO and its exit from workers' compensation underwriting. Pan Am has successfully moved PICO business to alternative markets over several years and management believes that completing this process does not pose a material problem to customer retention or total commissions. (It was PICO's practice to pay a market based commission, so Pan Am should not suffer any reduction of commission to rotate business formerly underwritten by its affiliate.)

        The agency intends to maintain its involvement in the PAULA Trading Company ("PTC") as a way to keep fixed costs efficient and to strengthen markets available to Pan Am customers.

Customers

Agribusiness

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

Trade Associations and Safety Groups

        The Company believes that it gains significant marketing benefits from endorsements from agricultural trade associations. Trade association endorsements are made and renewed on an annual basis. In most cases, trade association endorsements are held by Pan Am.

        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 and formed primarily to encourage workplace safety among employer members of the group and to purchase workers' compensation insurance as a group.

        As of December 31, 2001, three trade associations or safety groups accounted for 22.7% of PICO's Estimated Annual Premium ("EAP"). Additionally, almost 70% of PICO's inforce policies at December 31, 2001 were in trade associations and safety groups.

Distribution

Direct

        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

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placement of insurance with carriers. In 2001, 2000 and 1999, Pan Am placed 16%, 29% and 37% respectively, of its total insurance premiums with PICO. For 2001, 2000 and 1999, 28%, 32% and 30%, respectively, of PICO's premiums written were sold through Pan Am.

PAULA Trading Company

        The Company affiliates with insurance agencies of similar size and operating histories to Pan Am, primarily through the PTC membership arrangement. PTC members have the potential to join various insurance agency marketing arrangements. Commission structures with PICO were negotiated separately with each agency; however, the majority of PTC agencies received PICO's standard commission rate.

Independent Insurance Agents

        PICO appointed a limited number of independent insurance agents, who were not affiliated with the PTC, to sell its workers' compensation insurance, primarily in states other than California. PICO favored appointing independent agents who primarily represented PICO in its desired agribusiness focused markets rather than presenting PICO 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

        PICO's rate making process relied upon more than 50 years of claim experience in the agribusiness industry and a proprietary database built over more than 25 years. This database includes experience by class of business and by subclass within those business classes in which the Company specialized. This experience enabled PICO to differentiate risks by creating many farm classes and subclasses, reflecting the unique characteristics of job classifications and differences in farming operations.

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Risk Selection

        Most of PICO's business was produced through Pan Am, PTC and a group of selected independent agents which have a local presence in the major agricultural areas throughout PICO's operating markets. PICO focused 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 $8,650 as of December 31, 2001.

        PICO also regularly performed analysis of underwriting results by jurisdiction. In jurisdictions where PICO did not believe it was able to obtain an adequate return of capital, PICO ceased underwriting business in those locations. In recent years this has been the case in Florida, Texas, Nevada and the coastal regions of California.

Underwriting Process

        PICO's relationship with Pan Am and other agents allowed 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. PICO's agents also met with the employer's management to assess the extent to which management was committed to safety and early return to work programs.

        Once an account passed this initial screening process and prior to approving an application, the Company's underwriting department reviewed 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 $150,000 or greater, a pre-inspection was conducted by the Company's loss control department. The Company's underwriters evaluated 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 $150,000 in EAP, the Company's underwriters generally consulted with the Company's senior claims management and actuarial personnel during the underwriting process.

        PICO established an underwriting referral policy designed to allow the 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 PICO's standard rates were 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.

Pricing

        The amount of premium PICO charged for workers' compensation insurance was dependent on the size of an employer's payroll, the job classifications of its employees and the application of PICO's rating plan to each individual employer. PICO's rating plan varied from state to state due to differences in regulatory environments. In certain states, the premium rate charged to a particular employer was 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 was then adjusted based on the employer's experience modification, which was determined by a third party rating bureau.

        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. The increase in ultimate loss experience for the years subsequent to open rating have revealed how under-priced the California marketplace was during that

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period. PICO began aggressively pursuing rate increases in mid-1998 on its California book of business. Rate increases on business retained by PICO averaged 16%, 25% and 5% in 2001, 2000 and 1999, respectively. The increases were ultimately not enough to offset the Company's decision to grow premiums in a declining rate environment and the associated adverse claim development on the 1997-2000 accident years.

Claims

        PICO'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.

Management of Claims Costs

        PICO's Special Investigation Unit reviews each claim for potential fraud as it is reported rather than only those claims referred to the unit by claims adjusters after they suspect fraud, as PICO believes is more typical in the industry. PICO believes its Special Investigation Unit's review of every claim diminishes the number of fraudulent claims paid by PICO. PICO 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. Additionally, PICO periodically holds special one-day arbitration conferences with retired workers' compensation judges to attempt to settle pending claims.

        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.

Claims Personnel

        PICO's claims management is conducted under the direction of a management team with extensive experience in the industry.

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 loss and loss adjustment expenses ("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 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 PICO relies on both actual historical data, which reflect past inflation, and on other factors which are judged to be

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appropriate modifiers of past experience, PICO 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.

        PICO sets an initial case reserve upon being notified of an insured injury. Since 1992, PICO has employed automated computer technology utilizing a database comprised of data from participating unaffiliated workers' compensation carriers to assist in setting such initial reserves. As more facts regarding the loss become known, the claims examiner reviews and, if appropriate, revises the initial case loss reserve.

        In addition to case reserves, PICO 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. PICO 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.

        PICO's internal procedures have historically analyzed PICO'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. The adverse loss development on the 1997-2000 accident years was not fully apparent in the years immediately following those accident years as the expansion in claim durations was not present in earlier periods. The establishment of loss reserves is an inherently uncertain process and there can be no assurance that ultimate losses and LAE will not exceed PICO's reserves. Any future reserve development at PICO would not impact the consolidated financial statements of the Company as PAULA Financial has already written its investment in PICO down to $—0- and is not obligated to fund additional obligations. Effectively, under the California Insurance Code, insurance companies under the regulatory control of the California DOI may only turn to the California Insurance Guarantee Association to satisfy their obligations to pay claims.

        PICO currently 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 PICO'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"). PICO 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)

        In the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, the loss reserve balance for PICO as of December 31, 2001 is not reflected in the Company's consolidated financial statements. See Footnotes 1 and 2 to the consolidated financial statements for additional discussion.

        The table below shows changes in historical workers' compensation net loss and LAE reserves for PICO for each year since 1991. 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. 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 1994 to be $10,000 was first reserved in 1991 at $8,000, the $2,000 deficiency would be included in the cumulative redundancy (deficiency) for each of the years 1991 through 1994 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, 2001. 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)

        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.

        PICO experienced an aggregate of approximately $1.6 million in net reserve development in calendar year 1997. 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 PICO 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 PICO saw reserve development on the 1997 accident year for California business in excess of its expectations given prior year reserving trends.    PICO's second quarter reserve adjustment, expressed as a percentage of related premiums, implied a pricing deficiency for those periods. PICO began to address this pricing deficiency in mid-1998 through rate increases and non-renewal activity. PICO continued to pursue rate increases in 1999, 2000 and 2001.

        In 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

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accident year as well as a contributing factor to the 1998 development can be attributed to the Texas operations.

        PICO experienced an aggregate of approximately $43.1 million in net reserve development in calendar year 2001. The continued reserve development on prior accident years relates primarily to the 1998-2000 accident years. Adverse development on the 1998 and 1999 accident years of $10.0 million and $10.1 million, respectively relates primarily to the California operations. Similar to the claims development experienced by the California workers' compensation insurance industry in general, PICO has seen ongoing expansion in incurred claims values, primarily related to medical inflation and litigation activity. The adverse loss development on the 2000 accident year of $16.2 million assumes that claims trends in the 1997-1999 accident year continue. Also contributing to the adverse loss reserve development on the 1999 and 2000 accident years are the Texas operations.

Policyholder Dividends

        Workers' compensation policies can be written on a participating or non-participating basis. Participating policies allow PICO 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), PICO's overall loss experience and competitive conditions. Since January 1, 1997, the majority of the workers' compensation insurance underwritten by PICO has been written without the expectation that PICO would pay significant policyholder dividends on such policies.

Reinsurance

        Insurance risk is ceded primarily to reduce the liability on individual claims and to protect against catastrophic losses. PICO follows the industry practice of reinsuring a portion of its risks on an excess of loss reinsurance basis. For this coverage, PICO pays the reinsurer a portion of the premiums received on all policies. In return, the reinsurer agrees to reimburse PICO for all losses in excess of a predetermined amount, commonly referred to as the insurance company's retention. Occasionally, PICO has also chosen to quota-share a portion of its retained claims exposure. In a quota-share reinsurance contract, PICO 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.

        PICO maintains excess of loss reinsurance treaties with various reinsurers for workers' compensation. Since 1974, GeneralCologne Reinsurance Corporation ("GenRe") has been PICO's primary excess of loss reinsurer. GenRe is currently assigned a letter rating of "A++ (Superior)" by A.M. Best. PICO'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, PICO 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 PICO'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 six months ended December 31, 2000 and the year ended December 31, 2001, PICO ceded 10% of

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policy years 2000 and 2001 premiums earned. The contract with ICH was terminated effective January 1, 2002.

        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 30% and has the option to cede up to a maximum of 50% of policy year 2001 earned premium to Everest Re. During the first six months of 2001, PICO ceded 50% of policy year 2001 earned premium to Everest Re. For the last six months of 2001, the quota share was adjusted to 30% of policy year 2001 earned premium. Effective January 1, 2002, the contract with Everest Re was canceled.

        In October 1998, PICO entered into a two year excess of loss and quota-share reinsurance arrangement with Reliance Insurance Company ("Reliance"). Under this arrangement, PICO 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. PICO 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. PICO 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. PICO 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.

Investments and Investment Results

        In the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, PICO's investment portfolio as of December 31, 2001 is not reflected in the Company's consolidated financial statements. (See Footnotes 1 and 2 to the consolidated financial statements for additional discussion.) The following discussion primarily relates to PICO's investment holdings at the end of 2001. As of December 31, 2001, the carrying value of PICO's investment portfolio was approximately $90.4 million and amortized cost was approximately $90.7 million. Additionally, PICO had cash of $6.0 million, a portion of which was held in money market accounts.

        The Company has employed a conservative investment strategy emphasizing asset quality and the matching of maturities of its fixed maturity investments to PICO's anticipated claim payments and other obligations. General Re—New England Asset Management, Inc. ("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 PICO'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.

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        The amount and types of investments that may be made by PICO 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 PICO's investment committee and are reviewed by the Board of Directors.

        The diversification of PICO's investment portfolio as of December 31, 2001 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.

(3)

Includes investment in the common stock of PAULA Financial.

        In 2001, PICO elected to realize a significant portion of the gain imbedded in its fixed income portfolio. As of December 31, 2001, a portion of the proceeds from these transactions had not yet been reinvested in fixed income securities due to the low interest rate environment. Consequently, as of December 31, 2001, PICO had short-term investments totaling $60.5 million.

        At December 31, 2001, PICO owned a total of $11.0 million amortized cost of AAA-rated asset backed securities which primarily consist of home equity loans. In addition PICO had investments in collateralized bond obligations and a modest exposure to auto loans. As of December 31, 2001, the average life of the asset backed securities portfolio was just over 2 years.

        It is the Company's practice to purchase almost exclusively investment grade fixed maturity securities and mutual funds primarily holding such securities for PICO's portfolio. 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.

        PAULA Financial has a minority investment of $0.7 million in a founding member of the PTC. This investment is carried at cost and is reflected in the consolidated financial statements as other investments.

        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'

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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. In 2001 the management of Montlake entered into a workout agreement with its reinsurer to fund the captive's deficit over time.

        As of December 31, 2001 the Company did not own any mortgages or real estate.

        The following table sets forth certain information regarding the investment ratings PICO's fixed maturity investment portfolio as of December 31, 2001:

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.

        As of December 31, 2001, all of PICO's fixed maturity securities carried a National Association of Insurance Commissioners ("NAIC") Class 1 designation (or a comparable rating agency designation).

        The following table sets forth certain information regarding the maturity profile of PICO's fixed maturity securities as of December 31, 2001 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.

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        The Company's investment results for each of the years in the three year period ended December 31, 2001 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 amortized cost.

(3)

Pre-tax yield is calculated as investment income divided by average total invested assets. The 2001 yield is skewed by the impact of the de-consolidation of PICO in the fourth quarter. 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 in both 2001 and 2000 is closer to historical levels.

(4)

In the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, net pre-tax investment income and net pre-tax realized investment gains (losses) for 2001 only include PICO's results for the first nine months of the year.

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        The following table summarizes net investment income from the Company's portfolio for the years ended December 31, 2001, 2000 and 1999:

Net Investment Income by Investment Type

(1)

Pre-tax yield is calculated as investment income divided by the average of the beginning and end of year investment balances. For the purpose of this calculation, investment balances were 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 3.1% for 2001, 6.4% for 2000, and 6.8% for 1999 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)

In the fourth quarter of 2001, PAULA Financial began accounting for its investment in PICO using the equity method. Consequently, net pre-tax investment income and net pre-tax realized investment gains (losses) for 2001 only include PICO's results for the first nine months of the year.

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 1, 2002, as a result of the Company's February 28, 2002 announcement, A.M. Best announced that they were lowering PICO's rating from a "B-" (Fair) to a "D" (Poor).

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Regulation

General

        PICO is subject to regulation by the Departments of Insurance ("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 PICO's 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 is domiciled in California. PICO is licensed to sell insurance in Alaska, Arizona, California, Florida, Idaho, New Mexico, Nevada, Oregon, and Texas. As discussed in more detail below, PICO has entered into the Oversight Agreement with the California DOI. Additionally, based on its RBC results and statutory surplus position at the end of 2001, PICO has received requests from Idaho and Oregon to surrender its certificate of authority in those jurisdictions. PICO anticipates that the other insurance regulatory authorities will act in the near term to withdraw or restrict PICO's authority to issue policies in their states as well.

        As previously discussed, the Company recently announced that PICO would voluntarily cease underwriting workers' compensation insurance in all jurisdictions.

Risk-Based Capital

        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 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:

        As of December 31, 2001, PICO's adjusted capital fell within the Mandatory Control Level. Consequently, on March 12, 2002, the Company and the California DOI entered into the Oversight Agreement. The Oversight Agreement generally provides that all of the ongoing operations of PICO are subject to California DOI regulatory control. More specifically the Oversight Agreement provides, most significantly, that the California DOI will appoint a Special Deputy Examiner to provide supervision and regulatory oversight, limits PICO's ability to enter transactions with any affiliated company without the prior approval of the California DOI, restricts PICO's ability to pay dividends to PAULA Financial without prior approval of the California DOI and restricts PICO's ability to consummate transactions outside the normal course of business or to incur debt without prior approval of the California DOI. Additionally, PICO cannot write any new or renewal business of any type without the prior approval of the California DOI. The agreement remains in effect until PICO either receives written notice that it is released from the agreement or the agreement is superseded by an Administrative or Superior Court Order. Under the terms of the agreement, the California DOI can amend or supplement the agreement at its sole discretion.

        In addition, certain other state insurance regulatory authorities have acted to withdraw or restrict PICO's authority to issue policies in their states. PICO anticipates that states which have not yet acted will take action in the near term to withdraw or restrict PICO's authority to do business in their respective states.

Examinations

        The accounts and businesses of PICO 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 finalized its report for PICO for the three-year period ended December 31, 1999 which disclosed an adjustment to loss reserves as of December 31, 1999 which is less than the amount of adverse development recorded by PICO in 2000 and 2001. Consequently, there is no impact to statutory surplus as of December 31, 2001.

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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 did business, 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.

        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, Florida, Idaho, Oregon, Nevada and New Mexico.

        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, Florida, New Mexico and Nevada, having a book value as of December 31, 2001 of $70.6 million, $8.1 million, $7.8 million, $0.4 million, $0.3 million, $2.2 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 did business, PICO was allowed to establish its own rates under a "file and use" system in Alaska and Texas. Prior approval by insurance regulators was 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 were 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.

        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 did business, active state funds exist in Arizona, California, Idaho, Nevada, New Mexico, Oregon and Texas.

Membership in Insolvency Funds and Associations

        PICO, like other insurers, is 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. 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.

        PICO was assessed 2% of gross written premium in the state of Florida in 2001, 2000 and 1999.

        In 2000, PICO received a notice of assessment of 1% of subject 2001 premium by the California Insurance Guarantee Association ("CIGA"). Prior to 2001, the maximum assessment available to CIGA in any given year was 1% of related California premiums. In 2001, the California legislature increased

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the maximum assessment to 2% of related California premiums. The full 2% of related California premiums has been assessed by CIGA for the 2002 and 2003 policy years. However, California law requires that such assessments be surcharged to policyholders. Original assessment amounts are "trued up" to actual results at the end of the related policy periods.

        In January 2002, PICO was assessed 1% of 2001 net direct premiums written in the state of Texas. Under Texas regulations, insurance companies recoup their assessments as an offset to future premium taxes. Since PICO is no longer writing business in the state of Texas, PICO has requested an exception from the state of Texas for this assessment.

Agency Regulation

        Regulatory authorities in the states in which Pan Am conducts business may require individual or company licensing to act as brokers, agents, third party administrators, or adjusters. Under the laws of most states, regulatory authorities have relatively broad discretion with respect to granting, renewing and revoking brokers' and agents' licenses to transact business in the state.

Competition

        Agency operations face competition primarily from local agencies in the communities where the Company's agency operations are conducted. On larger accounts, competition also comes from regional and national insurance agents and brokers.

        The workers' compensation insurance industry is highly competitive. In most states in which PICO operated, PICO's single largest competitor in its targeted agricultural markets was the applicable state fund. In those states without minimum rate laws, PICO faced competition on the basis of price as well as on the services which it delivered to policyholders.

Employees

        As of December 31, 2001, the Company, including PICO, employed 211 full-time employees including 65 in its agency, 122 in its underwriting and TPA operations and 24 in corporate administration and finance. Given the decision to exit underwriting operations, in the first quarter of 2002, the Company took action to reduce its work force. As of the end of the first quarter of 2002, the Company employed 175 full-time employees including 71 in its agency operations, 89 in its underwriting and TPA operations and 15 in corporate administration and finance. The Company considers its relationship with its employees to be excellent.

Risk Factors

Risks Related to the Variability of Operating Results

        The Company operates in a cyclical industry affected by many factors that may cause fluctuations in its operating results. The factors that may adversely affect the operations and profitability of the Company include: competition; general economic and business conditions and trends; and fluctuations in insurance rates. Many of these factors are beyond the control of the Company. The foregoing factors have contributed to significant, industry-wide year-to-year and quarter-to-quarter fluctuations in operating results and net income and could have a material adverse effect on the Company's business, financial condition and results of operations.

Significant Geographic and Industry Concentration

        The Company's current business is concentrated geographically, with approximately 89% of its commission revenue in 2001 coming from California. Adverse economic or other conditions in the

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Company's geographic area of operations would have a more severe impact on the Company than on a more diversified company.

        Currently approximately 52% of Pan Am's commission revenue is derived from the workers' compensation line of business. Adverse economic or other conditions in workers' compensation would have a more severe impact on the Company than on a more diversified company.

Highly Competitive Industry

        The insurance industry is highly competitive. The Company's competitors include, among others, direct insurance writers, specialized provider groups, in-house or multiple employer benefits administrators, and local, regional and national insurance agency operations. Many of the Company's existing or potential competitors are larger and have considerably greater financial and other resources than the Company. To the extent that any of these existing or potential competitors concentrates increased resources in the Company's specific market segments, has access to a more extensive network of carriers or offers more or better services in any of the Company's market segments, the Company could be adversely affected.

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 16 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.

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 2001.

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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 2000 and 2001 and for the period January 1, 2002 through March 25, 2002 were as follows:

Holders of Record

        As of March 22, 2002, the Common Stock was held of record by 217 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. Since 2000, the Board of Directors has elected not to declare any cash 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, 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. In addition, the Company's bank loan currently restricts the payment of dividends.

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, 2001, 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, 2001 and 2000 and for each of the years in the three-year period ended December 31, 2001, 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

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of Operations and the Consolidated Financial Statements and notes thereto appearing elsewhere herein.

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