UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-K

 

 

PAULA FINANCIAL

(Exact name of registrant as specified in its charter)

 

 

(626) 844-7100

(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

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).   o  Yes   ý  No.

 

The aggregate market value of the voting stock held by nonaffiliates of the registrant was $3,730,813 as of June 30, 2002.

 

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

 

As of March 19, 2004, the registrant had outstanding 6,193,645 shares of Common Stock, $0.01 par value.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

1.               The information called for by Part III, Items 10, 11, 12, 13 and 14 of this report are incorporated herein from the Company’s Proxy Statement for its 2004 Annual Meeting of Stockholders.

 

2.               A number of the exhibits to this Report called for by Part IV, Item 15 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, 2002, 2001, 2000, 1999 and 1998, 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 and from the Company’s Form 8-K filed on April 26, 2002.

 

 

PART I

 

Item 1.           BUSINESS

 

The Company

 

PAULA Financial and subsidiaries (collectively, “the Company”) is a California-based specialty distributor of commercial insurance products and services. The Company’s subsidiaries, Pan American Underwriters, Inc. in California and Pan American Underwriters Insurance Agents and Brokers, Inc. in Arizona (collectively “Pan Am”), place on behalf of its customers a full array of commercial insurance products.  See “Business Strategy” for additional discussion.

 

In the past several years the Company has affiliated with insurance agencies of similar size and operating histories to Pan Am through the PAULA Trading Company (“PTC”) .  See “Business Strategy” for additional discussion of the PTC.  The PTC is a wholly owned subsidiary of Paula Financial.  The financial operations of PTC are not material to the Company’s consolidated financial statements.

 

In addition, the Company owns Pan Pacific Benefit Administrators (“PPBA”), a third party administration operation with minimal operating activity.

 

The Company began operations in 1946 as an insurance agency providing employer’s liability, workers’ compensation and group medical employee benefits to agribusiness employers and fieldworkers.

 

The Company’s agency business has operated in California for more than 56 years and in Arizona for more than 46 years.  In 2003, approximately 96% of the Company’s agency commission income was generated in the state of California compared to 93% in 2002 and 89% in 2001.

 

Between 1974 and early 2002, the Company also operated an insurance company which underwrote workers’ compensation insurance.  The insurance company operation was ceased in the first quarter of 2002.  See “Discontinued Operations” for additional discussion.

 

Products and Services

 

Pan Am is an agency with commission income derived from the placement of group health, property and casualty (emphasizing workers’ compensation), and some life and disability insurance products. In 2003, approximately 43% of commission revenue was derived from the workers’ compensation line of business compared to 45% in 2002 and 52% in 2001.

 

Business Strategy

 

The sales competency of Pan Am is not limited to workers’ compensation and group medical sales, but these two lines predominate as a direct result of the now former insurance company operational focus on agribusiness employee benefits.  In 2003, these two lines of business accounted for approximately 59% of Pan Am’s total commission revenue compared to 64% in 2002 and 70% in 2001.  The pattern of declining relative dependence on these two lines has been intentional.  In some respects, the absence of an affiliated underwriter has allowed Pan Am, who has the customer base and skills to place insurance coverage related to general liability, property, commercial auto, crop, personal lines and life insurance—to do so with more volition than in previous periods.  While the Company anticipates that workers’ compensation and group

 

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medical sales will continue to account for a significant portion of its business, the Company believes diversifying its revenue mix provides several positives.  These benefits include the potential for improving margins, hedging the rationalization of the current hard market pricing cycle, and delivering risk flows with more balance to key insurance company markets, as the agency waits out the California workers’ compensation legislative and regulatory turmoil—with its potential for downward pressure on agency revenues (commission levels are already 40% off 2002 highs and the political pressure to reduce rates is extreme—which will further reduce the agency’s willingness to provide this coverage to clients without offsetting gains in collateral products and fee for service engagements).

 

Pan Am has access to market appointments with more than 200 property and casualty carriers and more than 100 life and health carriers, including excess and surplus lines brokers and other wholesale providers.  In practice, Pan Am places the majority of its business with ten markets.  Pan Am does not retain any underwriting risk.

 

The Company believes that there continues to be significant share growth opportunity in its historical area of focus, agribusiness and rural markets in California and Arizona.  Additionally, the Company believes that there are growth opportunities in market segments not traditionally served by Pan Am.

 

The Company also maintains a significant investment in insurance company assets, especially loss control and field service personnel.  In the past, these services were largely provided by the related insurance carriers including Pan Am’s former underwriting affiliate.  Today, many insurance carriers outsource this function or offer it to their policyholders only on a limited basis.  Pan Am provides loss control and other services both as a contractor to selected insurance carriers and on a direct basis to its customers.  Service fees increased to $602,000 in 2003 from $80,000 in 2002 and $36,000 in 2001.  The Company believes that there is the potential for additional growth in this area.

 

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.

 

The Company has historically been effective in identifying, closing and integrating acquisitions of agencies.  In mid-2002, the Company successfully recruited a team whose concentration in large account agribusiness and crop insurance complimented Pan Am’s small to mid-size account and employee benefit focus.  Additionally, joining Pan Am in the first quarter of 2003 was a group whose niche in the crop insurance marketplace makes Pan Am the largest producer of crop insurance in the western United States.

 

The PTC is an affiliation of agencies who work together to keep fixed costs efficient and to strengthen markets available to their customers.  Pan Am is one of three founding agencies to form PTC.  The PTC founders have worked together to combine selected backroom processing functions, accounting and data processing, proposal preparation, paperless electronic library infrastructure, and marketing, in an effort to achieve consolidation economics without a change in control.  This has resulted in economies of scale which are unattainable on a stand alone basis.  Additionally, the founders of PTC have made available to each other access to certain carrier relationships which would not otherwise be available to the founders operating alone.

 

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Customers

 

The Company has served the insurance needs of agribusiness employers since its inception in 1946.  Pan Am places insurance coverages for all size customers – from minimum premium accounts to large, sophisticated customers.  The current trend is to grow the segment which is defined by the needs of larger employers.

 

The Company believes that it gains significant marketing benefits from endorsements from agricultural trade associations, particularly for the small to mid-size accounts.  Trade association endorsements represent a cost effective sales marketing opportunity for Pan Am resulting from positive affiliation of the trade name and Pan Am, as well as permissible access to association membership lists for sales prospecting.  Trade association endorsements are made and renewed on an annual basis.  The Company generally does not pay for trade association endorsements but routinely supports association activities as a sponsor and occasionally purchases association newsletter advertising at market rates.  A notable exception pertains to the California Association of Winegrape Growers who, beginning in 2004, will receive a significant annual fee from Pan Am related to crop insurance sales to their members.

 

Additionally, 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.

 

The agency is also retained as the program manager of a Bermuda based alternative risk workers’ compensation facility.  The agency has a carried interest in underwriting gains of the Bermuda facility but has no explicit participation in any underwriting risk with downside potential.  The agency assumes no credit risk on behalf of its clients who are also participants in the Bermuda facility.

 

Distribution

 

Pan Am, as agent and broker, offers its customers a wide range of insurance products tailored to agribusiness employers’ specific risk transfer needs, including full or partially self-funded structures. Pan Am is a market maker in group medical and workers’ compensation products for California agribusiness employers.  Seasonal work schedules, transitory labor resources and highly perishable commodities present unique management-labor challenges to the agribusiness employer in California, including a view by many insurance carriers that this risk segment is undesirable—and thereby benefits from an advocate such as Pan Am with its demonstrated expertise in the area.

 

Pan Am’s ability to aggregate the insurance interests of thousands of agribusiness employers has made it possible to provide group health insurance to seasonal farm labor, an underserved market segment.  Pan Am has also been able to provide access to affordable workers’ compensation insurance for small agribusiness employers via proprietary safety group and trade association agribusiness marketing programs.

 

Pan Am has long term relationships with select medical providers in Mexico and is able, from time to time, to facilitate the special needs of non-resident farm workers employed in California or Arizona who seek occupational and/or non-occupational medical services in San Luis, Sonora, Mexicali and Tijuana, Baja California Norte, Mexico.

 

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Pan Am has been an effective producer of stable carrier market support for the general liability, multiple passenger bus and van liability, and bond requirements of California and Arizona farm labor contractors.

 

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.

 

In certain instances, Pan Am invoices the customer for the full premium amount and remits payment, less commission, to the insurance companies.  Pan Am maintains these net premiums due in separate trust accounts, in compliance with insurance regulations.

 

Competition

 

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

 

Employees

 

As of December 31, 2003, the Company employed 104 full-time employees.  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; fluctuations in insurance premium rates charged to the policyholders; and fluctuations in commission rates paid by the carrier to the agency.  Many of these factors are beyond the control of the Company.  Additionally, while the Company believes it maintains adequate E&O liability insurance protection, the possibility of an uncovered event has not been precluded.  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 96% of its commission revenue in 2003 coming from California.  Adverse economic or other conditions in the Company’s geographic area of operations would have a more severe impact on the Company than on a more diversified company.

 

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Currently approximately 43% 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.

 

For example the realities of the current workers’ compensation marketplace in California are that the State Compensation Insurance Fund (“SCIF”) is the largest single market for workers’ compensation insurance in the state.  Consequently, Pan Am places a significant portion of its related business with SCIF.  Prior to August 2003, SCIF’s maximum commission rate was 8.0%.  Effective August 2003, the maximum commission rate is 5.5%.  Since commission rates are only adjusted at renewal, the full impact of this change will not be reflected in the Company’s consolidated financial statements until the last half of 2004.  Additionally, effective with the 2004 calendar year, SCIF has eliminated contingent commissions related to volume bonus and retention targets.  See additional discussion regarding SCIF in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

 

In addition, the Company expects that prevailing political pressures in California may potentially result in reduced premium rates charged to California employers for workers’ compensation coverage with a resulting decline in commission revenues.

 

Highly Competitive Industry

 

The insurance agency 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.

 

Key Employees

 

The loss of services of either Jeffrey A. Snider, the Company’s Chairman, Chief Executive Officer and President or Roberts F. Underwood, Pan Am’s President, could adversely affect the Company’s ability to carry out its business plan.

 

Discontinued Operations

 

Historically, the Company also underwrote workers compensation insurance products through its underwriting subsidiary, PAULA Insurance Company (“PICO”).  On February 28, 2002, the Company announced that PICO 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 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”).

 

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The Oversight Agreement remained in effect until April 26, 2002.  On that date, the California DOI obtained a court order appointing the Insurance Commissioner of the State of California (the “Commissioner”) the conservator of PICO.  In accordance with the order the Commissioner took possession of the property, business, books, records, accounts and offices occupied by PICO.  Additionally, the Commissioner assumed responsibility for conducting the business operations of PICO.  On June 21, 2002, the Commissioner obtained a liquidation order.

 

Subsequent to the liquidation order, the Company provided limited operational support to PICO.  For example, the Company provided payroll and human resource department support into the third quarter of 2002 and Pan Am had inforce premiums on PICO’s books until all policies were cancelled in July 2002.  Subsequent to that date there was on-going involvement with PICO related to the separation of previously commingled locations.  Given the continued activity with PICO through the third quarter of 2002, the Company was precluded from treating PICO as a discontinued operation for accounting purposes.  In the fourth quarter of 2002 the requirements of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets” for treating a segment as a discontinued operation were met.  Consequently, the Company’s consolidated financial statements for current and prior periods have been adjusted to reflect the operations of PICO as discontinued operations.

 

California insurance regulation provides that when an insurance company is deemed insolvent, the state steps in and assumes control of all operations of the insurance company, including a provision for any shortfall in funds to pay claims. The California Insurance Guaranty Association is the entity responsible for all policyholder claims obligations of insolvent insurance companies.  Because PAULA Financial has no continuing legal obligation, the Company has made no provision for the excess of liabilities over assets of PICO.

 

Item 2.           PROPERTIES.

 

The Company’s principal executive offices, comprised of approximately 4,500 square feet of office space leased through May 2005, are located in Pasadena, California. In addition, the Company maintains 14 branch offices in various locations in California and Arizona 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 as discussed below and 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.

 

Pan American Underwriters Insurance Agents and Brokers, Inc. (the “Arizona Company”) is a defendant in an action filed in Arizona Superior Court, Maricopa County, by two hospitals and two individuals seeking damages for the Arizona Company’s sale of SGP Benefit Plan, Inc. (“SGP”), a Multi-Employer Welfare Arrangement (“MEWA”) licensed by the State of California.  SGP operated in California and Arizona and has filed for Chapter 7 bankruptcy protection in the United States Bankruptcy Court for the Eastern Division of California.

 

At the time of the filing of the bankruptcy, SGP allegedly owed plaintiffs certain unpaid benefits under its plans.  Plaintiffs allege that those benefits total approximately $935,000.  The plaintiffs contend that the MEWA required a license from the Arizona Department of Insurance, that the MEWA lacked such a

 

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license, and that the Arizona Company is liable for unpaid benefits pursuant to Arizona Revised Statute 20-402 (B) which provides for an agents liability when an unlicensed insurer fails to pay any claim or loss within the provisions of the insurance contract.

 

The Arizona Company has filed an answer to the complaint denying liability and has filed a counterclaim against the hospital plaintiffs and a cross complaint against a third party, Sunkist Growers, Inc. alleging that it is responsible in whole or part for any damages caused to plaintiffs.

 

While it is difficult to predict the outcome of any litigation, as the nature of litigation is always uncertain, the Company believes that the results of the above discussed litigation will not have a material impact on the financial operations of the Company.

 

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 2003.

 

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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 2003 and 2002 were as follows:

 

		High		Low
First Quarter 2003		0.970		0.700
Second Quarter 2003		1.700		0.800
Third Quarter 2003		1.590		1.280
Fourth Quarter 2003		2.810		1.270
First Quarter 2002		1.700		0.150
Second Quarter 2002		2.090		0.360
Third Quarter 2002		1.000		0.810
Fourth Quarter 2002		0.900		0.630

 

Holders of Record

 

As of March 19, 2004, the Common Stock was held of record by 169 holders.

 

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. The Board of Directors has held discussions regarding the reinstatement of a stockholder dividend and has indicated that at the earliest practical convenience they will consider declaring a regular dividend.  There can be no assurance that the Company will declare and pay dividends in the future.

 

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Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table set forth information as to securities authorized for issuance under equity compensation plans as of December 31, 2003.

 

Plan Category		Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights		Weighted Average Exercise Price of Outstanding Options, Warrants and Rights			Number of Securities remaining Available for Future Issuance
Equity compensation plans approved by security holders:
1994 Plan		—		—			3,233
1997 Plan		379,126		$	0.53		283,310
Equity compensation plans not approved by security holders		—		—			—
Total		379,126		$	0.53		286,543

 

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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, 2003, are derived from the consolidated financial statements of the Company.  The consolidated financial statements as of December 31, 2003 and 2002 and for each of the years in the three-year period ended December 31, 2003 are included elsewhere herein. The selected financial data set forth below should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto appearing elsewhere herein.

 

 

		Years Ended December 31,
		2003			2002			2001 (3)			2000 (3)			1999 (3)
		(dollars in thousands, except per share data)
Income Statement Data:
Commissions		$	16,716		$	11,640		$	10,282		$	8,924		$	7,759
Contingent commissions		2,039			1,720			1,516			1,608			1,245
Net investment income		7			17			158			531			514
Net realized investment gains (losses) (2)		—			—			72			(5,248		)	(1,314		)
Service fees		602			80			36			92			267
Other income		32			232			54			704			846
Total income		19,396			13,689			12,118			6,611			9,317
Salaries and related expenses		10,165			7,958			6,377			5,951			5,866
Interest expense		149			268			672			1,524			741
Amortization expense		538			389			755			947			848
Other expenses		6,022			3,816			3,854			3,728			3,039
Total operating expenses		16,874			12,431			11,658			12,150			10,494
Equity in net loss of unconsolidated affiliate		—			—			—			(1,377		)	(506		)
Income (loss) from continuing operations before taxes		2,522			1,258			460			(6,916		)	(1,683		)
Income tax expense (benefit)		1,094			(144		)	198			1,530			(473		)
Income (loss) from continuing operations		1,428			1,402			262			(8,446		)	(1,210		)
Loss from operations of discontinued underwriting segment - PICO		—			(1,426		)	(38,601		)	(15,713		)	(19,540		)
Income tax benefit		—			(604		)	(7,047		)	(4,954		)	(7,011		)
Loss on discontinued operations		—			(822		)	(31,554		)	(10,759		)	(12,529		)
Net income (loss)		$	1,428		$	580		$	(31,292	)	$	(19,205	)	$	(13,739	)

 

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		Years Ended December 31,
		2003			2002			2001 (3)			2000 (3)			1999 (3)
		(dollars in thousands, except per share data)
Earnings (loss) per share (1)
Income (loss) from continuing operations		$	0.23		$	0.23		$	0.05		$	(1.54	)	$	(0.21	)
Loss on discontinued operations		—			(0.13		)	(5.58		)	(1.97		)	(2.14		)
Net income (loss)		$	0.23		$	0.10		$	(5.53	)	$	(3.51	)	$	(2.35	)
Weighted average shares outstanding (1)		6,321,322			6,095,617			5,656,278			5,475,170			5,847,836
Earnings (loss) per share - assuming dilution(1)
Income (loss) from continuing operations		$	0.22		$	0.22		$	0.05		$	(1.54	)	$	(0.21	)
Loss on discontinued operations		—			(0.13		)	(5.58		)	(1.97		)	(2.14		)
Net income (loss)		$	0.22		$	0.09		$	(5.53	)	$	(3.51	)	$	(2.35	)
Weighted average shares outstanding - assuming dilution (1)		6,555,298			6,150,698			5,656,278			5,475,170			5,847,836
Balance Sheet Data:
Total assets related to continuing operations		$	19,401		$	14,300		$	13,181		$	14,505		$	27,367
Net assets related to discontinued operations		—			—			—			37,849			45,277
Notes payable		1,676			2,750			4,051			12,879			16,632
Total liabilities		10,045			6,641			6,799			16,593			21,021
Net stockholders’ equity		9,356			7,659			6,382			35,761			51,623

 

(1)          See Note 1 of Notes to Consolidated Financial Statements for a description of the calculation of weighted average shares outstanding and earnings (loss) per share.

(2)          In 2000 includes impairment loss on unconsolidated affiliate.

(3)          Previously reported financial information has been adjusted to reflect the reclassification of the underwriting operation as a discontinued operation.

 

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Quarterly Data

 

The following is a summary of operations by quarter for the years ended December 31, 2003 and 2002:

 

		2003
		March 31			June 30			Sept 30			Dec 31
		(dollars in thousands)
Total income		$	4,619		$	4,299		$	5,230		$	5,248
Total expenses		4,097			4,097			4,387			4,293
Income from continuing operations		296			113			476			543
Net income		$	296		$	113		$	476		$	543
Earnings per share from continuing operations – assuming dilution*		$	0.05		$	0.02		$	0.07		$	0.08

 

		2002
		March 31			June 30			Sept 30			Dec 31
		(dollars in thousands)
Total income		$	3,244		$	2,928		$	3,520		$	3,997
Total expenses		2,797			2,702			3,268			3,664
Income from continuing operations		260			122			147			873
Loss on discontinued operations		(48		)	(72		)	(41		)	(661		)
Net income		$	212		$	50		$	106		$	212
Earnings per share from continuing operations – assuming dilution*		$	0.04		$	0.02		$	0.02		$	0.09

 

*  Quarters do not add to full year due to changes in shares outstanding.

 

Item 7.           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Critical Accounting Policies and Estimates

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”).  The preparation of these financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the applicable period.  On an ongoing basis, management evaluates its estimates, assumptions and judgments, including those related to revenue recognition, intangible assets, income taxes, financing arrangements and contingencies.  Management bases its estimates, assumptions and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

 

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Management believes the following critical accounting policies, among others, affect its more significant estimates, assumptions and judgments used in the preparation of the consolidated financial statements.

 

Revenue Recognition. Commission income is recorded on the effective date of the policy or the billing date, whichever is later.  In the case of contingent commissions tied to achieving specified volume levels, revenue is recorded when the related criteria has been met.  Contingent commission income associated with profit sharing arrangements is recorded at the earlier of the amounts being reasonably estimatable or receipt of such amounts.  Service fees are earned over the period the related services are performed.

 

Discontinued Operations.  As of December 31, 2001, PICO’s Risk Based Capital fell into the “Mandatory Control Level.”  Consequently, on March 12, 2002, PICO and the California DOI entered into an Oversight Agreement which effectively gave the California DOI control over PICO’s operations.

 

On April 26, 2002, the California DOI obtained a conservation order for PICO which was followed on June 21, 2002 by a liquidation order.  Subsequent to the liquation order, the Company provided limited operation support to PICO.  Given the continued activity with PICO through the third quarter of 2002, the Company was precluded from treating PICO as a discontinued operation for accounting purposes.

 

In the fourth quarter of 2002 the requirements of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets” (“SFAS 144”) for treating a segment as a discontinued operation were met.  Consequently, operating activity related to workers’ compensation underwriting has been reclassified as discontinued operations.  As a result, certain financial information previously issued has been adjusted to give effect to the classification of the PICO business as discontinued operations in accordance with SFAS 144.

 

Amounts related to discontinued operations in 2002 primarily relate to the write off of PICO receivables and employee severance costs associated with the discontinuance of PICO operations.

 

Business Acquisitions and Purchase Price Allocations.  All of the Company’s acquisitions have been accounted for using the purchase method.  Consequently, the net assets and results of operations of the acquired operations have been included in the Company’s consolidated financial statements from the respective acquisition dates.  The Company structures such transactions to include “earn out” provisions whereby the ultimate purchase price is tied to actual revenues in the months immediately following the effective date (generally twelve months).  Additional or reduced consideration resulting from such “earn out” provisions is reflected as an adjustment to goodwill when the contingency is resolved.

 

The Company uses a methodology based on discounted future cash flows derived from acquired client lists and attrition rates to estimate the fair value of the expiration rights and other intangible assets at the date of acquisition.  Expiration rights are amortized on a straight line basis over their estimates lives of five to seven years.  Non-compete agreements are typically valued at their stated contractual amount and are amortized on a straight line basis over the terms of the agreements.  Goodwill is not subject to amortization.  Both the allocation of purchase price and the estimation of useful lives require management’s judgment.  If historical fact patterns were to change, such as the rate of attrition of acquired client accounts, the Company may be required to allocate more purchase price to goodwill or accelerate the amortization of expiration rights, which may have a material negative impact on the Company’s financial position or results of operations.

 

13

 

Goodwill and Other Intangible Asset Impairment.  The Company assesses the recoverability of goodwill and other intangible assets at least once a year or as required based on triggering events.  A triggering event is a change in business circumstances that indicates that the carrying value of the asset may not be recoverable.  Examples of a triggering event include poor financial results or projections, deterioration of client base, loss of key employees or changes in the marketplace.  Reviews for triggering events require the use of management’s judgment.  If as a result of the impairment review, the Company finds that the carrying value of an asset is in excess of the fair value, the Company would be required to take a charge against current earnings.  The results of our reviews disclosed no such asset impairments in 2003 and 2002.

 

Income Taxes.  Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and any related valuation allowance involves judgment.  GAAP requires deferred tax assets and liabilities to be recognized for the estimated future tax effects attributed to temporary differences and carryforwards based on provisions of the enacted tax law.  The effects of future changes in tax laws or rates are not anticipated.  Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements.  Carryforwards primarily include items such as net operating losses, which can be carried forward to future tax years.

 

The Company is required to reduce its net deferred tax asset by a valuation allowance to the extent that, based on the weight of available evidence, it is “more likely than not” that any deferred tax asset will not be realized.  Any increase in the related allowance account would decrease reported earnings on a dollar for dollar basis in the year in which such recognition was to occur.  Because of the quasi-reorganization effected by the Company in 2003, any decrease in the valuation allowance will be a direct increase to additional paid in capital.

 

Overview

 

The Company’s revenues consist primarily of commission income, contingent commission income, service fees and other income. Commission income is earned from Pan Am’s distribution of insurance. Contingent commission income is related to volume and profit sharing arrangements with insurance carriers.

 

The Company’s expenses consist of salaries and related expenses, interest expense, amortization expense and other general and administrative expenses.

 

Results of Operations

 

2003 Compared to 2002

 

Commission income.  Commission income increased 43.6% to $16.7 million for 2003 from $11.6 million for 2002.  The increase was largely driven by increases in Pan Am’s placement of crop insurance which has been a focus of the Company since mid-2002.  In 2003, approximately 50% of the total increase in commission income is due to increases in the crop line of business.  The Company has made efforts to expand this line through producer recruitment and the 2003 acquisition of Roudebush & Avina Insurance Agency, Inc. (“R&A”), a Modesto, California agency specializing in crop insurance to commercial wine grape growers.

 

Also, contributing to the increase in commission income in 2003 was an increase in the workers’ compensation line of business.  In 2003, approximately 39% of the total increase in commission income is due to increases in the workers compensation line of business.  Currently SCIF is the largest single market for workers’ compensation insurance in the state of California.  Consequently, the Company places a

 

14

 

significant portion of its related business with SCIF.  Prior to August 2003, SCIF’s maximum commission rate was 8.0%.  Effective August 2003, the maximum commission rate is 5.5%.  Since commission rates are only adjusted at renewal, the full impact of this change will not be reflected in the Company’s consolidated financial statements until the last half of 2004.

 

The Company is attempting to mitigate the impact of the SCIF commission adjustment in a number of significant ways.  First, the Company is actively engaged in offering alternative risk structures, including proprietary access to a member owned Bermuda captive.  Second, the Company is diversifying its revenue base by expanding its property and casualty commissions and developing a significant crop insurance platform as discussed above.  Service fees are also becoming a more meaningful part of the revenue schedule.

 

The Company is continuing to see the impact of its diversification efforts.  For the year ended December 31, 2003, workers’ compensation accounted for 43% of commission income as compared to 45% for the comparable 2002 period.

 

Contingent commission income.  Contingent commission income increased 18.5% to $2.0 million for 2003 from $1.7 million for 2002.  Contingent commission fluctuates from year to year based on the profitability of the underlying business and external market conditions which can result in changes to contingency programs offered by insurance carriers.

 

In 2003, approximately 50% of the contingent commission income earned related to volume and retention bonuses related to the SCIF business.  SCIF has discontinued these contingent commissions arrangements for the 2004 calendar year (although the profit share component remains), therefore, contingent commission income is expected to decline in 2004.  See discussion above related to actions taken by the Company to mitigate the impact of SCIF commission adjustments.

 

Service Fees.  Service fee income increased to $602,000 for 2003 from $80,000 for 2002.  The increase in service fees is due to new service arrangements where the Company is paid for providing loss control and other field support services to selected accounts.  Pan Am provides loss control and other services both as a contractor to selected insurance carriers and on a direct basis to its customers.

 

Salaries and related expenses. Salaries and employee benefits increased 27.7% to $10.2 million for 2003 from $8.0 million for 2002.  The increase is due to three primary factors: the transfer of selected employees from PICO’s payroll to Pan Am in early to mid-2002, the addition of new employees beginning in July 2002 and the elimination of previous cost sharing arrangements that were in effect with PICO through mid-2002.  Salaries and related expenses was 52% of total revenues for 2003 as compared to 58% for the comparable 2002 period

 

Interest expense. Interest expense decreased 44.4% to $149,000 for 2003 from $268,000 for 2002.  The decrease is due to a decline in the outstanding balance of the related note payable as well as a decrease in the interest rate on the note payable.  As of the beginning of 2002, the note payable to bank had a balance of $4.1 million which was reduced to $2.8 million at the beginning of 2003 and further reduced to $1.7 million by the end of 2003.

 

Amortization expense. Amortization expense increased 38.3% to $538,000 for 2003 from $389,000 for 2002.  The increase is due to an increase in intangible assets related to agency purchases in mid 2002 and early 2003.

 

15

 

Operating expenses.  Operating expenses increased 57.8% to $6.0 million for 2003 from $3.8 million for 2002.  The increase is primarily due to the elimination of previous cost sharing arrangements that were in effect with PICO until mid-2002 as well as the costs associated with an increased number of employees, including insurance and facilities expense.  Also contributing to the increase in operating expenses are accruals associated with legal matters.

 

Income from continuing operations before taxes.  Income from continuing operations before taxes increased to $2.5 million in 2003 from $1.3 million in 2002.  The increase was primarily driven by an increase in commission income.

 

Income taxes on continuing operations.  Income tax expense on continuing operations for 2003 was $1.1 million compared to a benefit of $144,000 for 2002.  The effective income tax rates for 2003 and 2002 were 43.4% and (11.4%), respectively. The total tax expense (benefit) from continuing operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):

 

		2003			2002
Expected tax expense		$	858		$	428
Nondeductible expenses		68			22
State income taxes, net of Federal benefit		168			132
Change in valuation allowance		—			(525		)
Alternative minimum tax carryback		—			(197		)
Other, net		—			(4		)
		$	1,094		$	(144	)

 

On a Federal income tax basis, the Company currently has significant net operating loss carryforwards.  The income tax expense in 2003 largely reflects the utilization of those net operating loss carryforwards and does not represent taxes paid or payable.

 

The net deferred tax asset is the amount the Company believes is more likely than not will be realized in the next several years and is adjusted based on anticipated future operating results.  In 2002, changes in the tax law made available for recovery certain alternative minimum tax payments made for years which were previously closed.

 

2002 Compared to 2001

 

Commission income.  Commission income increased 13.2% to $11.6 million for 2002 from $10.3 million for 2001.  The increase was largely driven by Pan Am’s entry into crop insurance and an increase in the placement of general liability, property, and commercial auto lines of business.  The increase in these lines of business account for more than 90% of the increase in commission income.  Also, contributing to the increase were rate increases on underlying workers’ compensation and accident and health policies.

 

Contingent commission income.  Contingent commission income increased 13.5% to $1.7 million for 2002 from $1.5 million for 2001.  Contingent commission fluctuates from year to year based on the profitability of the underlying business.

 

Net investment income.  Net investment income is comprised of interest income on various trustee savings accounts.  Net investment income decreased 89.2% to $17,000 for 2002 from $158,000 for 2001.

 

16

 

The decline is due to a combination of a lower interest rate environment and less funds being held in these interest bearing accounts.

 

Salaries and related expenses. Salaries and employee benefits increased 24.8% to $8.0 million for 2002 from $6.4 million for 2001.  The increase is due to two primary factors:  the transfer of selected employees from PICO’s payroll to Pan Am in early to mid-2002 and the addition of new employees beginning in July 2002.

 

Interest expense. Interest expense decreased 60.1% to $268,000 for 2002 from $672,000 for 2001.  The decrease is due to a decline in the outstanding balance of the related note payable.  As of the beginning of 2001, the note payable to bank had a balance of $12.9 million which was reduced to $4.1 million at the beginning of 2002 and further reduced to $2.8 million by the end of 2002.

 

Amortization expense. Amortization expense decreased 48.5% to $389,000 for 2002 from $755,000 for 2001.  The decrease in amortization on intangibles is due to the related intangible asset becoming fully amortized at the end of 2001.  In addition, the Company ceased recording goodwill amortization in accordance with SFAS 142 beginning on January 1, 2002.

 

Operating expenses.  Operating expenses decreased 1.0% to $3.8 million for 2002 from $3.9 million for 2001.

 

Income from continuing operations before taxes.  Income from continuing operations before taxes increased to $1.3 million in 2002 from $460,000 in 2001.  The increase was primarily driven by an increase in commission income.

 

Income taxes on continuing operations.  Income tax benefit on continuing operations for 2002 was $144,000 compared to an expense of $198,000 for 2001.  The effective income tax rates for 2002 and 2001 were (11.4%) and 43.0%, respectively. The total tax expense (benefit) from continuing operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):

 

		2002			2001
Expected tax expense		$	428		$	156
Nondeductible expenses		22			6
State income taxes, net of Federal benefit		132			39
Change in valuation allowance		(525		)	—
Alternative minimum tax carryback		(197		)	—
Other, net		(4		)	(3		)
		$	(144	)	$	198

 

The net deferred tax asset is the amount the Company believes is more likely than not will be realized and is adjusted based on anticipated future operating results and various tax planning strategies.  In 2002, changes in the tax law made available for recovery certain alternative minimum tax payments made for years which were previously closed.

 

17

 

Loss from discontinued operations before taxes.  In 2002, these costs primarily included the write off of PICO receivables and employee severance costs associated with the discontinuance of PICO operations.  In 2001 the loss from discontinued operations largely related to adverse development on prior accident year loss reserves.

 

Income taxes on discontinued operations.  Income tax benefit on discontinued operations for 2002 was $604,000 compared to $7.0 million for 2001.  The effective income tax rates for 2002 and 2001 were 42.4% and 18.3%, respectively. The total tax benefit from discontinued operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation ($’s in 000’s):

 

		2002			2001
Expected tax benefit		$	(484	)	$	(13,124	)
Tax exempt investment income		—			(163		)
State income taxes, net of Federal benefit		(128		)	—
Change in valuation allowance		—			6,195
Nondeductible expenses		—			42
Other, net		8			3
		$	(604	)	$	(7,047	)

 

Net income (loss).  Net income for 2002 was $580,000 compared to a loss of $31.3 million in 2001.  The 2001 net loss was due to loss from discontinued operations.

 

Liquidity and Capital Resources

 

The Parent Company

 

As a holding company, PAULA Financial’s principal sources of funds are dividends and expense reimbursements from its operating subsidiaries and proceeds from the sale of its capital stock. PAULA Financial’s principal uses of funds are capital contributions to its subsidiaries, payment of operating expenses, and repurchase of Company common stock.

 

Prior to the refinancing discussed below, PAULA Financial had a credit agreement with Bank of the West.  On November 1, 2003, the Company refinanced its outstanding bank debt with a $1,800,000 reducing revolving line of credit (the “Line of Credit”) with US Bank (the “Lender”).  The line of credit matures one year from funding, with a one-year automatic option to extend as long as the Company is in compliance with all covenants.  As of December 31, 2003, PAULA Financial was in compliance with all of the covenants.  Balances outstanding under the term loan bear interest at prime rate plus 1.0%.  As of March 15, 2004, the interest rate was 5.0%.

 

PAULA Financial’s subsidiaries have guaranteed the obligations of PAULA Financial under the Line of Credit.  Additionally, the Lender has a security interest in the assets of the Company.

 

The Company’s Board of Directors had previously approved a 1,000,000 share repurchase program.  On February 20, 2003, the Board of Directors authorized an additional 2,000,000 shares for the share repurchase program.  As of December 31, 2003, the Company held 924,734 shares in treasury stock.

 

18

 

Contractual Obligations and Commitments

 

The following is a summary of the Company’s contractual obligations as of December 31, 2003:

 

					Payments Due by Period
		Total			Less Than 1 Year			2-3 Years			4-5 Years			More than 5 Years
		(dollars in thousands)
Debt		$	1,676		$	400		$	1,276		$	—		$	—
Acquisition payable		$	2,319		$	993		$	1,125		$	201		$	—
Operating lease		$	1,517		$	620		$	773		$	124		$	—
Total		$	5,512		$	2,013		$	3,174		$	325		$	—

 

Management believes that funds currently available and expected to be generated by agency operations will be sufficient to meet the required contractual obligations.

 

Operating Subsidiaries

 

The sources of funds of the agency operations are cash flows from operating activities and the major use of funds is operating expenses. In the most recent years, operating cash flows at Pan Am have met the agency subsidiaries’ liquidity requirements as well as a substantial portion of the parent company’s cash flow requirements, including debt service requirements.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2003 the Company had no off-balance sheet arrangements.

 

Related Party Transactions

 

Since 1999, the Company’s agency operations have outsourced certain backroom functions to a service center operation.  In 2001, a partial owner of this agency, James G. Parker, III, was elected to the Company’s board of directors.  Fees paid by the Company’s agency to the service center were $1.5 million, $1.3 million and $1.1 million for the years ended December 31, 2003, 2002 and 2001, respectively which consisted primarily of direct expense reimbursements.  Additionally, the Company has a $0.7 million minority investment in the related agency.

 

New Accounting Standards

 

In December 2002, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123”. This Statement amends SFAS No. 123, “Accounting for Stock Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock based employee compensation. In addition, this SFAS amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the notes to the accompanying consolidated financial statements.

 

19

 

Forward-Looking Statements

 

In connection with, and because it desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers to recognize the existence of certain forward-looking statements in this Form 10-K and in any other statement made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission.  Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments.  Some forward-looking statements may be identified by the use of terms such as “expects,” “believes,” “anticipates,” “intends,” or “judgment.” Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties, many of which are beyond the Company’s control and many of which, with respect to future business decisions, are subject to change.  Examples of such uncertainties and contingencies include, among other important factors, those affecting the insurance industry in general, such as the economic and interest rate environment, legislative and regulatory developments and market pricing and competitive trends, and those relating specifically to the Company and its businesses, such as the level of commission revenue and fee income, and acquisitions of companies or blocks of business.  These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company disclaims any obligation to update forward-looking statements.

 

Item 7A.                QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.

 

The following sections address the significant market risks associated with the Company’s financial activities as of December 31, 2003. Caution should be used in evaluating the Company’s overall market risk from the information below, since actual results could differ materially from the estimates and assumptions used below.

 

Interest Rate Risk

 

The Company does not utilize stand-alone derivatives to manage interest rate risks.  The Company has historically utilized a moderate level of corporate borrowings and debt. As of December 31, 2003, notes payable to bank account for 17% of total liabilities.

 

Any change in interest rates would not change the fair value of the Line of Credit as the Line of Credit has a variable interest rate.  A 100 bp change in interest rate would change interest expense in 2004 by approximately $15,000.

 

Equity Price Risk

 

The Company generally does not invest in equity securities for trading purposes.

 

20

Item 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

Report of Ernst & Young LLP, Independent Auditors
Report of KPMG LLP, Independent Auditors
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2003
Consolidated Statements of Comprehensive Income (Loss) for each of the three years in the period ended December 31, 2003
Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2003
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2003
Notes to Consolidated Financial Statements

 

F-1

 

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

 

The Board of Directors

PAULA Financial

 

We have audited the accompanying consolidated balance sheet of PAULA Financial and subsidiaries as of December 31, 2003, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for the year then ended.  Our audit also included the financial statement schedules as of and for the year ended December 31, 2003 listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit.

 

We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of PAULA Financial and subsidiaries at December 31, 2003, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States.  Also, in our opinion, the related financial statement schedules as of and for the year ended December 31, 2003, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

 

	/s/ Ernst & Young LLP
Los Angeles, California
February 13, 2004

 

F-2

 

INDEPENDENT AUDITORS’ REPORT

 

The Board of Directors

PAULA Financial:

 

We have audited the accompanying consolidated balance sheet of PAULA Financial and subsidiaries as of December 31, 2002 and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the years in the two-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PAULA Financial and subsidiaries as of December 31, 2002 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 141, “Business Combinations” and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” which changed the Company’s method of accounting for goodwill and other intangible assets effective January 1, 2002.

 

	/s/ KPMG LLP
Los Angeles, California
March 7, 2003

 

F-3

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Balance Sheets

 

(Dollars in thousands)

 

Assets

 

		December 31,
		2003			2002
Current Assets:
Cash, unrestricted		$	614		$	439
Cash, restricted		2,496			851
Total cash		$	3,110		$	1,290
Receivables:
Accounts receivable, net of allowance for uncollectible accounts ($80 and $140 at December 31, 2003 and 2002, respectively)		1,829			875
Commissions receivable		2,896			1,284
Income tax receivable		—			141
Other		13			92
Total receivables		$	4,738		$	2,392
Deferred income taxes		1,662			1,274
Other assets		372			262
		$	9,882		$	5,218
Non-Current Assets:
Property and equipment, net		246			266
Investment in related party, at cost		703			703
Goodwill, net		2,069			1,590
Other intangibles assets, net		2,159			1,056
Deferred income taxes		4,169			5,368
Other assets		173			99
		$	19,401		$	14,300

 

F-4

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Balance Sheets Continued

 

(Dollars in thousands)

 

Liabilities and Stockholders’ Equity

 

		December 31,
		2003			2002
Current Liabilities:
Due to underwriters and assureds		$	4,257		$	1,890
Accounts payable and accrued expenses		1,027			760
Employment related accruals		645			403
Acquisition related accruals		993			238
Income taxes payable		121			—
Note payable to bank		400			1,300
		$	7,443		$	4,591
Non-Current Liabilities:
Acquisition related accruals		1,326			600
Note payable to bank		1,276			1,450
		$	10,045		$	6,641
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value. Authorized 4,058,823 shares; none issued and outstanding		$	—		$	—
Common stock, $0.01 par value. Authorized 15,000,000 shares; issued shares 7,118,379 and 7,023,379 shares at December 31, 2003 and 2002, respectively		71			70
Additional paid-in capital		13,962			68,294
Accumulated earnings (deficit), after January 1, 2003, net of $54,405 deficit eliminated		1,428			(54,405		)
Unearned compensation		(127		)	(26		)
Employee loans for stock purchase		(20		)	(397		)
Treasury stock, at cost (924,734 and 873,500 shares at December 31, 2003 and 2002, respectively)		(5,958		)	(5,877		)
Net stockholders’ equity		9,356			7,659
		$	19,401		$	14,300

 

See accompanying notes to consolidated financial statements.

 

F-5

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Statements of Operations

 

(Dollars in thousands, except per share data)

 

		Years ended December 31,
		2003			2002			2001
Income:
Commissions		$	16,716		$	11,640		$	10,282
Contingent commissions		2,039			1,720			1,516
Net investment income		7			17			158
Net realized investment gains		—			—			72
Service fees		602			80			36
Other income		32			232			54
		$	19,396		$	13,689		$	12,118
Operating expenses:
Salaries and related expenses		10,165			7,958			6,377
Interest expense		149			268			672
Amortization expense		538			389			755
Other expenses		6,022			3,816			3,854
		$	16,874		$	12,431		$	11,658
Income from continuing operations before income taxes		2,522			1,258			460
Income tax expense (benefit)		1,094			(144		)	198
Income from continuing operations		$	1,428		$	1,402		$	262
Discontinued operations:
Loss from operations of discontinued underwriting segment (including loss on disposal in 2002 of $495)		—			(1,426		)	(38,601		)
Income tax benefit		—			(604		)	(7,047		)
Loss on discontinued operations		—			$	(822	)	$	(31,554	)
Net income (loss)		$	1,428		$	580		$	(31,292	)
Earnings per share:
Income from continuing operations		$	0.23		$	0.23		$	0.05
Loss on discontinued operations		—			(0.13		)	(5.58		)
Net income (loss)		$	0.23		$	0.10		$	(5.53	)
Earnings per share– assuming dilution:
Income from continuing operations		$	0.22		$	0.22		$	0.05
Loss on discontinued operations		—			(0.13		)	(5.58		)
Net income (loss)		$	0.22		$	0.09		$	(5.53	)

 

See accompanying notes to consolidated financial statements.

 

F-6

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Statements of Comprehensive Income (Loss)

 

(Dollars in thousands)

 

		Years ended December 31,
		2003			2002			2001
Net income (loss)		$	1,428		$	580		$	(31,292	)
Other comprehensive income from discontinued operations, net of tax:
Unrealized holding gains arising during period (tax impact: 2001:$318)		—			—			617
Reclassification adjustment for realized gains included in net loss (tax impact:  2001:$264)		—			—			512
		$	—		$	—		$	1,129
Comprehensive income (loss)		$	1,428		$	580		$	(30,163	)

 

See accompanying notes to consolidated financial statements.

 

F-7

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Statements of Stockholders’ Equity

 

(Dollars in thousands)

 

		Number of shares		Com- mon Stock			Additional paid-in capital			Accum- ulated earnings (deficit)			Un- earned Compen- sation			Employee Loans for Stock Purchase			Net unrealized gain (loss) on investments			Treasury stock			Net stockholders’ equity
Balance at December 31, 2000		5,341,979		$	63		$	67,371		$	(23,693	)	—			$	(570	)	$	(1,129	)	$	(6,281	)	$	35,761
Net loss		—		—			—			(31,292		)	—			—			—			—			(31,292		)
Restricted stock awards		629,000		7			874			—			(583		)	—			—			—			298
Impact of de-consolidation of PICO		121,600		—			—			—			—			—			—			404			404
Change in employee loans for stock purchases		—		—			—			—			—			82			—			—			82
Net change in unrealized loss on investments (net of tax)		—		—			—			—			—			—			1,129			—			1,129
Balance at December 31, 2001		6,092,579		$	70		$	68,245		$	(54,985	)	$	(583	)	$	(488	)	$	—		$	(5,877	)	$	6,382
Net income		—		—			—			580			—			—			—			—			580
Common stock issued		60,100		—			53			—			—			—			—			—			53
Restricted stock forfeitures		(2,800	)	—			(4		)	—			—			—			—			—			(4		)
Change in employee loans for stock purchases		—		—			—			—			—			91			—			—			91
Change in unearned compensation		—		—			—			—			557			—			—			—			557
Balance at December 31, 2002		6,149,879		$	70		$	68,294		$	(54,405	)	$	(26	)	$	(397	)	$	—		$	(5,877	)	$	7,659
Net income		—		—			—			1,428			—			—			—			—			1,428
Quasi-Reorganization		—		—			(54,405		)	54,405			—			—			—			—			—
Common stock issued		35,000		—			7			—			—			—			—			—			7
Restricted stock awards		60,000		1			66			—			—			—			—			—			67
Repurchase common stock		(51,234	)	—			—			—			—			81			—			(81		)	—
Change in employee loans for stock purchases		—		—			—			—			—			296			—			—			296
Change in unearned compensation		—		—			—			—			(101		)	—			—			—			(101		)
Balance at December 31, 2003		6,193,645		$	71		$	13,962		$	1,428		$	(127	)	$	(20	)	$	—		$	(5,958	)	$	9,356

 

See accompanying notes to consolidated financial statements.

 

F-8

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

 

(Dollars in thousands)

 

		Years Ended December 31,
		2003			2002			2001
Cash flows from operating activities:
Net income (loss)		$	1,428		$	580		$	(31,292	)
Loss from discontinued operations		—			822			31,554
Income from continuing operations		1,428			1,402			262
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		688			511			814
Loss on sale of property and equipment		—			3			40
Gain on sales and calls of equity and fixed maturities		—			—			(72		)
(Increase) decrease in receivables		(2,346		)	(1,679		)	1,170
(Increase) decrease in deferred income taxes		811			48			(156		)
Increase (decrease) in accounts payable and accrued expenses		2,947			155			(917		)
Decrease in unearned compensation		6			557			—
Other, net		38			67			(721		)
Net cash provided by operating activities		$	3,572		$	1,064		$	420
Cash flows from investing activities:
Purchase of property and equipment		(127		)	(259		)	(234		)
Purchase of book of business		(589		)	—			217
Net cash used in investing activities		$	(716	)	$	(259	)	$	(17	)
Cash flows from financing activities:
Payments on note payable to bank		(2,750		)	(1,300		)	(7,198		)
Borrowings on line of credit		1,775			—			—
Payments on line of credit		(100		)	—			—
Payments on notes payable		—			—			(1,629		)
Issuance of common stock		—			—			881
Repayment of employee loans for stock purchases		39			91			—
Retirement of common stock		—			(4		)	—
Funding of discontinued operations		—			(299		)	(7,954		)
Net cash used in financing activities		$	(1,036	)	$	(1,512	)	$	(15,900	)
Net increase (decrease) in cash		1,820			(707		)	(15,497		)
Cash at beginning of period		1,290			1,997			17,494
Cash at end of period		$	3,110		$	1,290		$	1,997

 

See accompanying notes to consolidated financial statements.

 

F-9

 

PAULA FINANCIAL AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

(Dollars in thousands, except per share data)

 

(1)  Summary of Significant Accounting Policies

 

Description of Operations

 

PAULA Financial and subsidiaries (collectively, “the Company”) is a California-based specialty distributor of commercial insurance products. The Company’s agency operations place a full array of commercial insurance products for their customers. In addition, the Company owns a third party administration operation which has minimal operations.

 

In 2003, approximately 96% of the Company’s agency commission revenue was generated in the state of California compared to 93% in 2002 and 89% in 2001.  In 2003, approximately 43% of commission revenue was derived from the workers’ compensation line of business compared to 45% in 2002 and 52% in 2001.

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of PAULA Financial and its wholly owned subsidiaries. The principal subsidiaries are: Pan American Underwriters, Inc., Pan American Underwriters Insurance Agents and Brokers, Inc., and PAULA Trading Company Insurance Agents and Brokers, Inc. (agency operations) and Pan Pacific Benefit Administrators, Inc. (third-party administration operation).  All significant intercompany balances and transactions have been eliminated in consolidation.

 

As discussed further in Note 9 - Discontinued Operations, prior to 2002 the Company also underwrote workers’ compensation insurance through its subsidiary PAULA Insurance Company (“PICO).

 

Where necessary, prior years’ information has been reclassified to conform to the 2003 presentation.

 

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and revenues and expenses for the period. Actual results could differ significantly from those estimates.

 

Cash

 

In certain instances, the agency operations invoice the customer for the full premium amount and remit payment, less commission, to the insurance companies. Restricted cash consists of premiums collected by the agencies but not yet remitted to insurance companies which is restricted as to use by law in the states in which the agencies operate.  The balance sheet account balances related to accounts receivable and due to underwriters and assured are also associated with this activity.

 

F-10

 

Revenue Recognition

 

Commission income is recorded on the effective date of the policy or the billing date, whichever is later. In the case of contingent commissions tied to achieving specified volume levels, revenue is recorded when the related criteria has been met.  Contingent commission income associated with profit sharing arrangements is recorded at the earlier of the amounts being reasonably estimatable or receipt of such amounts.  Service fees are earned over the period the related services are performed.

 

Property and Equipment

 

Office furniture and equipment is depreciated over the estimated useful lives of the respective assets, primarily using the modified accelerated cost recovery system (which approximates the double-declining-balance method). Automobiles are depreciated on a straight-line basis. Principal estimated useful lives used in computing the depreciation provisions are five to seven years for furniture and equipment and three to five years for automobiles. Leasehold improvements are depreciated on a straight-line basis over the term of the lease or the estimated useful life of the improvement if less than the lease term.

 

The following table summarizes property and equipment by classification:

 

		December 31,
		2003			2002
Property and equipment, at cost:
Office furniture, fixtures and equipment		575			3,200
Automobiles		99			99
Leasehold improvements		27			27
		701			3,326
Less accumulated depreciation		(455		)	(3,060		)
Net property and equipment		$	246		$	266

 

In 2003, certain fully depreciated assets with a cost basis of $2,752 were written off against accumulated depreciation.  No gain or loss was associated with this activity.

 

Excess of Cost over Net Assets Acquired and Other Intangibles

 

Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) requires that an intangible asset that is acquired shall be initially recognized and measured based on its fair value. The statement also provides that goodwill should not be amortized, but shall be tested for impairment annually or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount.

 

F-11

 

As required by SFAS 142, the Company has completed an annual goodwill impairment test on its reporting units and has determined that each of its reporting units has a fair value in excess of its carrying value. Accordingly, no goodwill impairment has been recorded.

 

Beginning on January 1, 2002, the Company ceased recording goodwill amortization in accordance with SFAS 142. The following table reconciles reported net earnings and net earnings per share to adjusted net earnings and net earnings per share:

 

		Years ended December 31,
		2003			2002			2001
Reported net income (loss)		$	1,428		$	580		$	(31,292	)
Add back: Amortization of excess of cost over net assets acquired		—			—			30
Add back: Tax effect of amortization of excess of cost over net assets acquired		—			—			(10		)
Adjusted net income (loss)		$	1,428		$	580		$	(31,272	)
Earnings (loss) per share:
Net income (loss)		$	0.23		$	0.10		$	(5.53	)
Amortization of excess of cost over net assets acquired		—			—			—
Tax effect of amortization of excess of cost over net assets acquired		—			—			—
Adjusted net income (loss)		$	0.23		$	0.10		$	(5.53	)
Earnings (loss) per share – assuming dilution:
Net income (loss)		$	0.22		$	0.09		$	(5.53	)
Amortization of excess of cost over net assets acquired		—			—			—
Tax effect of amortization of excess of cost over net assets acquired		—			—			—
Adjusted net income (loss)		$	0.22		$	0.09		$	(5.53	)

 

At December 31, 2003 and 2002, excess of cost over net assets acquired was $2,149 and $1,670, respectively, less accumulated amortization of $80 and $80 in 2003 and 2002, respectively.  In accordance with SFAS 142, the Company ceased recording goodwill amortization beginning on January 1, 2002.

 

Prior to the adoption of SFAS 142, excess of cost over net assets acquired was amortized on a straight-line basis over twenty five years and assessed for recoverability by an analysis of the undiscounted future cash flows generated by the underlying assets.

 

F-12

 

Other intangible assets, which consist mainly of contracts not to compete and expiration lists, are amortized on a straight-line basis over periods not to exceed seven years.  At December 31, 2003 and 2002, other intangible assets were $4,379 and $2,739, respectively, less accumulated amortization of $2,220 and $1,683, respectively.  Aggregate amortization expense for the years ended December 31, 2003 and 2002 was $538 and $389, respectively.  Estimated amortization expense for the next five years is $585 in 2004, $584 in 2005, $563 in 2006, $307 in 2007, $110 in 2008 and $10 in 2009.

 

Income Taxes

 

The Company accounts for income taxes under the liability method. Accordingly, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  A valuation allowance is recorded to reduce deferred tax assets to the amount that is more likely than not to be realized.  Because of the quasi-reorganization effected by the Company in 2003, any decrease in the valuation allowance will be a direct increase to additional paid in capital.

 

Fair Value of Financial Instruments

 

The fair values of financial instruments are estimates of the fair values at a specific point in time using appropriate valuation methodologies. These estimates are subjective in nature and involve uncertainties and significant judgment in the interpretation of current market data. Therefore, the fair values presented are not necessarily indicative of amounts the Company could realize or settle currently. The Company does not necessarily intend to dispose of or liquidate such instruments prior to maturity.

 

Cash, accounts and commissions receivable, due to underwriters and assureds, other current liabilities and the note payable to bank are considered financial instruments.  Due to the short duration of certain financial instruments, specifically cash, accounts and commissions receivable, due to underwriters and assureds and other current liabilities, the carrying amounts approximate fair value.  The fair values of the note payable to bank is estimated using discounted cash flow analyses based on current market interest rates. The estimated fair value of the note payable to bank approximates the related carrying value.

 

Comprehensive Income (Loss)

 

Comprehensive income (loss) includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. In 2001, the Company’s only component of other comprehensive income (loss) relates to unrealized gains and losses on investments from discontinued operations.  The Company has included consolidated statements of comprehensive income (loss) in the accompanying consolidated financial statements.

 

F-13

 

Earnings per Share (“EPS”)

 

The EPS calculations for the years ended December 31, 2003, 2002 and 2001 were based upon the weighted average number of shares of common stock outstanding.  The EPS - assuming dilution calculations were based upon the weighted average number of shares of common stock outstanding adjusted for the effect of convertible securities, and options and warrants considered common stock equivalents.  Stock options and warrants are considered to be common stock equivalents, except when their effect is antidilutive.

 

The following table reflects the weighted average shares of common stock outstanding used in the EPS calculation as well as the EPS - assuming dilution calculation. (In loss periods options are excluded from the calculation of EPS-assuming dilution as the inclusion of such options would have an antidilutive effect.)

 

		Years ended December 31,
		2003		2002		2001
Shares used in EPS calculation		6,321,322		6,095,617		5,656,278
Impact of options		233,976		55,081		—
Shares used in diluted EPS calculation		6,555,298		6,150,698		5,656,278

 

Stock options to purchase 20,000 shares that were outstanding as of December 31, 2003 and 2002 were not included in the computation of earnings per share for 2003 and 2002 as inclusion of such shares would be antidilutive.

 

Stock-Based Compensation

 

The Company’s stock-based employee compensation plans are described more fully in Note 5.  The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“Opinion 25”), and related interpretations in accounting for its employee stock options and adopt the disclosure requirements of Statement of Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123” (“SFAS 148”).

 

The fair value of stock based compensation to employees is calculated using an option pricing model developed to estimate the fair value of freely tradable and fully transferable options without vesting restrictions, which differ from the Company’s stock option program.  The model also requires considerable judgment, including assumptions regarding the future stock price volatility and expected time to exercise, which greatly affect the calculated value.

 

F-14

 

The fair value for options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:  risk free interest rate of 3% for options granted in 2002 and 2001, average option exercise period of seven years, and a volatility factor of 50%.  The fair value per option was $0.25 for options granted in 2002 and $0.98 to $1.14 for options granted in 2001.

 

Had compensation cost for the Company’s stock-based compensation plan been reflected in the accompanying consolidated financial statements based on the fair value at the grant dates for option awards consistent with the method of SFAS 123, the Company’s net income would have been reduced to the pro forma amounts indicated below:

 

 

Discontinued Operations

 

In the accompanying consolidated financial statements, operating activity related to workers’ compensation underwriting have been reclassified as discontinued operations.  As a result, certain financial information previously issued has been adjusted to give effect to the classification of the PICO business as discontinued operations in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets” (“SFAS 144”).

 

(2)  Note Payable to Bank

 

At December 31, 2002, the Company had an outstanding credit agreement with Bank of the West that required that the loan balance be paid over the next two years with the final principal payment due January 1, 2005.  On November 1, 2003, the Company refinanced its outstanding bank debt with a $1,800 reducing revolving line of credit (the “Line of Credit”) with US Bank (the “Lender”).  The Line of Credit matures one year from funding, with a one-year automatic option to extend as long as the Company is in compliance with

 

F-15

 

all covenants.  Balances outstanding under the term loan bear interest at prime rate plus 1.0%.  As of March 15, 2004, the interest rate was 5.0%.

 

Aggregate annual commitments under notes payable to bank are as following as of December 31, 2003:

 

2004		400
2005		1,276

 

The Company’s subsidiaries have guaranteed the obligations of PAULA Financial under the Line of Credit.  Additionally, the Lender has a security interest in the assets of the Company.

 

Management believes that funds currently available and expense reimbursements and dividends from its operating subsidiaries will be sufficient to meet the required principal and interest payments.

 

(3)  Income Taxes

 

The Company and its subsidiaries file a consolidated Federal income tax return. Income tax expense (benefit) from continuing operations for the years ended December 31, 2003, 2002 and 2001 is shown as follows:

 

Years ended December 31,		Federal			State			Total
2003:
Current		$	51		$	232		$	283
Deferred		811			—			811
		$	862		$	232		$	1,094
2002:
Current		$	(197	)	$	5		$	(192	)
Deferred		48			—			48
		$	(149	)	$	5		$	(144	)
2001:
Current		$	(673	)	$	58		$	(615	)
Deferred		813			—			813
		$	140		$	58		$	198

 

F-16

 

The total tax expense (benefit) from continuing operations is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation:

 

		Years ended December 31,
		2003			2002			2001
Expected tax expense		$	858		$	428		$	156
Nondeductible expenses		68			22			6
State income taxes, net of Federal benefit		168			132			39
Change in valuation allowance		—			(525		)	—
Alternative minimum tax carryback		—			(197		)	—
Other, net		—			(4		)	(3		)
		$	1,094		$	(144	)	$	198

 

Temporary differences which give rise to a significant portion of deferred tax assets and liabilities are as follows:

 

		December 31
		2003			2002
Deferred tax assets:
Net operating loss carryforward		$	25,222		$	26,319
Net capital loss carryforward		1,677			1,677
Goodwill		646			594
Allowance for uncollectible accounts		343			381
Other		589			317
Gross deferred tax assets		28,477			29,288
Less valuation allowance		(22,646		)	(22,646		)
Deferred tax assets		$	5,831		$	6,642
Gross deferred tax liabilities		—			—
Net deferred tax asset		$	5,831		$	6,642

 

The net operating loss carryforward includes losses generated by PICO which are available to offset future taxable income of the Company.  As of December 31, 2003 and 2002, the Company has established a $20,969 valuation allowance related to the net operating loss carryforward.

 

The recoverability of the net deferred tax asset is demonstrated by anticipated future operating results.  Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income in the periods necessary to realize the net deferred tax asset.

 

The Company received Federal income tax refunds of $123, $92 and $672 during the years ended December 31, 2003, 2002 and 2001, respectively.

 

F-17

 

At December 31, 2003, the Company had a tax net operating loss carryforward of $74,184 that begins to expire in 2018.

 

(4)  Stockholders’ Equity

 

Effective January 1, 2003, the Company implemented a quasi-reorganization of its capital accounts.  At December 31, 2002, the Company had an accumulated deficit of $54.4 million which was primarily generated by the Company’s former underwriting operations, PICO (see Note 9).  After approval by the stockholders on May 21, 2003, the Company effected the quasi-reorganization pursuant to which the Company eliminated its accumulated deficit and charged the corresponding amount to additional paid-in-capital.

 

In September 1998, the Board of Directors adopted a Stockholder Rights Plan (“Rights Plan”).  The Rights Plan provided for the distribution of one Right for each share of common stock outstanding on October 1, 1998 (6,085,315 shares).  The Rights Plan provides that if any person acquires 10% or more of the Company’s common stock, each Right (other than the Rights held by the 10% stockholder) will become exercisable to purchase PAULA common stock with a value equal to two times the Right’s exercise price.  In addition, if on or after such event the Company is merged out of existence or 50% or more of its assets or earning power are sold, each Right (other than Rights held by the 10% stockholder) will become exercisable to purchase common shares of the acquiring corporation with a value equal to two times the Right’s exercise price.  The Rights expire in ten years unless previously triggered and are subject to redemption by the Board of Directors prior to being triggered.

 

(5)  Employee Benefit Plans

 

The Company maintains a 401(k) plan covering substantially all employees. Employees may contribute up to 17% of their compensation. The Company makes a matching contribution of 50% of the employee contribution, limited to 6% of compensation. Total employer costs for continuing operations under the plan were $138, $154 and $177 for the years ended December 31, 2003, 2002 and 2001, respectively.

 

Employees of the Company receive an annual year-end bonus. Amounts expensed under bonus programs related to continuing operations were $495, $95 and $360 for the years ended December 31, 2003, 2002 and 2001, respectively.

 

In 1998, the Company implemented a key employee/consultant loan program which provided funds exclusively for the borrowers’ purchase of Company stock.  The Company authorized loans of up to $1,000.  The loans were full recourse, bore interest at the rate of 8.5% per annum, were payable quarterly, and were secured by the stock purchased.  The loan program was reviewed and approved by the Compensation Committee of the Board of Directors.  As of December 31, 2003 and 2002, the Company had outstanding loans in the principal amount of $20 and $450, respectively.  During 2003, the Company forgave loans due from former employees totaling $191.  Stock held as collateral of $32 was taken back into treasury stock.

 

F-18