-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, VrfUtdZj5cWvlkG1PskgBHlbOgrHcM6ijkW0Ek+UJ3biAbI1S1C73U68uDdFBr6v t7RBQgTV+f9sbhfFPgzwBA== 0001047469-99-012369.txt : 19990331 0001047469-99-012369.hdr.sgml : 19990331 ACCESSION NUMBER: 0001047469-99-012369 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PAULA FINANCIAL CENTRAL INDEX KEY: 0000929031 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 954640368 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-23181 FILM NUMBER: 99578242 BUSINESS ADDRESS: STREET 1: 300 NORTH LAKE AVE CITY: PASADENA STATE: CA ZIP: 91101 BUSINESS PHONE: 6263040401 MAIL ADDRESS: STREET 1: 300 NORTH LAKE AVE CITY: PASADENA STATE: CA ZIP: 91101 10-K 1 10-K - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------- FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-23181 PAULA FINANCIAL (Exact name of registrant as specified in its charter) DELAWARE 95-4640368 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) identification number) PAULA FINANCIAL 300 NORTH LAKE AVENUE, SUITE 300 PASADENA, CA 91101 (Address of principle executive offices) (626) 304-0401 (Registrant's telephone number, including area code) Securities Registered pursuant to Section 12(b) of the Act: NONE Securities Registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.01 PAR VALUE (Title of Class) RIGHTS TO PURCHASE PREFERRED STOCK, $0.01 PAR VALUE (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- (Cover page 1 of 2 pages) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ---------- The aggregate market value of the voting stock held by nonaffiliates of the registrant was $36,635,594 as of March 15, 1999. (APPLICABLE ONLY TO CORPORATE REGISTRANTS) As of March 15, 1999, the registrant had outstanding 5,928,967 shares of Common Stock, $0.01 par value. DOCUMENTS INCORPORATED BY REFERENCE 1. The information called for by Part III, Items 10, 11, 12 and 13 of this report are incorporated herein from the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders. 2. A number of the exhibits to this Report called for by Part IV, Item 14 are incorporated herein from the Company's Registration Statement on Form S-1 (Reg. No. 333-33159) filed on August 8, 1997, from Amendment No. 1 thereto, and from the Company's Quarterly Report on Form 10-Q for the quarter ending September 30, 1998. - ------------------------------------------------------------------------------- 2 PART I ITEM 1. BUSINESS THE COMPANY The Company is a California-based specialty underwriter and distributor of commercial insurance products which, through its subsidiary PAULA Insurance Company ("PICO"), is one of the largest underwriters specializing in workers' compensation insurance products and services for the agribusiness industry. The Company began operations in 1946 as an insurance agency providing workers' compensation and group medical employee benefits to agribusiness employers in underserved rural markets. In 1974, PICO was formed to underwrite the workers' compensation portion of the business distributed by Pan American Underwriters, Inc. ("Pan Am"), the Company's insurance agency. The Company's other principal subsidiary is PAULA Assurance Company ("PACO"), a life and health carrier. The Company transacts all of its business in the United States. WORKERS' COMPENSATION SYSTEM Workers' compensation is a statutory system under which an employer is required to reimburse its employees for the costs of medical care and other specified benefits for work-related injuries or illnesses. Most employers comply with this requirement by purchasing workers' compensation insurance. The principal concept underlying workers' compensation laws is that an employee injured in the course of his employment has only the legal remedies for that injury available under workers' compensation law and does not have any other claims against his or her employer. Generally, workers are covered for injuries which occur in the course and scope of their employment. The obligation to pay such compensation does not depend on any negligence or wrong on the part of the employer and exists even for injuries that result from the negligence or wrongs of another person, including the employee. Workers' compensation insurance policies obligate the carrier to pay all benefits which the insured employer may become obligated to pay under applicable workers' compensation laws. Each individual state has its own workers' compensation regulatory system that determines the level of wage replacement to be paid, the level of medical care required to be provided and the cost of permanent impairment. For instance, there are four types of benefits payable under California workers' compensation policies: (i) temporary or permanent disability benefits (either in the form of short-term to life-term payments or lump sum payments); (ii) vocational rehabilitation benefits; (iii) medical benefits; and (iv) death benefits. The amount of benefits payable for various types of claims is determined by regulation and varies with the severity and nature of the injury or illness and the wage, occupation and age of the employee. BUSINESS STRATEGY The Company believes that its differentiated approach as a provider of insurance services to the agribusiness industry and its expertise with immigrant employee groups, partial year workforces and businesses in rural communities have been important to its success. The Company views its strengths as: (i) its integrated distribution and underwriting activities; (ii) the distinctive labor relations and cost containment services it provides; and (iii) its underwriting and risk management expertise with respect to agribusiness risks. 1 The Company's target agribusiness market includes those employers who farm, harvest, transport, pack and process tree fruit, vegetables, fiber, flowers, vine fruit and dairy products. Labor intensive agribusiness employers rely on their workforces performing to maximum productivity in order to deliver their fresh product to market at the best price. Agribusiness insurance risks are generally characterized by: (i) monolingual Spanish speaking workforces; (ii) moving work sites and a relative lack of machinery and equipment, making loss control engineering more difficult; (iii) large seasonal fluctuations and high turnover in the employee pool, making timely and frequent safety training more critical and increasing the opportunity for filing fraudulent claims; (iv) fewer opportunities for discounts from health providers in rural locations; and (v) a relatively young workforce performing physically demanding labor for low hourly or piece-work wages. The Company continues to grow outside of its historic California and Arizona markets. Since 1994, the Company has become licensed in seven additional states: Oregon, Idaho, Texas, Florida, Alaska, Nevada and New Mexico. In addition, the Company has entered into a reinsurance fronting arrangement allowing it to underwrite risks in most other states. The Company has begun to use this facility to write agribusiness risks in the midwestern and southeastern United States. In new states, the Company targets the same types of small-to-medium-sized agribusiness operations that it has historically served. With the addition of New Mexico and Texas, the Company is now licensed in all states that share a border with Mexico. Migrant labor pools, however, stretch into Oregon, Idaho and any other locations where fresh food is hand harvested in the United States. The Company has capitalized on its experience working in the agribusiness industry by expanding into other industries with immigrant workforces, including grocery stores, restaurants and garment manufacturers. Like agribusiness employers, these business typically hire low-wage immigrant labor forces to perform semi-skilled labor and have risk characteristics and service requirements similar to those of the Company's agribusiness client base. PAULA Trading Company ("PTC") member agencies with expertise in these industries have been the key factor behind the Company's growth in non-agribusiness industries. INTEGRATED DISTRIBUTION The Company has developed an expertise in the agribusiness industry through its long history of both distributing and underwriting insurance and through a focus on the agent-customer relationship. PICO was formed by the owners of Pan Am in 1974 to underwrite the workers' compensation portion of the business distributed by Pan Am. The Company believes that Pan Am's direct interest in the Company's success results in a cooperative relationship among the agent, the underwriter, loss control consultants, claims management personnel and the customer and its employees. Pan Am, which has 17 locations in California, Oregon and Arizona, is the largest distributor for PICO. To enhance the Company's presence in rural areas not served by Pan Am, the Company affiliates with insurance agencies of similar size and operating histories to Pan Am. In late 1996 and early 1997, the Company made minority equity investments in two regional commercial insurance agencies and formed the PTC to affiliate with other independent agencies. Typically, PTC member agencies have extensive operating histories, a significant commercial insurance presence in rural communities and historically high client persistency rates. The Company believes it gains significant marketing benefits from the endorsements Pan Am has developed for the Company. These endorsements by more than 25 prominent trade associations have allowed the Company to be identified with brand names significant to agribusiness customers. Trade associations 2 which have endorsed the Company have recommended the Company's products and services to their members. Endorsements provide the Company with access to large groups of potential customers without the usual sales process of prospecting individual clients. The Company believes that solicitation of association members results in a higher percentage of sales than do individual unaffiliated solicitations. DISTINCTIVE SERVICES TO AGRIBUSINESS EMPLOYERS Throughout its history, the Company has tailored its labor relations and cost containment services to the unique needs of the agribusiness employer. From the initial reporting of a claim to the careful explanation of benefits to the medical treatment delivery to the return of an employee to work, the Company's capabilities are field-based, bilingual, cross-cultural and sensitive to the unique fraud-prevention and cost-containment issues present in agribusiness. The Company's safety training, early return to work efforts, case management and case settlement operations are tailored specifically to the labor relations and cost containment needs of agribusiness employers and to the needs of Hispanic and other immigrant laborers. LOSS PREVENTION. Since employee turnover is high among agribusiness employers and labor intensive agribusiness requires little fixed equipment, the Company's field representatives hold employee safety training, forklift training and tail-gate sessions for the Company's clients and their employees. In addition, the Company's field representatives train crew foremen and field supervisors on safety practices, visit the workplace to help prevent fraudulent claims and report safety concerns to the Company's loss control consultants and underwriters. The Company's field representatives are a team of community-based bilingual employees with agribusiness employment backgrounds. CLAIMS REPORTING AND FRAUD DETECTION. The Company's Special Investigation Unit reviews each claim for potential fraud as it is reported to the Company rather than only those claims referred to the unit by claims adjusters after they suspect fraud, as the Company believes is more typical in the industry. By reviewing every claim at an early stage, the Company is able to take advantage of its experience in identifying the principal indicators of fraud and thereby mitigate its exposure to fraudulent claims. The Company has implemented a toll-free injury reporting telephone number which allows employers and injured workers to report claims more quickly. CLAIMS MANAGEMENT EXPERTISE. The Company commits significant resources to its claims operations. The Company's claims staff is bilingual, with many years of claims experience and manages its number of open claims per examiner below the industry average. BENEFIT DELIVERY AND EXPLANATION OF BENEFITS TO FARM WORKERS. It has been a long-standing and distinctive practice of the Company's field representatives to hand deliver first-time benefit checks as often as possible and explain benefits in the language of preference of the claimant. The Company believes this helps to reduce the cost of claims, particularly by reducing the number of litigated claims, and reduces the incidence of fraud. The Company's field representatives also assist in returning employees to modified duty as part of the Company's early return to work program. MEDICAL DELIVERY IN MEXICO. The Company offers occupational medical treatment options in Mexico in three approved clinics in Tijuana, Mexicali and San Luis. The Company believes it is the only carrier to provide this service, which allows covered employees to obtain culturally-compatible care in sought-after private medical facilities in Mexico. The Company realizes significant average cost savings from Mexico-based medical care compared with comparable care in the United States. 3 AGRIBUSINESS UNDERWRITING EXPERTISE KNOWLEDGE OF AGRIBUSINESS RISKS. The Company's proprietary loss experience database, its trade association endorsements and its understanding of the risk management needs of agribusiness employers are the key elements of its underwriting capabilities. The Company's rate making process benefits significantly from more than 50 years of claim experience in the agribusiness industry and a proprietary database built over 25 years. This database includes experience by class of business and by subclass within those business classes in which the Company specializes. The information in the database has been developed since PICO's inception and is relevant today in that the Company continues to specialize in many of the same classes of business in which it has historically focused. This experience has enabled the Company to differentiate risks by creating many farm classes and subclasses, reflecting the unique characteristics of job classifications and differences in farming operations. TRADE ASSOCIATION ENDORSEMENTS AND SAFETY GROUPS. The Company enjoys the endorsement of more than 25 trade associations and has promoted the formation and operation of more than 40 other safety groups that purchase workers' compensation insurance from the Company. Each employer participating in these groups is pooled with other homogeneous employers for the purpose of rating experience. These groups help the Company to achieve the actuarial benefit of writing larger pools, to provide safety training and services to small accounts more efficiently and to promote the selection of good risks and safety practices by linking the self interest of each group member. The Company believes that the loss ratios of its trade association and safety group customers have been lower than those of its customers as a whole. The trade association endorsements, in particular, are also a good source of marketing opportunities through access to association mailing lists. Approximately one-third of the Company's policies are in trade associations and safety groups. RISK MANAGEMENT. Risk management is the process of identifying and analyzing loss exposures and taking steps to minimize the financial impact of those exposures. The Company's loss control consultants, most of whom are bilingual and are trained and certified in various farm safety practices, assist the underwriters in reviewing new accounts and in initiating safety programs based on industry best practices for each type of customer. CUSTOMERS AGRIBUSINESS The Company has served the insurance needs of western agribusiness employers and other employers of immigrant workers for over 50 years. The Company defines "agribusiness" to include those employers who farm, harvest, transport, pack and process tree fruit, vegetables, fiber, flowers, vine fruit, and dairy products. Because the Company focuses on clients in a limited number of industries, it believes it has developed expertise in assessing the risks associated with those industries. The Company believes that the experience level required to be successful in serving the agribusiness industry makes it difficult for competitors to enter this market. In most states in which it operates, the Company's single largest competitor for agribusiness is that state's workers' compensation insurance fund. Due in part to the limited number of non-governmental carriers, state funds have built substantial market share in the states where they exist. 4 TRADE ASSOCIATIONS AND SAFETY GROUPS Two significant factors in the Company's insurance operations have been the efforts of Pan Am to obtain endorsements from agricultural trade associations and to promote the formation and operation of safety groups. The Company believes that it gains significant marketing and underwriting benefits from these relationships. Trade association endorsements are made and renewed on an annual basis. As of December 31, 1998, no single trade association or safety group accounted for more than 5% of the Company's estimated annual premium ("EAP"). The Company individually underwrites each policy and is not obligated to offer insurance to any trade association member. The Company works with significant independent employers or groups of employers in selected crops or industries to form safety groups for group insurance purchasing and safety training purposes. Safety groups are chartered business entities which are registered with the applicable Department of Insurance and formed primarily to encourage workplace safety among employer members of the group and to purchase workers' compensation insurance as a group. OTHER EMPLOYERS OF HISPANIC AND IMMIGRANT LABORERS In recent years, the Company has leveraged its experience working with non-English speaking immigrant workers into serving the needs of other businesses employing low-wage, Hispanic workers and other immigrant populations. Examples include Company programs focused on grocery stores, restaurants and garment manufacturers. DISTRIBUTION DIRECT The Company, operating through its wholly-owned subsidiary Pan Am, distributes its workers' compensation products to employers in California, Arizona and Oregon. Management believes Pan Am is one of the largest agency operations specializing in offering employee benefit products to agribusiness-related employers in California and Arizona. Pan Am primarily has developed internally, to a current full-time sales force of approximately 32, with commission revenues (before intercompany eliminations) of $8.7 million in 1998. Pan Am, as agent and broker, offers its customers a wide range of insurance products tailored to agribusiness employers' specific needs. Pan Am's revenues are derived from commissions from the placement of insurance with insurance carriers, including PICO and PACO. In 1998, Pan Am placed 53.5% of its total insurance premiums with PICO and PACO. The Company's integration of the sales and underwriting elements of the workers' compensation insurance business sold through Pan Am enhances the Company's ability to retain this business. PICO's insurance business sold through Pan Am is not vulnerable to being moved at the sole discretion of the agent, although PICO's insurance sold through Pan Am is still subject to competition from other insurance agents. For 1998, 30% of PICO's premiums written was sold through Pan Am. Pan Am has approximately 59 full-time equivalent employees operating from 17 offices in California, Arizona and Oregon; these locations also house PICO personnel and operations. This provides Pan Am sales personnel with direct access to insurance company underwriting and claims personnel which, the Company believes, improves the effectiveness of Pan Am's sales and servicing efforts. 5 PAULA TRADING COMPANY To enhance the Company's presence in rural areas not served by Pan Am, the Company affiliates with insurance agencies of similar size and operating histories to Pan Am, primarily through the PTC membership arrangement. The insurance agencies that have been selected to join the PTC are expected to submit applications on risks where there is a high likelihood of PICO successfully writing the business. PICO also typically expects the first and last chance to quote agribusiness or Hispanic-focused workers' compensation business written by a PTC member. The agencies also pay a membership fee to the PTC. PTC members have access to PAULA's innovative product features such as an employment practices liability insurance ("EPL") product and have the potential to join an insurance agency marketing arrangement established by the founders of the PTC. The Company believes the PTC allows the Company to receive better quality insurance submissions, face less price competition and maintain relatively lower insurance business acquisition costs. INDEPENDENT INSURANCE AGENTS The Company appoints a limited number of independent insurance agents, who are not affiliated with the PTC, to sell its workers' compensation insurance, primarily in states outside of California. The Company favors appointing independent agents who will primarily represent the Company in its desired agribusiness focused markets rather than presenting the Company as one of many competing quotes together in a pricing comparison. OTHER AGENCY OPERATIONS Other products and services offered by Pan Am include group health insurance, third party administration, managed care programs, property and casualty insurance, crop insurance, life and disability insurance and other financial services. SCOPE OF OPERATIONS The Company has operated successfully in California for more than 50 years and in Arizona for more than 40 years. In 1994, the Company commenced operations in Oregon to test whether its business formula would prove successful in other jurisdictions. The Company wrote its first policy in Oregon on January 1, 1995. The Company next commenced operations in Idaho, where it wrote its first policy on July 1, 1996, just prior to the legislative requirement that workers' compensation insurance become mandatory for agricultural employers for the first time in January 1997. Most recently, the Company has expanded into Alaska, Florida, New Mexico and Texas. The Company has been licensed to write insurance in Nevada and expects to commence operations there in July 1999. The Company also writes insurance risks in other states through a reinsurance fronting facility put in place in late 1998. The Company has focused its expansion in states with significant labor-intensive agribusiness insurance opportunities. PRODUCTS AND SERVICES The Company's principal product consists of workers' compensation insurance policies sold primarily to agribusiness employers. For the year ended December 31, 1998, workers' compensation premiums earned accounted for 88.8% of the Company's revenues. 6 In order to differentiate its product from its competitors and provide the members of the PTC with points of difference to aid them with the sale and retention of business, the Company has developed a number of innovative product features, including: (i) automatic coverage in California for discrimination claims based on an employee's intent to file a workers' compensation claim; (ii) available EPL insurance in California, which provides coverage for sexual harassment, wrongful termination and discrimination; (iii) automatic benefits for the provision of occupational medicine to workers' compensation claimants in Mexico; and (iv) additional premium credit to the insured employer in California when the agent provides both the workers' compensation and health insurance to the employer client and its employees. The Company has entered into a quota-share reinsurance agreement with Lloyds of London with respect to the underwriting risk of its EPL product. The Company's EPL product was introduced in April 1997 and generated gross premiums written of $632,000 for the year ended December 31, 1998. The Company sells "AmeriMex", a product underwritten by PACO, which is typically sold alongside PICO's workers' compensation product in California, and which provides group medical benefits for services rendered at three provider hospitals in Mexico. PACO also offers low limit group term life and accidental death and dismemberment insurance to employer groups. The Company's third party administrator ("TPA") services consist of the independent administration of claims and related matters for self-insured employers' health benefit plans. For the year ended December 31, 1998, TPA, group medical and group life products accounted for an aggregate of less than 2% of the Company's revenues. These products are typically sold to the same employers that purchase the Company's workers' compensation products. As a general commercial agent, Pan Am distributes group health insurance, property and casualty insurance, life and disability insurance and other products underwritten by unaffiliated insurance companies to the Company's agribusiness clients. The Company believes that the ability of Pan Am to offer these products and the ability of Pan Am and the PTC member agencies to offer the Company's distinctive products strengthen the relationship between the agent and the Company's policyholders. UNDERWRITING RISK SELECTION The Company's focus allows it to concentrate on agribusiness in rural areas where litigation, fraud and abuse, which tend to increase the frequency of claims as well as the Company's loss adjustment expense ("LAE"), are less pronounced. The Company believes the historically lower claim frequency and LAE in these areas are due in large part to the stronger work ethic and lower wage level in these areas coupled with a lower density of attorneys and other workers' compensation claimants' intermediaries. Most of PICO's business is produced through Pan Am and a group of selected independent agents which have a local presence in the major agricultural areas throughout the Company's operating markets. The Company believes that this local involvement in rural communities allows its agents to gain insight into the insureds' financial stability, ability to run their business, attitudes toward safety and loss control and willingness to work as partners with the Company in the management of their workers' compensation program. 7 The Company focuses on small- to medium-sized accounts which make up the broadest segment of agribusiness employers. PICO's average annual workers' compensation policy premium, as measured by EAP, was $11,156 as of December 31, 1998. The Company has found that smaller businesses tend to be supervised by the owner rather than management staff. The Company believes that an employer's claims experience directly depends on the owner's commitment to workplace safety and its hiring practices. By underwriting small- to medium-sized accounts, the Company has an opportunity to assess directly the owners' commitment to workplace safety rather than trying to assess such commitment through interaction with management staff. UNDERWRITING PROCESS PICO's relationship with Pan Am and other agents allows the pre-screening by such agents of new workers' compensation accounts according to criteria established by PICO, including the employers' prior loss experience, hiring practices, safety record, credit history, geographic location and types of job assignments within employment classifications. The Company's agents also meet with the employer's management to assess the extent to which management is committed to safety in the workplace. Once an account passes this initial screening process and prior to approving an application, the Company's underwriting department reviews each employer applicant's prior loss experience, safety record, operations, geographic location and payroll classifications and the types of job assignments within employment classifications. If necessary, more often for accounts with EAP of $250,000 or greater, a pre-inspection is conducted by the Company's loss control department to evaluate safety in the workplace, hiring practices, industrial health hazards and the potential insured's enthusiasm for loss control and workplace safety. The Company's underwriters evaluate the potential profitability of each insurance application by analyzing the various potential loss exposures related to that particular risk compared to the standard exposures in that classification. On accounts larger than $75,000 in EAP, the Company's underwriters generally consult with the Company's senior claims management personnel during the underwriting process. For new business submissions, this process improves the Company's ability to estimate an employer's expected claims experience. For renewing businesses, this process informs the underwriters of the Company's experience handling claims for the particular employer and the employer's attitude toward safety, cooperation in the claims settlement process, return to work efforts and collection payment history. Once an account is written, a service plan is put into place utilizing appropriate members of the Company's team of bilingual field representatives and certified loss control specialists and employer personnel to establish and periodically review formal and informal safety programs, safety committees, conformity with OSHA standards, procedures for reporting injuries, medical cost containment, anti-fraud information, accident investigation, safety incentive/rewards programs and claims review procedures. The Company's field representatives provide a number of valuable services for the Company's underwriting and claims personnel as well as to the Company's insured employers. All of the field representatives speak English and Spanish. The field representatives spend their working hours making periodic visits to the Company's insured employers and their workers. Among other things, the field representatives provide feedback to the Company's underwriting personnel about particular accounts and their attitude toward, and actions to implement, workplace safety. The Company uses its bilingual, state-certified loss control personnel to hold safety seminars to train insureds' employees. 8 The Company has established an underwriting referral policy designed to allow the Company's senior underwriting officer to review all large and unusual underwriting opportunities. All accounts with (i) high EAP, (ii) high experience modifications (indicating poor prior claims experience), (iii) a projected overall rate reduction at renewal, or (iv) large variations from the Company's standard rates are reviewed by the senior underwriting officer, often in consultation with senior claims officers, loss control officers and/or the chief operating officer. The Company's underwriting department consists of 8 senior underwriters with extensive experience in property/casualty underwriting and 17 other underwriting staff members. Each of the senior underwriters is given individually determined binding authority. PRICING The amount of premium the Company charges for workers' compensation insurance is dependent on the size of an employer's payroll, the job classifications of its employees and the application of the Company's rating plan to each individual employer. The Company's rating plan varies from state to state due to differences in regulatory environments. In certain states, the premium rate charged to a particular employer may be affected by a risk premium modifier if the employer is a member of a safety group or meets certain safety or other requirements. Each employer's indicated premium is then adjusted based on the employer's experience modification, which is determined by a third party rating bureau. Application of the experience modification factor results in an increase or decrease to the indicated premium rate based on the employer's loss experience and, therefore, provides an incentive to employers to reduce work-related injuries and illnesses. In certain states, at the time the Company issues a policy to an employer, the Company is paid a deposit premium, which is a percentage of the EAP of the policy at the time of issuance. The percentage ranges from 10% to 100% of the EAP depending, among other things, on the premium payment schedule, the employer's credit history and employment classifications. The employer remits its premiums either in installments based on a payment plan or in amounts calculated from periodic reports of its payrolls. At the end of the policy term, or when the policy is canceled, a final audit of the employer's records is conducted by the Company to determine the correct amount of premium due to the Company. For a description of regulation of workers' compensation insurance premium rates, see "Business-Regulation-Regulation of PICO's Business in Each State in Which it is Licensed". CLAIMS The Company's policy is to protect injured workers or their dependents and policyholders by promptly investigating each loss occurrence, administering benefits in a prompt, efficient and cost effective manner and maintaining an appropriate reserve estimate on each claim through closure. The Company expends significant efforts to improve its insureds' claim experience. Because the Company charges insurance rates based in part on an insured's claims experience over a three-year period, improvements in an insured's claims experience are not immediately reflected in lower rates, thereby providing an opportunity for the Company's loss ratio to improve as each accounts' claims experience is reduced. 9 MANAGEMENT OF CLAIMS COSTS The Company's Special Investigation Unit reviews each claim for potential fraud as it is reported to the Company rather than only those claims referred to the unit by claims adjusters after they suspect fraud, as the Company believes is more typical in the industry. By reviewing every claim at an early stage, the Company is able to take advantage of its experience in identifying the principal indicators of fraud and thereby mitigate its exposure to fraudulent claims. The Company believes its Special Investigation Unit's review of every claim diminishes the number of fraudulent claims paid by the Company. The Company has also established a separate litigation management unit, utilizing its own administrative hearing representatives, which makes extensive use of alternative dispute resolution techniques to settle claims prior to these claims going before local workers' compensation appeals boards. The Company periodically holds special one-day arbitration conferences with retired workers' compensation judges to attempt to settle pending claims. In addition, the Company has taken significant steps to reduce its outside legal fee expenses when litigated claims cannot be resolved by the Company's in-house litigation personnel. The Company has entered into capitation arrangements with many of the members of its panel of outside law firms. These arrangements limit the amount the Company will be charged by its attorneys for given legal actions. The Company believes these capitation arrangements have reduced its LAE. As an integral part of its claims operations, PICO utilizes specially trained personnel, both employees and independent contractors, to carry out cost containment techniques in the areas of medical management, litigation management, vocational rehabilitation management, subrogation management, fraud investigation, bill review, utilization review and benefit delivery compliance. The Company's medical management efforts are devoted to providing medical utilization review and quality assurance with the objectives of controlling unit cost, volume of services and lost work days due to work-related injury and illness. In particular, due to its long experience in rural markets, the Company understands how the delivery of occupational medical services varies in rural areas from metropolitan areas, allowing the Company, it believes, to more effectively utilize its rights to direct injured workers to medical providers approved by the Company during the first weeks after an injury occurs. The Company has implemented a toll-free injury reporting telephone number which allows employers and injured workers to report claims more quickly. Callers receive assistance reporting their claim and the Company's claims personnel receive a "head start" on the management of the costs of that claim. The head start allows the Company to investigate the circumstances of the injury to determine the claim status, assist the injured worker in the selection of medical providers approved by the Company and assist the injured party through the claims process in a manner designed to reduce the likelihood that the injured party will need to seek the assistance of legal counsel with the claims process. The Company believes that there is a direct relationship between the speed with which it learns of a claim and its ability to reduce the cost of the claim to its lowest possible value. The Company has created a panel of medical providers practicing in three facilities in Mexico who are skilled in delivering occupational medicine in a manner consistent with the requirements of the California workers' compensation system at less cost than United States providers for those workers more comfortable with Mexico clinics and hospitals. 10 CLAIMS PERSONNEL The Company's claims management is conducted under the direction of 17 claims management personnel with extensive experience in the industry. The Company's claims examiners are responsible for the management of caseloads per examiner which are lower than the industry average. Due to the combination of experience and more manageable caseloads, the Company's claims personnel can be more effective at managing claims through more frequent contact with policyholders, injured workers and medical providers. Moreover, the Company's claims personnel are able to more quickly and cost effectively respond to changes in mandated workers' compensation benefits. LOSSES AND LOSS RESERVES In many cases, significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims with respect to insured events that have occurred, including events that have occurred but have not yet been reported to the insurer. Reserves are also established for LAE representing the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. Reserves for losses and LAE are based not only on historical experience but also on management's judgment of the effects of factors such as future economic and social forces likely to impact the insurer's experience relative to the type of risk involved, benefit changes, circumstances surrounding individual claims and trends that may affect the probable number and nature of claims arising from losses not yet reported. Consequently, loss reserves are inherently subject to a number of highly variable circumstances. Reserves for losses and LAE are evaluated quarterly using a variety of actuarial and statistical techniques for producing current estimates of expected claim costs. Claim frequency and severity and other economic and social factors are considered in the evaluation process. Since the Company relies on both actual historical data, which reflect past inflation, and on other factors which are judged to be appropriate modifiers of past experience, the Company uses an implied, rather than explicit, provision for inflation in its calculation of estimated future claim costs. Adjustments to reserves are reflected in operating results for the periods in which they are made. The Company sets an initial case reserve upon being notified of an insured injury. Since 1992, the Company has employed automated computer technology utilizing a database comprised of data from participating unaffiliated workers' compensation carriers to assist the Company in setting such initial reserves. As more facts regarding the loss become known, the Company reviews and, if appropriate, revises the initial case loss reserve. In addition to case reserves, the Company also establishes bulk reserves. Bulk reserves are established on an aggregate basis to provide for losses incurred but not yet reported to the insurer and to supplement the overall adequacy of individual case reserves established by claims adjusters and estimated expenses of settling such claims, including legal and other fees and general expenses of administering the claims adjustment process. The Company establishes bulk reserves by estimating the ultimate net liability for losses and LAE by using actuarial reserving techniques. Such techniques are used to adjust, in the aggregate, the amount estimated for individually established case reserves, as well as to establish estimates for reserves 11 for unreported claims. Adjustments are made for changes in the volume and mix of business, mix of claim categories, claims processing and other items which affect the development patterns over time. On the basis of the Company's internal procedures which analyze, among other things, the Company's experience with similar cases and historical trends such as reserving patterns, loss payments and pending levels of unpaid claims, as well as court decisions, economic conditions and public attitudes, management has made its best estimate of the Company's liabilities for unpaid losses and LAE and believes that adequate provision has been made for such items. However, because the establishment of loss reserves is an inherently uncertain process, there can be no assurance that ultimate losses and LAE will not exceed the Company's reserves. There can be no assurance that future loss development will not require reserves for prior periods to be increased, which would adversely affect earnings in future periods. The Company employs an actuarial staff of two and also utilizes an outside actuarial firm. The following table sets forth a reconciliation of beginning and ending reserves for losses and LAE after reinsurance deductions for the periods indicated. There are no material differences between the Company's reserves for losses and LAE shown below calculated in accordance with Generally Accepted Accounting Principles ("GAAP") and those calculated in accordance with Statutory Accounting Principles ("SAP"). The Company does not discount claim reserves on either a GAAP basis or under SAP. RECONCILIATION OF RESERVES FOR LOSSES AND LAE (IN THOUSANDS)
1998 1997 1996 ---- ---- ---- Unpaid loss and loss adjustment expenses beginning of year.............. $77,784 $55,720 $57,049 Less: reinsurance recoverable on unpaid losses and LAE.................. 6,394 6,427 6,775 PACO reserves.................................................. 343 533 292 ------------ ------------ ------------ Net PICO balance, beginning of year.................................. $71,047 $48,760 $49,982 ------------ ------------ ------------ Incurred related to: Current period....................................................... 107,850 66,330 35,938 Prior periods........................................................ 6,268 1,586 (2,646) ------------ ------------ ------------ $114,118 $67,916 $33,292 ------------ ------------ ------------ Paid related to: Current period....................................................... 34,374 20,495 12,833 Prior periods........................................................ 39,989 25,134 21,681 ------------ ------------ ------------ $74,363 $45,629 $34,514 ------------ ------------ ------------ Net PICO balance, end of year........................................ 110,802 71,047 48,760 Plus: reinsurance recoverable on unpaid losses and LAE.................. 25,137 6,394 6,427 PACO reserves.................................................. 377 343 533 ------------ ------------ ------------ Unpaid loss and loss adjustment expenses, end of year................... $136,316 $77,784 $55,720 ------------ ------------ ------------ ------------ ------------ ------------
12 The table below shows changes in historical workers' compensation net loss and LAE reserves for PICO for each year since 1988. Reported reserve development is derived from information included in PICO's statutory financial statements. The first line of the upper portion of the table shows the net reserves as of December 31 of each of the indicated years, representing the estimated amounts of net outstanding losses and LAE for claims arising during that year and in all prior years that are unpaid, including losses that have been incurred but not yet reported to the Company. The upper portion of the table shows the restated amount of the previously recorded net reserves for each year based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about claims for individual years. The lower portion of the table shows the cumulative net amounts paid as of December 31 of successive years with respect to the net reserve liability for each year. In evaluating the information in the table below, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, if a loss determined in 1991 to be $10,000 was first reserved in 1988 at $8,000, the $2,000 deficiency would be included in the cumulative redundancy (deficiency) for each of the years 1988 through 1991 shown below. This table, unlike the table headed "Calendar Year Development by Accident Year" that follows, does not present accident or policy year development data. Conditions and trends that have affected the development of liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. 13 CHANGES IN HISTORICAL NET RESERVES FOR LOSSES AND LAE (IN THOUSANDS)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Unpaid losses and loss adjustment expenses at end of year............ $52,893 $49,994 $49,104 $57,909 $59,492 $56,792 $53,287 $49,982 $48,760 $71,047 $110,802 Reserve re-estimated as of: One year later......... 47,061 47,833 52,209 58,618 57,000 52,837 49,403 47,335 50,346 77,315 Two years later........ 46,462 50,060 53,491 60,095 57,115 50,480 48,189 45,041 50,910 Three years later...... 47,725 49,970 54,316 60,733 55,305 50,647 46,855 45,814 Four years later....... 47,473 50,321 55,269 59,806 56,725 50,056 47,928 Five years later....... 47,064 51,095 54,808 60,286 56,813 50,707 Six years later........ 47,444 51,025 55,184 60,794 57,225 Seven years later...... 47,346 51,348 55,738 61,188 Eight years later...... 47,847 51,714 55,932 Nine years later....... 48,216 51,913 Ten years later........ 48,093 Cumulative redundancy (deficiency).............. 4,800 (1,919) (6,828) (3,279) 2,267 6,085 5,359 4,168 (2,150) (6,268) Cumulative paid as of: One year later......... 16,761 19,757 21,736 25,543 23,464 21,711 21,742 21,680 25,133 39,989 Two years later........ 29,212 32,602 36,021 40,328 37,040 34,721 33,601 33,007 38,328 Three years later...... 36,832 40,456 43,482 48,429 45,529 41,855 39,372 38,784 Four years later....... 41,251 44,254 47,923 53,416 50,395 45,253 42,807 Five years later....... 43,271 46,682 50,713 56,250 52,941 47,231 Six years later........ 44,676 48,430 52,442 58,261 54,642 Seven years later...... 45,562 49,406 53,801 59,406 Eight years later...... 46,465 50,333 54,558 Nine years later....... 47,145 50,926 Ten years later........ 47,341 Net unpaid losses and loss adj. expenses December 31............ $49,982 $48,760 $71,047 $110,802 Reinsurance recoverable... 6,775 6,427 6,394 25,137 --------- -------- --------- ------- Gross unpaid losses and loss adj. expenses December 31............ $56,757 $55,187 $77,441 $135,939 ------- ------- ------- -------- ------- ------- ------- -------- (Continued)
14
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Re-estimated net unpaid losses and loss adjustment expenses.... $45,814 $50,910 $77,315 Re-estimated reinsurance recoverable............ 7,659 8,190 9,172 --------- ---------- --------- Re-estimated gross unpaid losses and loss adjustment expenses.... $53,473 $59,100 $86,487 --------- ---------- --------- --------- ---------- --------- Gross cumulative redundancy (deficiency)........... $3,284 ($3,913) ($9,046) --------- ---------- --------- --------- ---------- ---------
The following table is derived from the table above and summarizes the effect of reserve re-estimates net of ceded reinsurance on calendar year operations for the same ten-year period ended December 31, 1998. The total of each row details the amount of reserve re-estimates made in the indicated calendar year and shows the accident years to which the re-estimates are applicable. The total of each accident year column represents the cumulative reserve re-estimates for the indicated accident year(s). CALENDAR YEAR DEVELOPMENT BY ACCIDENT YEAR (IN THOUSANDS)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 TOTAL AND ---- ---- ---- ---- ---- ---- ---- ---- ---- CALENDAR PRIOR YEAR ----- EFFECT ------ Calendar years 1998................ ($123) ($76) $5 ($200) ($18) ($239) ($422) $300 $209 ($5,704) ($6,268) 1997................ (369) 3 (188) 46 420 679 743 960 (3,880) (1,586) 1996................ (501) 178 (53) (104) (940) 1,253 1,381 1,433 2,647 1995................ 98 (28) 391 466 883 547 1,527 3,884 1994................ (380) (394) (179) 315 523 4,070 3,955 1993................ 409 (760) (474) (652) 3,969 2,492 1992................ 252 (162) (1,372) 573 (709) 1991................ (1,263) (964) (878) (3,105) 1990................ 599 1,562 2,161 1989................ 5,832 5,832 ---------------------------------------------------------------------------------------------------------------- Cumulative re-estimates for each accident year $4,554 ($641) ($2,748) $444 $4,837 $6,310 $3,229 $2,693 ($3,671) ($5,704) $9,303 ---------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------
15 PICO and the California workers' compensation industry as a whole experienced relatively high incurred losses and LAE during accident years 1989 - 1992 as a result of laws enacted in 1989 which had the unintended effect of permitting the filing of fraudulent and abusive workers' compensation claims. PICO determined reserves for accident years 1993 and 1994, and to a lesser extent, 1995, based on the relatively high incurred loss and LAE trends for the 1989 - 1992 accident years. PICO's actual incurred losses and LAE for the 1993 - 1995 accident years proved to be lower than anticipated and PICO's original reserves for these periods were ultimately redundant. PICO determined its reserves for the 1994 - 1996 accident years with the benefit of information indicating favorable development in the immediate prior accident years. Development of the 1994 and 1995 accident years has more closely approximated the development anticipated when reserves for those years were initially established. During 1994 and 1995, PICO experienced an aggregate of approximately $7.8 million in reserve recoveries attributable primarily to favorable development on losses and LAE for accident years 1990-1994. In 1996, PICO experienced an aggregate of approximately $2.6 million in reserve recoveries attributable primarily to favorable development on losses and LAE for the 1993 - 1995 accident years, offset in part by mildly negative development for the 1990 - 1992 accident years. During 1997, PICO experienced an aggregate of approximately $1.6 million in net reserve development. During 1997, reserve development of $3.9 million on the 1996 accident year was partially offset by reserve recoveries of $2.4 million on accident years 1993 - 1995. PICO established its initial reserves on the 1996 accident year based on the favorable trends for the 1993-1995 accident years. The development for the 1996 accident year resulted from claims trends less favorable than those experienced by the Company for the 1993-1995 accident years. During 1998, PICO experienced an aggregate of approximately $6.3 million in net reserve development, principally related to the 1997 accident year. In the first two quarters of 1998 the Company saw reserve development on the 1997 accident year for California business in excess of its expectations given prior year reserving trends. The Company's second quarter reserve adjustment, expressed as a percentage of related premiums, implied a pricing deficiency for those periods. The Company began to address this pricing deficiency early in 1998 through rate increases and non-renewal activity. POLICYHOLDER DIVIDENDS Workers' compensation policies can be written on a participating or non-participating basis. Participating policies allow the Company to declare and pay dividends to a policyholder after the expiration of the policy based upon a policyholder's specific loss experience (or, if the policyholder is part of a safety group, the group's specific loss experience), the Company's overall loss experience and competitive conditions. Since January 1, 1997, substantially all workers' compensation insurance underwritten by the Company in California, Alaska and Texas has been written without the expectation that the Company would pay policyholder dividends on such policies. Substantially all of the insurance underwritten by the Company in Arizona, Oregon, Idaho and Florida is written on participating policy forms. Currently, workers' compensation insurers in Arizona and Florida generally use policyholder dividends to reward favorable loss experience as a means of competitive pricing although with increasing upfront price competition in Arizona, dividends are becoming less of a competitive factor. In Oregon and Idaho, dividends are sometimes used as a competitive pricing tool, although rates are more flexible in those states. Dividends play little role in Alaska and Texas, due to the flexibility in the rating plans in those states. The Company makes the determination of the amount of the dividends it chooses to pay on its participating policies generally 12 to 30 months after policy expiration, and such payments require approval by PICO's board of directors. The Company intends to continue to issue policies in Arizona, Oregon, Idaho and Florida that are eligible for policyholder dividend consideration. 16 REINSURANCE Insurance risk is ceded primarily to reduce the liability on individual claims and to protect against catastrophic losses. The Company follows the industry practice of reinsuring a portion of its risks on an excess of loss reinsurance basis. For this coverage, the Company pays the reinsurer a portion of the premiums received on all policies. In return, the reinsurer agrees to reimburse the Company for all losses in excess of a predetermined amount, commonly referred to as the insurance company's retention. In connection with a new reinsurance arrangement entered into in October 1998, the Company has also chosen to quota-share a portion of its retained claims exposure. In a quota-share reinsurance contract, the Company and the reinsurer share premiums, losses and LAE on a proportional basis based on each parties interest in the quota-shared risk. The Company maintains excess of loss reinsurance treaties with various reinsurers for workers' compensation. Since 1974, General Reinsurance Corporation ("GenRe") has been the Company's primary excess of loss reinsurer. GenRe is currently assigned a letter rating of "A++ (Superior)" by A.M. Best. The Company's upper layers of reinsurance coverage (in excess of $10.0 million) are currently provided by a large group of companies contracted through a reinsurance intermediary owned by GenRe. All such carriers are currently assigned a rating of "A-" or better by A.M. Best. Under the current workers' compensation reinsurance treaties, various reinsurers assume liability on that portion of the loss that exceeds $250,000 per accident, up to a maximum of $60.0 million per accident. An accident is defined as a single event, whether it affects one or more persons. In July 1998, the Company modified its prior existing excess of loss reinsurance treaty on the $250,000 excess of $250,000 layer to retain the first $2.0 million in annual aggregate losses, with a corresponding reduction in the Company's reinsurance rate. In October 1998, the Company entered into a two year excess of loss and quota-share reinsurance arrangement with Reliance Insurance Company ("Reliance"). Under this arrangement, the Company has ceded various portions of its exposure for claims in excess of $10,000 and has quota-shared a portion of its risks under $10,000. Reliance is rated A- (Excellent) by A.M. Best. Although reinsurance makes the assuming reinsurer liable to PICO to the extent of the reinsurance ceded, it does not legally discharge PICO from its primary liability for the full amount of the claim. The Company has encountered no disputes with its reinsurers and has not experienced any difficulty on the part of reinsurers to fulfill their obligations under reinsurance treaties. The Company believes that suitable alternative excess of loss reinsurance treaties for the excess of $250,000 per accident layers are readily obtainable at the present time. The Company does not expect to be able to replace or renew its Reliance quota-share and $10,000 to $250,000 layer reinsurance treaty at current terms upon expiration. The Company has also entered into a quota-share reinsurance agreement with the Venton Syndicate of Lloyds of London with respect to the underwriting risk of its EPL product. The Company's EPL product was introduced in April 1997 and generated gross premiums written of $632,000 for the year ended December 31, 1998. 17 INVESTMENTS AND INVESTMENT RESULTS The Company employs a conservative investment strategy emphasizing asset quality and the matching of maturities of its fixed maturity investments to the Company's anticipated claim payments and expenditures or other liabilities. The Company employs Conning Asset Management Company ("Conning Asset Management") to act as its independent investment advisor for the bulk of the Company's investment portfolio pursuant to the terms of a written agreement with Conning Asset Management and the Company's written investment guidelines. Conning Asset Management has discretion to enter into investment transactions within the Company's investment guidelines. In practice, this discretion is generally exercised only with respect to the reinvestment of maturing securities in similar securities. In the case of sales of securities prior to maturity, or the acquisition of securities which differ from the types of securities already present in the portfolio, Conning Asset Management will routinely consult with the Company's Chief Financial Officer, who chairs the Company's investment committee, prior to entering into such transactions. Among other things, Conning Asset Management seeks to match the average duration of the portfolio's assets with the estimated average duration of the Company's liabilities. Conning Asset Management's fee is based on the amount of assets in the portfolio and is not dependent upon investment results or portfolio turnover. Conning Asset Management is affiliated with one of the Company's principal stockholders. The amount and types of investments that may be made by the Company's insurance subsidiaries are regulated under the California Insurance Code and related rules and regulations promulgated by the California Department of Insurance ("DOI"). Subject to such applicable state laws and regulations, investment policies and investment decisions are approved by the Company's investment committee and are reviewed by the Board of Directors. The Company modifies its mix of tax-exempt and taxable securities from time to time based on effective after-tax yield and tax planning considerations. Management intends to hold all of the Company's fixed maturity investments for indefinite periods of time but these investments are available for sale in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. During the third quarter of 1998, the Company repositioned a substantial portion of the investment portfolio from tax exempt to taxable securities. The overall asset quality and duration of the portfolio was unchanged. The repositioning was done for tax planning purposes. 18 As of December 31, 1998, the carrying value of the Company's investment portfolio was approximately $177.6 million and amortized cost was approximately $178.2 million. The diversification of the Company's investment portfolio as of December 31, 1998 is shown in the table below: CONSOLIDATED INVESTMENT POSITION
AS OF DECEMBER 31, 1998 --------------------------------------------- PERCENT OF CARRYING AMORTIZED CARRYING TYPE OF INVESTMENT VALUE (1) COST VALUE - ------------------ --------- ---- ----- (DOLLARS IN THOUSANDS) Fixed maturities: (2) United States government agencies and authorities $13,766 $13,445 7.8% States, municipalities and political subdivisions 24,346 24,082 13.7% Corporate securities........................... 79,625 79,927 44.8% Collateralized mortgage obligations and other asset backed securities.......... 53,055 53,925 29.9% --------------- ------------- -------------- Total fixed maturities......................... $170,792 $171,379 96.2% Equity securities (3)............................. 4,259 4,251 2.4% Invested cash..................................... 2,572 2,572 1.4% --------------- ------------- -------------- Total investments.............................. $177,623 $178,202 100.0% --------------- ------------- -------------- --------------- ------------- --------------
- ------- (1) All securities are carried at market value except invested cash is carried at cost, which approximates market value. (2) All fixed maturity securities have been designated as available for sale. (3) Excludes the Company's minority investments in James G. Parker Insurance Associates ("Parker") and CAPAX Management & Insurance Services ("CAPAX"), which had a carrying value as of December 31, 1998 of $1.7 million. It is the Company's practice to purchase almost exclusively investment grade fixed maturity securities and mutual funds primarily holding such securities for its insurance company portfolios. In addition, the Company generally invests its parent company portfolio in similar investments, although the Company selectively invests in unrated and below investment grade securities in this portfolio. As of December 31, 1998, the Company owned one bond with a carrying value of $1.6 million which was non-performing. In 1998, the Company realized an other than temporary decline of $0.1 million on this bond. At this time, the Company is unable to predict whether or not it will realize additional other than temporary declines on this security. As of December 31, 1998 the Company did not own any mortgages or real estate. As of December 31, 1998, 97.0% of the Company's fixed maturity securities carried a NAIC Class 1 designation (or a comparable rating agency designation). 19 At December 31, 1998, the Company owned a total of $53.9 million amortized cost of mortgage backed and other asset backed securities. Mortgage backed securities accounted for $31.4 million of the total. Approximately 84% of the mortgage backed securities holdings were AAA-rated Agency pass through and collateralized mortgage obligations ("CMO's"). The balance of the mortgage backed securities holdings consisted of short maturity non-Agency mortgage backed assets, also rated AAA. As of December 31, 1998, the average life of the mortgage backed security portfolio was just over five years. Asset backed holdings totaled $22.5 million at year end and primarily consisted of traditional AAA rated automobile loan and credit card receivable backed financings. In addition, the Company had modest exposures to AA-rated Home Equity Loan and AAA-rated Collateralized Bond obligation debt issues. As of December 31, 1998, the average life of the asset backed securities portfolio was just over four years. The primary objective of the mortgage and asset backed holdings is to provide incremental investment income while controlling maturity extension and prepayment risks. The following table sets forth certain information regarding the investment ratings of the Company's fixed maturity investment portfolio as of December 31, 1998: LONG TERM FIXED MATURITY PORTFOLIO BY STANDARD & POOR'S RATING
CARRYING AMORTIZED PERCENTAGE OF RATINGS (1) VALUE COST CARRYING VALUE - ----------- ----- ---- -------------- (DOLLARS IN THOUSANDS) AAA............................................................. $86,747 $86,945 50.8% AA.............................................................. 26,326 25,875 15.4% A............................................................... 44,848 44,000 26.3% BBB to B........................................................ 11,321 12,659 6.6% Not rated....................................................... 1,550 1,900 0.9% --------------- ----------------- ------------------ Total........................................................... $170,792 $171,379 100.0% --------------- ----------------- ------------------ --------------- ----------------- ------------------
- ------- (1) Ratings assigned by S&P when available, otherwise equivalent ratings assigned by Moody's or Fitch. S&P assigns ratings ranging from "AAA" to "D" reflecting its current opinion of the creditworthiness of the obligor with respect to the specific security rated. The following ratings reflect S&P's opinion of the obligor's capacity to meet its financial commitment on the relevant obligation: AAA-Extremely Strong; AA-Very Strong; and A-Strong. 20 The following table sets forth certain information regarding the maturity profile of the Company's fixed maturity securities as of December 31, 1998 based on the earlier of the pre-escrowed date or the scheduled maturity date: INVESTMENT PORTFOLIO BY YEARS TO MATURITY
PERCENTAGE OF MATURITY CARRYING VALUE CARRYING VALUE - -------- -------------- -------------- (DOLLARS IN THOUSANDS) One year or less..................................................................... $7,541 4.4% After one year through five years.................................................... 56,205 32.9% After five years through ten years................................................... 48,590 28.4% After ten years...................................................................... 5,401 3.2% Mortgage and asset backed securities (1)............................................. 53,055 31.1% --------------- ---------------- Total................................................................................ $170,792 100.0% --------------- ---------------- --------------- ----------------
- ------- (1) Mortgage- and asset-backed securities generally are more likely to be prepaid than other fixed maturity securities. Therefore, contractual maturities are excluded from this table since they may not be indicative of actual maturities. The Company's investment results for each of the years in the three year period ended December 31, 1998 were as follows: INVESTMENT PORTFOLIO RESULTS
Years Ended December 31, 1998 1997 1996 ---- ---- ---- (dollars in thousands) Net pre-tax investment income (1).................................... $9,540 $5,582 $4,701 Average total invested assets (2).................................... 156,872 110,576 83,644 Annual pre-tax yield on average total invested assets (3)............ 6.1% 5.0% 5.6% Net pre-tax realized investment gains................................ $1,706 $172 $444
- ------- (1) Calculated net of investment expenses and excluding capital gains and losses and provision for income taxes. (2) Calculated based on an average of the beginning and end of period total investments. For the purpose of this calculation, investment balances were at cost (fixed income securities at amortized cost). The Company's investment portfolio materially increased in October 1997 following the Company's initial public offering. (3) Pre-tax yield is calculated as investment income (including dividend income in the case of equities) divided by average total invested assets. The 1997 annual pre-tax yield as calculated above was diluted by the increase in the Company's investment portfolio in October 1997. The increase in the portfolio late in the year inflated the Company's average total invested assets for 1997 as calculated above. 21 The following table summarizes net investment income from the Company's portfolio for the years ended December 31, 1998, 1997 and 1996: NET INVESTMENT INCOME BY INVESTMENT TYPE
YEARS ENDED DECEMBER 31, ------------------------ (DOLLARS IN THOUSANDS) 1998 1997 ------------------------------------- ------------------------------------- PRE- PRE- TAX REALIZED TAX REALIZED YIELD GAINS YIELD GAINS ------ ------ INCOME (1) (LOSSES) INCOME (1) (LOSSES) ------ --- -------- ------ --- -------- Fixed maturity securities: Tax-exempt (2)..... $3,148 6.2% $1,846 $2,733 4.4% $(1) Taxable............ 5,338 5.9 (362) 2,216 6.6 - Equities (3).......... 500 7.8 222 121 2.3 173 Short-term............ 910 10.3 - 716 7.6 - ----------- ------------- ----------- ------------ Total.............. $9,896 6.3% $1,706 $5,786 5.2% $172 ----------- ------------- ----------- ------------ Less investment expense 356 - 204 - ----------- ------------- ----------- ------------ ----------- ------------- ----------- ------------ Total.............. $9,540 6.1% $1,706 $5,582 5.0% $172 ----------- ------------- ----------- ------------ ----------- ------------- ----------- ------------
YEARS ENDED DECEMBER 31, ------------------------ (DOLLARS IN THOUSANDS) 1996 ----------------------------------- REALIZED PRE- GAINS TAX INCOME YIELD (1) (LOSSES) ------ --------- -------- Fixed maturity securities: Tax-exempt (2)..... $2,660 5.5% $248 Taxable............ 1,841 6.0 196 Equities (3).......... 62 5.8 - Short-term............ 338 8.6 - ----------- ------------ Total.............. $4,901 5.9% $444 ----------- ------------ Less investment expense 200 - ----------- ------------ Total.............. $4,701 5.6% $444 ----------- ------------ ----------- ------------
(1) Pre-tax yield is calculated as investment income (including dividend income in the case of equities) divided by the average of the beginning and end of year investment balances. For the purpose of this calculation, investment balances were at cost (fixed income securities at amortized cost). (2) For purposes of comparison to yields on taxable securities, those yields on tax-exempt securities are equivalent to average pre-tax yields of 8.0% for 1998, 5.7% for 1997, and 7.1% for 1996 assuming that the tax rate was 34% and further assuming that 15% of a portion of the tax-exempt interest was subject to federal income tax under certain provisions applicable only to insurance companies. (3) Excludes the Company's minority investments in Parker and CAPAX, which had a carrying value as of December 31, 1998 of $1.7 million. REGULATION GENERAL PAULA Financial and its subsidiaries are subject to regulation by the departments of insurance in each jurisdiction in which they transact insurance. These departments of insurance have broad regulatory, supervisory and administrative powers over the insurance subsidiaries. Primary regulatory authority, however, rests with the California DOI, the regulator in the Company's insurance subsidiaries' state of domicile. While the exercise of their authority may have company-wide ramifications, regulators in non-domiciliary states focus primarily on the operation of an insurer within their respective states. 22 State insurance regulation is generally intended for the benefit and protection of policyholders and claimants under insurance policies rather than stockholders. The nature and extent of such regulation varies from jurisdiction to jurisdiction, but typically involve: (i) standards of solvency and minimum amounts of capital and surplus which must be maintained; (ii) limits on types and amounts of investments; (iii) restrictions on the size of risks which may be insured by a single company; (iv) licensing of insurers and their agents; (v) required deposits of securities for the benefit of policyholders; (vi) approval of policy forms; (vii) establishment of statutory reporting practices and the form and content of statutory financial statements; (viii) establishment of methods for setting statutory loss and expense reserves; (ix) review, and in certain instances prior-approval, of premium rates; (x) limits on transactions among insurers and their affiliates; (xi) approval of all proposed changes of control; (xii) approval of dividends; (xiii) setting and collecting guarantee fund assessments; and (xiv) required filing of annual and other reports with respect to the financial condition and operation of insurers. In addition, state regulatory examiners perform periodic financial and underwriting examinations of insurers. DOMICILE AND LICENSING PICO and PACO are domiciled in California. PICO is licensed to sell insurance in Alaska, Arizona, California, Florida, Idaho, New Mexico, Nevada, Oregon, and Texas. PACO is licensed to sell insurance in Arizona and California. RESTRICTIONS ON ACQUISITIONS OF CONTROL The California Insurance Code provides that any direct or indirect acquisition or change in "control" of a domestic insurer cannot be consummated without the prior approval of the California DOI. The California Insurance Code provides further that, unless the California DOI upon application determines otherwise, a presumption of "control" arises from the ownership, control, possession with the power to vote or possession of proxies with respect to 10% or more of the voting securities of a domestic insurer or of a person or entity that controls a domestic insurer. Any person who purchases shares of the Common Stock which, when combined with all other voting securities owned or otherwise controlled by that person, total 10% or more of the voting securities of the Company, will be deemed to have acquired control of the insurance subsidiaries unless the California DOI, upon application, determines otherwise. Any such acquisition of control is prohibited under the California Insurance Code unless prior approval of the California DOI is obtained or the California DOI does not disapprove the acquisition within 60 days after a complete application has been filed. The California DOI is authorized to disapprove any acquisition which (i) would cause the insurance subsidiaries to cease to qualify for their licenses to transact insurance, (ii) would substantially lessen competition or tend to create a monopoly, (iii) might, due to the financial condition of the acquiring person, jeopardize the financial stability of the insurance subsidiaries or prejudice the interests of their policyholders, (iv) would result in a major change in the insurance subsidiaries' business or corporate structure or management which is not fair and reasonable to policyholders, or (v) would result in control over the insurance subsidiaries by persons whose competence, experience and integrity indicate that it is not in the interest of policyholders or the public to permit them to assume control. 23 The need for such action, and the possibility of disapproval by the California DOI, could deter, delay or prevent certain transactions affecting the control of the Company or the ownership of the Company's Common Stock. Since the statutory disapproval criteria focus primarily on policyholder, rather than stockholder interests, these requirements could deter, delay or prevent transactions which could be advantageous to the stockholders of the Company. RESTRICTIONS ON STOCKHOLDER DIVIDENDS PAYABLE BY THE INSURANCE SUBSIDIARIES TO THE COMPANY PAULA Financial, as a non-insurer, is generally not restricted directly under applicable insurance laws with respect to the payment of dividends to stockholders or the acquisition of non-regulated businesses. PAULA Financial, however, is subject to regulation with respect to all transactions involving the insurance subsidiaries. Additionally, as a nonoperating holding company, a principal source of the PAULA Financial's liquidity is cash dividends received from its subsidiaries, including the insurance subsidiaries. California law places significant restrictions on the ability of the insurance subsidiaries to pay dividends to PAULA Financial. All dividends from PICO and PACO, as California-domiciled insurers, require prior notice to the California DOI. All "extraordinary" dividends must be approved in advance by the California DOI. A dividend is deemed "extraordinary" if, when aggregated with all other dividends paid within the preceding twelve months, the dividend exceeds the greater of (i) PICO's statutory net income or PACO's statutory net gain from operations (both excluding unrealized capital gains) for the preceding calendar year or (ii) 10% of policyholder surplus as of the preceding December 31st. Additionally, unless approved in advance by the California DOI, no dividend may be paid by PICO or PACO except from earned surplus. Dividends paid from earned surplus which do not exceed the definition of "extraordinary" must be reported to the California DOI within five business days after declaration. Insurers are prohibited from paying such dividends until ten business days after the California DOI's receipt of such notice. The California DOI may disallow payment of any dividend if, in the California DOI's opinion, the payment would in any way violate the California Insurance Code or be hazardous to policyholders, creditors or the public. Based on these limitations and statutory results, as of December 31, 1998, PAULA Financial would be able to receive $5.4 million in dividends in 1999 from its insurance subsidiaries without obtaining prior regulatory approval from the California DOI. RESTRICTIONS ON TRANSACTIONS AMONG AFFILIATES OF THE INSURANCE SUBSIDIARIES In addition to dividend restrictions, California law restricts the ability of the insurance subsidiaries to make other types of payments to their affiliates, including PAULA Financial. Certain material transactions between an insurance company and its affiliates, including sales, loans or investments which in any twelve month period aggregate at least 3% of its admitted assets or 25% of policyholders' surplus, whichever is less, are subject to thirty day prior notice to the California DOI during which period the California DOI may disapprove the transaction. All management, administrative, cost-sharing and similar agreements between an insurance company and its affiliates are also subject to thirty day prior notice and non-disapproval by the California DOI. The California Insurance Code requires that all affiliate transactions be fair and reasonable to the insurer, that such transactions be documented according to specified standards, and that the insurer's surplus after the transaction remains reasonable in relation to the insurer's liabilities and adequate to its financial needs. 24 EXAMINATIONS The accounts and businesses of PICO and PACO are subject to periodic statutory examination by the California DOI and by the Departments of Insurance in each jurisdiction in which they transact business. The California DOI has completed its examination of PICO and PACO for the three-year period ended December 31, 1996. The report disclosed no material problems or adjustments to statutory surplus. NAIC STATUTORY ACCOUNTING INITIATIVE The NAIC's project to codify accounting practices was approved by the NAIC in March 1998. The approval included a provision for commissioner discretion in determining appropriate statutory accounting for insurers in their state. Consequently, prescribed and permitted accounting practices may continue to differ from state to state. The California DOI has indicated that codification will become effective on January 1, 2001. The Company has not determined how implementation will affect its insurance subsidiaries' statutory financial statements and is unable to predict how insurance rating agencies will interpret or react to any such changes. No assurance can be given that future legislative or regulatory changes resulting from such activities will not adversely affect the Company and its subsidiaries. RISK-BASED CAPITAL AND IRIS RATIOS California, as well as numerous other states, uses analytical tools developed by the NAIC in the course of its financial surveillance of insurers. Among these is a methodology for assessing the adequacy of statutory surplus of property/casualty insurers and life/health insurers using a risk-based capital ("RBC") formula. The RBC formula attempts to measure statutory capital and surplus needs based on the risks in a company's mix of products and investment portfolio. The formula is designed to allow state regulators to identify potentially under-capitalized companies. Under the formula, a company determines its RBC by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). The RBC rules provide for different levels of regulatory attention depending upon the ratio of the company's total adjusted capital to its "authorized control level" of RBC. An insurer is obligated to submit a detailed financial plan to regulators if its RBC falls below 2.0 times its authorized control level. Enhanced regulatory scrutiny, including possible corrective orders, are required if an insurer's RBC falls below 1.5 times its authorized control level, with mandatory regulatory intervention, including possible seizure, if an insurer's RBC falls below its authorized control level (seizure is mandatory if RBC falls below 0.7 times authorized control level). As of December 31, 1998, PICO's RBC was $34.1 million in excess of the threshold requiring the least regulatory attention, which amount was $15.7 million. As of December 31, 1998, PACO's RBC was $4.6 million in excess of the threshold requiring the least regulatory attention, which amount was $0.1 million. Neither PICO nor PACO has ever triggered any RBC level requiring a financial plan or regulatory action. California and other states also utilize the NAIC Insurance Regulatory Information System ("IRIS"). IRIS identifies eleven ratios for property/casualty insurance companies and twelve ratios for life/health insurance companies. IRIS specifies a range of "usual values" for each ratio. No statutory requirements exist which determine regulators' response to unusual IRIS ratios. Regulators generally allow insurers to provide written explanations for any unusual values. If the explanations are accepted as reasonable, no regulatory action is generally taken. If regulators remain concerned, an insurer may be subject to regulatory examination, corrective orders, and possible seizure. Departure from the "usual value" range on four or more 25 ratios may lead to increased regulatory oversight from individual state insurance commissioners. For 1998, PICO has two ratios outside the usual values. The two ratios are change in net writings and two-year overall operating ratio. The usual range for the change in net writings ratios is (33%) to 33%. PICO experienced 38% growth in 1998. PICO's two-year overall operating ratio was 101% and a ratio in excess of 100% is considered unusual. For 1998, PACO has two ratios outside its usual value, one of which is caused by more than adequate investment income and the other related to change in premium. PICO and PACO are unaware of any increased regulatory scrutiny as a result of their 1998 IRIS values. REGULATION OF PICO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED PICO's transaction of workers' compensation insurance is closely regulated by departments of insurance in Alaska, Arizona, California, Florida, Idaho, Nevada, New Mexico, Oregon and Texas. In each of these states, the workers' compensation system is a mechanism to promptly compensate and rehabilitate injured workers without regard to fault. In each state where PICO is licensed, other than New Mexico (with respect to agricultural workers) and Texas, employer participation in the workers' compensation system is compulsory. Employers are required by law either to obtain workers' compensation insurance from a licensed insurer or to comply with specific requirements to self-insure. Workers' compensation benefits are established by law in each of the states where PICO is licensed. While benefit levels vary from state to state, they fall generally into three categories: (1) medical benefits for treatment of covered injuries or diseases; (2) disability benefits that indemnify covered claimants for loss of income, and (3) death benefits to compensate statutorily enumerated dependents of workers who have died because of covered accidents or diseases. Individual state statutes, regulations, administrative rulings and judicial opinions have created a complex body of law to determine when an injury, disease or death is employment related, when and to what extent it is compensable, and whether employees may sue employers, coworkers or other parties for damages outside of the no-fault workers' compensation system. Workers' compensation has been the subject of significant reform efforts in recent years, particularly in the areas of cost management and fraud detection. For example, legislation enacted in California in 1993 significantly reformed many areas of the workers' compensation system. Among other things, the 1993 legislation (i) granted employer's rights regarding disclosure of insurer claims information; (ii) required insurers to provide minimum levels of occupational safety and health loss control consultation services; (iii) increased benefits, phased in over a three-year period commencing July 1, 1994; (iv) tightened standards relating to stress-related claims; (v) limited post-termination claims; (vi) placed restrictions, including payment limitations, on vocational rehabilitation claims, (vii) increased measures to reduce fraudulent claims; (viii) increased the ability of insurance companies and employers to contract with managed care organizations and to direct claimants' medical care; and (ix) changed procedures for medical-legal evaluations. Similarly, legislation adopted in Oregon in 1995, among other things, reformed requirements pertaining to pre-existing conditions, vocational rehabilitation, payment of death benefits, review of benefit awards and dispute resolution. To protect persons covered under policies of workers' compensation insurance, several states impose special deposit requirements on insurers. In the event of an insurer insolvency, special deposits made by insurers are utilized by the relevant department of insurance to provide a pool of funds upon which workers' compensation claimants domiciled exclusively in that state possess a first priority claim and can be used by the regulators to pay those claimants. Under these requirements, PICO maintains special deposits in Arizona, California, Idaho, Oregon, Nevada and New Mexico. Additional special deposits may be required if PICO becomes licensed in additional states, or if Alaska, Florida or Texas enact deposit requirements. 26 While deposit requirements vary somewhat, they generally require insurers to deposit cash or securities with each states' treasurer, or an approved depository, in an amount based on a company's loss and loss expense reserves plus a percentage of its unearned premium reserves on workers' compensation insurance business transacted in each individual state. Thus, the size of the required deposit correlates positively with the amount of workers' compensation insurance sold by PICO in such state. PICO maintains deposits of securities in California, Arizona, Oregon, Idaho, New Mexico and Nevada, having a book value as of December 31, 1998 of $55.8 million, $16.1 million, $7.2 million, $0.3 million, $3.7 million and $0.2 million, respectively. An important aspect of workers' compensation insurance regulated by individual states is the setting of premiums. Among the states where it is currently licensed, PICO is allowed to establish its own rates under a "file and use" system in Alaska, California and Texas. Prior approval by insurance regulators is required for workers' compensation insurance rates in Florida, Nevada, New Mexico and Oregon. Hybrid systems exist in Arizona and Idaho, where workers' compensation insurance rates are determined initially by the National Council on Compensation Insurance ("NCCI"), a rating organization. Upon the request of an individual insurer, the Arizona or Idaho DOI, as applicable, may approve rates that deviate from those recommended by the NCCI. Prior to January 1, 1995, California had required workers' compensation insurers to adhere to minimum rates approved by the California DOI. Under this system, price competition among insurers had been generally restricted to the payment of dividends under participating policies. This system was replaced with a file and use system, in which insurers may use any rate within 30 days after filing it with the California DOI unless such rate is specifically disapproved. The repeal of the former minimum rate system in California has resulted in increased competition among workers' compensation insurers in California and has caused a material decrease in average rates charged by PICO. Competition among workers' compensation insurers is also affected in several states by the presence of quasi-public workers' compensation insurance funds, which compete against private insurers and which frequently serve as insurers of last resort to employers unable to secure coverage elsewhere. Among the states where PICO is licensed, active state funds exist in Arizona, California, Idaho, Nevada, New Mexico, Oregon and Texas. REGULATION OF PACO'S BUSINESS IN EACH STATE IN WHICH IT IS LICENSED PACO, a California-domiciled insurer, is licensed in California and Arizona. The transaction of life and health insurance is closely regulated in these states. Such regulation includes statutorily mandated benefits, sales disclosures, and claims settlement requirements. In 1998, PACO wrote $0.8 million in life and health premiums in California and Arizona combined. MEMBERSHIP IN INSOLVENCY FUNDS AND ASSOCIATIONS The Company's insurance subsidiaries, like other insurers, are required to participate in insolvency funds and associations and may be subject to assessments from time to time to cover unpaid policyholder claims of insolvent insurers participating in the same lines of business as the Company. The maximum assessment required by law in any one year has varied between 1% and 2% of annual premiums written in that state. Most of these payments are recoverable through future policy surcharges and premium tax 27 reductions. No material assessments have been made on the Company's insurance subsidiaries since prior to December 31, 1990. The Company was assessed 2% of gross written premium in the state of Florida in 1998. COMPETITION The workers' compensation insurance industry is highly competitive. In most states in which the Company operates, the Company's single largest competitor in its targeted agricultural markets is the applicable state fund. More recently, the Company has faced increased competition from alternative risk funding arrangements such as self-insurance or captive insurance programs. Captive insurance companies are insurance or reinsurance companies in which an insured, a group of insureds or an insurance agent holds significant ownership. Employers have the option of self insuring against workers' compensation liabilities. Normally, those companies who choose to self insure are very large employers and are not among the targeted insurance underwriting prospects of the Company. In those states without minimum premium laws, such as California, Oregon, Idaho, Alaska and Texas, the Company faces competition on the basis of price as well as on the services which it delivers to policyholders. Arizona's single deviated rating plan has resulted in price competition among firms with different rating plans, but not among firms with the same rating plan as PICO. As a result of Florida's minimum rate law, there has been no significant price competition in that state in terms of premiums charged. Competition among workers' compensation insurance carriers in Arizona and Florida has been based to varying degrees on emphasizing dividends to policyholders, loss control and claims management services and maintaining relations with and varying commission rates paid to brokers and agents. When the Company commences operations in Nevada in July 1999, rates will be set by the Nevada DOI and the Company expects competition to be based on service and dividends to policyholders. The Company believes that its ability to compete successfully with larger carriers and to obtain and retain its accounts is due to its claims expertise, extensive experience in the agribusiness market and emphasis on service to policyholders. The Company has entered into arrangements with two nationwide reinsurance companies which enable the Company to cause those companies to write qualifying workers' compensation insurance in states where the Company is not licensed and cede virtually all of the premiums and related risk to the Company. Under the arrangements, the Company is responsible for ensuring the writing carrier's compliance with its filed rating plans and the payment of claims in accordance with applicable state insurance laws. In this regard, the Company operates under the indirect regulation of the Departments of Insurance in these several states. CERTAIN EXECUTIVE OFFICERS OF THE COMPANY Information concerning the Company's executive officers who serve as members of the Company's Board of Directors will be set forth in the Company's definitive proxy materials. See "Item 10. Directors and Executive Officers of the Registrant." Mr. Victor Gloria III, Mr. James M. Hannah and Mr. James J. Muza also serve as executive officers of the Company. Mr. Gloria is Senior Vice President of PICO and is responsible for PICO's risk management operations including claims administration, loss control and field representative operations. Mr. Gloria has been with the Company since 1972 and has served in PICO's claims department for a majority of that time. He has served as Manager of that Department since 1987 and was appointed Senior Vice President in 1987. Mr. Gloria is 44. 28 Mr. Hannah is a Senior Vice President and Chief Underwriting Officer of PICO and is responsible for PICO's underwriting operations. Mr. Hannah joined the Company in March 1995. Mr. Hannah is 50. Mr. Muza is a Vice President and Chief Actuary of PICO and is responsible for rate making and reserve setting functions. Mr. Muza joined the Company in July 1998 following 15 years with California Casualty Insurance Company. Mr. Muza is 45. EMPLOYEES As of December 31, 1998, the Company employed 309 full-time employees including 61 in its agency and TPA operations, 222 in its underwriting operations and 26 in corporate administration and finance. The Company considers its relationship with its employees to be excellent. All employees with at least one year of service are eligible to participate in the Company's Employee Stock Ownership Plan except for those employees employed on an hourly basis. ITEM 2. PROPERTIES. The Company's principal executive offices, comprised of approximately 35,000 square feet of office space leased through April 2000, are located in Pasadena, California. The Company is currently evaluating various alternatives for its headquarters office after its current lease expires. In addition, the Company maintains 22 branch offices in various locations in the western United States and Florida in leased facilities with various lease terms. Management believes that the Company's facilities are suitable and adequate for their intended uses. ITEM 3. LEGAL PROCEEDINGS Except for ordinary, routine litigation incidental to the Company's business, there are no pending material legal proceedings to which the Company is a party or which any of its properties are subject. The nature of the Company's business subjects it to claims or litigation relating to policies of insurance it has issued. Management believes that the Company is not a party to, and none of its properties is the subject of, any pending legal proceedings which are likely to have a material adverse effect on its business, financial conditions or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1998. 29 ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. MARKET INFORMATION The Company's Common Stock has traded on the Nasdaq Stock Market under the symbol "PFCO" since the consummation of the Company's initial public offering of its Common Stock on October 24, 1997. The high and low closing prices of the Common Stock on the Nasdaq Stock Market during the fourth quarter of 1997 and 1998 were as follows:
High Low ---- --- Fourth Quarter 1997 (1) 25.250 21.250 First Quarter 1998 24.250 22.625 Second Quarter 1998 25.625 19.375 Third Quarter 1998 22.000 6.750 Fourth Quarter 1998 11.875 6.875
- ------------ (1) From October 24, 1997 through December 31, 1997 HOLDERS OF RECORD As of March 15, 1999, the Common Stock was held of record by 216 holders. The Company estimates that the number of beneficial holders of the Common Stock as of such date exceeded 800. DIVIDENDS The Company did not pay cash dividends to its stockholders prior to the first quarter of 1998. Since the first quarter of 1998, the Company has declared and paid quarterly dividends of $0.04 per share of Common Stock. The most recent dividend is payable to stockholders of record on March 15, 1999. Although the Company currently intends to continue to pay quarterly dividends, the declaration and payment of dividends is subject to the discretion of the Company's Board of Directors and will depend upon, among other things, the Company's results of operations, financial condition, cash requirements, future prospects and capital requirements, regulatory restrictions on the payment of dividends by the Company's insurance company subsidiaries, general economic and business conditions and other factors deemed relevant by the Board of Directors. There can be no assurance that the Company will continue to declare and pay any dividends. The ability of the Company's subsidiaries to pay dividends to the Company is subject to substantial regulation. In addition, the Company's line of credit restricts the payment of dividends under certain circumstances. See Management's Discussion and Analysis of Financial Condition and Results of Operation-Liquidity and Capital Resources", "Business-Regulation" and Note 10 of Notes to Consolidated Financial Statements. 30 ITEM 6. SELECTED FINANCIAL DATA. The selected data presented below under the captions "Income Statement Data" and "Balance Sheet Data" as of and for each of the years in the five-year period ended December 31, 1998, are derived from the consolidated financial statements of the Company, which financial statements have been audited by KPMG LLP, independent certified public accountants. The consolidated financial statements as of December 31, 1998 and 1997 and for each of the years in the three-year period ended December 31, 1998, and the report thereon are included elsewhere herein. The information presented below under the caption "Other Data" is unaudited. The selected financial data set forth below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto appearing elsewhere herein.
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 1995 1994 ---- ---- ---- ---- ---- (DOLLARS IN THOUSANDS) INCOME STATEMENT DATA: Gross premiums written....................... $152,448 $100,797 $63,606 $46,762 $53,545 --------------------------------------------------------------------------- --------------------------------------------------------------------------- Net premiums earned: Workers' compensation..................... $127,997 $91,957 $54,563 $44,224 $50,977 Group medical and life.................... 773 878 941 307 312 Commissions.................................. 3,234 3,434 4,213 3,964 4,299 Net investment income........................ 9,540 5,582 4,701 4,817 4,536 Net realized investment gains................ 1,706 172 444 37 - Other........................................ 842 1,047 896 1,569 1,712 -------------------------------------------------------------------------- Total revenue............................. $144,092 $103,070 $65,758 $54,918 $61,836 Losses and loss adjustment expenses incurred. 114,483 68,107 33,900 29,363 28,618 Dividends provided for policyholders......... 677 (2,713) 1,628 3,438 6,221 Operating expenses........................... 37,636 30,741 25,480 22,608 20,720 -------------------------------------------------------------------------- Total expenses............................ $152,796 $96,135 $61,008 $55,409 $55,559 Income (loss) before taxes................... (8,704) 6,935 4,750 (491) 6,277 Income tax expense (benefit)................. (3,827) 1,776 827 (791) 1,572 -------------------------------------------------------------------------- Net income (loss)......................... ($4,877) $5,159 $3,923 $300 $4,705 -------------------------------------------------------------------------- -------------------------------------------------------------------------- Earnings (loss) per share (1)................ ($0.78) $1.88 $2.07 $0.16 $1.54 Weighted average shares outstanding (1)...... 6,228,479 2,737,065 1,896,464 1,850,956 3,057,088 Earnings (loss) per share - assuming dilution(1)............................... ($0.78) $1.11 $1.00 $0.08 $1.23 Weighted average shares outstanding - assuming dilution (1)..................... 6,228,479 4,664,511 3,910,715 3,763,059 3,827,487
31
AS OF DECEMBER 31, ------------------- 1998 1997 1996 1995 1994 ---- ---- ---- ---- ---- (DOLLARS IN THOUSANDS) BALANCE SHEET DATA: Investments (2)..................... $177,623 $137,864 $86,792 $83,991 $83,084 Total assets........................ 254,948 188,264 125,127 118,906 117,297 Unpaid losses and loss adjustment expenses 136,316 77,784 55,720 57,049 60,473 Notes payable....................... 2,667 456 11,279 10,824 4,205 Total liabilities................... 180,912 103,444 99,151 93,301 90,384 Preferred Stock (convertible and redeemable)...................... - - 21,402 19,501 18,918 Net stockholders' equity............ 74,036 84,820 4,574 6,104 7,995 AS OF AND FOR THE YEARS ENDED DECEMBER 31, ------------------------------------------ 1998 1997 1996 1995 1994 ---- ---- ---- ---- ---- (DOLLARS IN THOUSANDS) PICO AND PACO GAAP RATIOS: Loss ratio.......................... 88.9% 73.4% 61.1% 65.9% 55.8% Expense ratio....................... 26.4 26.9 32.1 32.3 26.7 Policyholder dividend ratio......... 0.5 (2.9) 2.9 7.7 12.1 ----------------------------------------------------------------- Combined ratio................... 115.8% 97.4% 96.1% 105.9% 94.6% ----------------------------------------------------------------- ----------------------------------------------------------------- PICO STATUTORY DATA: Statutory net income (loss)......... ($7,182) $6,037 $ 5,051 $ 3,175 $ 5,217 Statutory surplus................... 49,870 45,822 31,135 25,992 19,381 Premiums/surplus.................... 2.7x 2.1x 1.9x 1.7x 2.6x Loss ratio.......................... 89.2% 73.8% 61.0% 65.9% 55.9% Expense ratio....................... 25.0 25.9 29.4 30.9 25.9 Policyholder dividend ratio......... 0.5 (3.0) 3.0 7.8 12.2 ----------------------------------------------------------------- Combined ratio................... 114.7% 96.7% 93.4% 104.6% 94.0% ----------------------------------------------------------------- ----------------------------------------------------------------- OTHER DATA: Number of PICO policies (period-end)....................... 10,867 8,579 6,481 4,041 2,227 Number of Company employees (period-end)....................... 309 264 242 237 272 PICO Estimated Annual Premium (period-end)(3).................. $121,230 $90,526 $61,316 $41,176 $41,929
(footnotes follow on next page) 32 (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) As of December 31, 1994, a portion of the portfolio was classified as held to maturity and was therefore reflected at amortized cost and the remaining portfolio was shown at market value. Investments as of December 31, 1995, 1996, 1997 and 1998 are reflected at market value. (3) "PICO Estimated Annual Premium" means, as of any date, the estimated total annualized premiums for all policies written by PICO in force on that date, whether earned prior to or after such date. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company's revenues have consisted primarily of premiums earned from workers' compensation insurance underwriting, premiums earned from group medical insurance, commission income, net investment income and other income. Premiums earned during a period are the direct premiums earned by the Company on in force policies, net of reinsurance. Commission income is earned from Pan Am's distribution of insurance for insurers other than PICO and PACO. The commission the Company pays to Pan Am is eliminated when the Company's operations are consolidated. Net investment income represents earnings on the Company's investment portfolio, less investment expenses. Other income consists of third party administration fees and other miscellaneous items. The Company's expenses have consisted of losses and loss adjustment expenses incurred, dividends provided for policyholders and operating expenses. Losses include reserves for future payments for medical care and rehabilitation costs and indemnity payments for lost wages. Loss adjustment expenses include expenses incurred in connection with services provided by third parties, including expenses of independent medical examinations, surveillance costs, and legal expenses as well as staff and related expenses incurred to administer and settle claims. Loss and loss adjustment expenses are offset in part by estimated recoveries from reinsurers under excess of loss reinsurance treaties. Operating expenses include commission expenses to third party insurance agencies and other expenses that vary with premium volume, such as premium taxes, state guaranty fund assessments and underwriting and marketing expenses, as well as general and administrative expenses, which are less closely related to premium volume. The Company's revenues have been seasonal, and have tended to be highest in the second and third quarters of each year. This is due primarily to the seasonality of the size of the workforce employed by the Company's agribusiness clients. 33 The following table sets forth selected information relating to the growth of PICO's workers' compensation insurance book of business:
AS OF AND FOR THE YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- (DOLLARS IN THOUSANDS) Gross premiums written............................................... $151,675 $99,919 $62,665 Net premiums earned.................................................. $127,997 $91,957 $54,563 Policyholder persistency rate........................................ 73.0% 83.5% 86.8% Number of policies (period-end)...................................... 10,867 8,579 6,481
RESULTS OF OPERATIONS 1998 COMPARED TO 1997 GROSS PREMIUMS WRITTEN. The Company's gross premiums written for 1998 increased 51.2% to $152.4 million from $100.8 million in 1997. The growth in premiums written was primarily attributable to the net addition of new policyholders, increased policyholder payrolls and rate increases in California, particularly in the second half of the year. These increases were partially offset by lower premium rates from increased price competition, especially in the first two quarters of the year. The premium growth was particularly strong in Texas. California continued to account for approximately 70% of gross premiums written. NET PREMIUMS EARNED. For the reasons described above for gross premiums written, the Company's net premiums earned for 1998 increased 38.7% to $128.8 million from $92.8 million in 1997. The Company's net premiums earned increased at a lower rate than gross written premiums because of the impact of premiums ceded of $14.4 million in the fourth quarter under the Reliance reinsurance arrangement. COMMISSION INCOME. Commission income decreased slightly to $3.2 million for 1998 from $3.4 million for 1997. The decrease was primarily the result of decreased workers' compensation premiums placed with carriers other than PICO, a result of the Company's decision to focus on writing PICO workers' compensation insurance. Commission income is earned on premiums placed with carriers other than PICO and PACO. Commission income paid by PICO and PACO to Pan Am is eliminated in consolidation. NET INVESTMENT INCOME. Net investment income increased 70.9% to $9.5 million for 1998 from $5.6 million for 1997. The increase was the result of significant cash flow increases from PICO's underwriting activity and, to a lesser extent, the funds received in the fourth quarter of 1997 from the Company's initial public offering. Average invested assets increased to $156.9 million for 1998 from $110.6 million for 1997. The Company's average yield on its portfolio was 6.1% in 1998 and 5.0% in 1997. The 1997 average yield was diluted by the increase in the Company's investment portfolio in October 1997 following the Company's initial public offering. NET REALIZED INVESTMENT GAINS. The Company had net realized investment gains of $1.7 million for 1998 compared to $0.2 million for 1997. The increase is a result of a tax planning strategy to reposition a portion of the investment portfolio from tax exempt to taxable securities. 34 OTHER INCOME. Other income decreased $0.2 million to $0.8 million for 1998 from $1.0 million for 1997. LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's net loss ratio for 1998 increased to 88.9% from 73.4% for 1997. The increase in the 1998 loss ratio is due to higher 1998 losses on the Company's California book of business and to a reserving action taken by the Company in the second quarter of 1998 to increase loss reserves on the 1997 and 1998 accident years by a total of $14.8 million. In the first two quarters of 1998, the Company saw reserve development on the 1997 accident year for California business in excess of its expectations, given prior year reserving trends. The Company's second quarter 1998 reserve adjustment implied a pricing deficiency for the 1997 and six month 1998 periods. The Company began to address this pricing deficiency early in 1998 through rate increases and non-renewal activity. DIVIDENDS PROVIDED FOR POLICYHOLDERS. Dividends provided for policyholders as a percentage of premiums earned for 1998 was 0.5% compared to (2.9%) for 1997. With the advent of open rating in California and an emphasis in most states in which the Company operates on, among other things, competitive pricing at inception, the Company's dividends provided for policyholders decreased significantly commencing in late 1995. In 1997, the prior year accrual was reduced by $2.7 million. During 1998, the Company paid $0.3 million in policyholder dividends related to certain Arizona policies in which the loss experience developed better than anticipated and accrued a small amount for future dividend obligations. OPERATING EXPENSES. Operating expenses increased 22.4% to $37.6 million for 1998 from $30.7 million for 1997 due in part to a net $4.7 million increase in variable expenses, principally commissions paid to unaffiliated agencies and a $1.8 million increase in personnel costs related to the growth in the Company's insurance operations. Variable expenses include the benefit of $3.0 million in ceding commissions received in the fourth quarter of 1998 in conjunction with the Reliance reinsurance arrangement. INCOME TAXES. Income tax benefit for 1998 was $3.8 million compared to an expense of $1.8 million for 1997. The effective combined income tax rates for 1998 and 1997 were (44.0%) and 25.6%, respectively. These rates vary from the combined statutory rate due to the investment income on tax-exempt securities. NET INCOME (LOSS). Net loss for 1998 was $4.9 million compared to net income of $5.2 million in 1997. The 1998 net loss is primarily attributable to actions taken by the Company to increase loss reserves on the 1997 and 1998 accident years by a total of $14.8 million in the second quarter of 1998. 1997 COMPARED TO 1996 GROSS PREMIUMS WRITTEN. The Company's gross premiums written for 1997 increased 58.5% to $100.8 million from $63.6 million in 1996. The growth in gross premiums written was primarily attributable to the net addition of new policyholders and increased policyholder payrolls, partially offset by lower premium rates resulting from increased price competition. The premium growth was particularly strong in California and the Northwest. In addition, the Company began writing business in Texas and Florida in the second and third quarters of 1997, respectively. NET PREMIUMS EARNED. For the reasons described above for gross premiums written, the Company's net premiums earned for 1997 increased 67.3% to $92.8 million from $55.5 million in 1996. 35 COMMISSION INCOME. Commission income decreased 18.5% to $3.4 million for 1997 from $4.2 million for 1996. The decrease was primarily the result of decreased premiums placed with carriers other than PICO and PACO, a result of the Company's decision to focus on writing PICO workers' compensation insurance. Commission income is earned on premiums placed with carriers other than PICO and PACO. Commission income paid by PICO and PACO to Pan Am is eliminated in consolidation. NET INVESTMENT INCOME. Net investment income increased 18.7% to $5.6 million for 1997 from $4.7 million for 1996. The increase was the result of significant cash flow increases from PICO's underwriting activity and to a lesser extent the funds received in the fourth quarter as a result of the Company's initial public offering. Average invested assets increased to $110.6 million for 1997 from $83.6 million for 1996. The Company's average yield on its portfolio was 5.0% in 1997 and 5.6% in 1996. The 1997 average yield was diluted by the increase in the Company's investment portfolio in October 1997 following the Company's initial public offering. The increase in the portfolio late in the year inflated the Company's average total invested assets for 1997. NET REALIZED INVESTMENT GAINS. The Company had net realized investment gains of $0.2 million for 1997 compared to $0.4 million for 1996. OTHER INCOME. Other income increased $0.1 million to $1.0 million for 1997 from $0.9 million for 1996. LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's net loss ratio for 1997 increased to 73.4% from 61.1% for 1996. The Company's net loss ratio for 1996 was positively impacted by net recoveries from loss and loss adjustment expense reserves for prior years, principally 1993-1995, of $2.6 million or 4.8% of 1996 earned premium. In 1997, the Company's loss ratio included a net strengthening of prior year reserves, principally 1996, of $1.6 million or 1.7% of 1997 earned premium. The increase in the 1997 loss ratio is also related to lower premium rates as a result of increased competition. The impact of the increase in net loss ratio in 1997 was offset in part by a reduction in the Company's policyholder dividend accrual. DIVIDENDS PROVIDED FOR POLICYHOLDERS. With the advent of open rating in California and an emphasis in most states in which the Company operates on, among other things, competitive pricing at inception, the Company's dividends provided for policyholders decreased significantly commencing in late 1995. Currently, the Company does not anticipate paying additional significant policyholder dividends on 1997 and prior policy years. Therefore, the related accrual was reduced by $2.7 million in 1997. OPERATING EXPENSES. Operating expenses increased 20.6% to $30.7 million for 1997 from $25.5 million for 1996 due in part to a $2.8 million increase in commissions paid to unaffiliated agencies and a $1.8 million increase in personnel costs related to the growth in the Company's insurance operations. INCOME TAXES. Income tax expense for 1997 increased to $1.8 million from $0.8 million for 1996. The effective combined income tax rates for 1997 and 1996 were 25.6% and 17.4%, respectively. These rates are below the combined statutory rate due to the significant portion of the Company's investment portfolio consisting of tax-exempt securities. The difference in effective tax rates between 1997 and 1996 is due to a change in the mix of tax-exempt and taxable investment income. 36 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, proceeds from the sale of its capital stock and income from its investment portfolio. PAULA Financial's principal uses of funds are capital contributions to its subsidiaries, payment of operating expenses, investments in new ventures, dividends to its stockholders and repurchase of Company common stock. California law places significant restrictions on the ability of the insurance subsidiaries to pay dividends to PAULA Financial. All dividends from PICO and PACO, as California-domiciled insurers, require prior notice to the California DOI. All "extraordinary" dividends must be approved in advance by the California DOI. A dividend is deemed "extraordinary" if, when aggregated with all other dividends paid within the preceding twelve months, the dividend exceeds the greater of (i) PICO's statutory net income or PACO's statutory net gain from operations (both excluding unrealized capital gains) for the preceding calendar year or (ii) 10% of policyholder surplus as of the preceding December 31st. Additionally, unless approved in advance by the California DOI, no dividend may be paid by PICO or PACO except from earned surplus. Based on these limitations and statutory results, as of December 31, 1998, PAULA Financial would be able to receive $5.4 million in dividends in 1999 from its insurance subsidiaries without obtaining prior regulatory approval from the California DOI. No dividends were paid by the insurance subsidiaries to PAULA Financial during 1998. Management believes that the remaining proceeds from the Company's initial public offering held at the parent company level, funds available under the Credit Agreement described below, and expense reimbursements and dividends from its operating subsidiaries will be sufficient to meet the parent company's operating cash needs for at least the next twelve months. In March 1997, PAULA Financial entered into the Credit Agreement with a commercial bank providing PAULA Financial with a revolving credit facility of $15.0 million until December 31, 1999. As of March 15, 1999, $8.1 million was outstanding under this facility. The use of the credit facility was for repurchase of the Company's common stock and investments in new ventures. On December 31, 1999, PAULA Financial may elect to convert all or a portion of the borrowings then outstanding under such facility into a term loan payable in quarterly installments and maturing on December 31, 2001. The Company is currently in discussions with the bank to renew and extend the Credit Agreement at the end of its initial term in December 1999. Borrowings under the Credit Agreement bear interest at variable interest rates. The Credit Agreement limits the Company's ability to (i) enter new lines of business; (ii) incur or assume debt; (iii) pay dividends and repurchase or retire capital stock upon a default or event of default; and (iv) make acquisitions, investments and capital expenditures. The Credit Agreement contains financial covenants with respect to minimum stockholders' equity, minimum statutory surplus, a ratio of debt to stockholders' equity, a ratio of PICO's premiums written to statutory surplus and excess statutory reserves, a debt service coverage ratio, A.M. Best rating and risk-based capital levels. Each of PAULA Financial's non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement. As of December 31, 1998, the Company was in compliance with its debt covenants. 37 On August 12, 1998, the Company announced the approval of the Board of Directors of a 500,000 share stock repurchase program. On October 29, 1998, the Board authorized an additional 500,000 shares bringing the total authorization under the program to 1,000,000 shares. The shares are expected to be repurchased over the next 30 months through open market and/or privately negotiated purchases. As of December 31, 1998, the Company had repurchased 409,800 shares at an average price of $7.84 per share. In early 1999, the Company made an investment in the recently formed Altus Insurance Holdings, LLC, the parent company of Altus Casualty Company Ltd. ("Altus"), a specialty workers' compensation insurance company. The Company made a capital commitment of $5.5 million and has the option to acquire additional equity and provide quota-share reinsurance to Altus through PICO. In March 1999, the Company announced that Pan Am had agreed to purchase the insurance agency assets of the Sacramento and Stockton, California offices of CAPAX for approximately $3.2 million. The Company will fund the transaction with $2.1 million in cash plus $1.1 million in CAPAX securities which the Company currently holds. The transaction is expected to close in April, subject to certain conditions. OPERATING SUBSIDIARIES The sources of funds of the Company's operating subsidiaries are cash flows from operating activities, investment income and capital contributions from PAULA Financial. The insurance company operating subsidiaries' major uses of funds are claim payments and underwriting and administrative expenses and maintaining the required surplus to expand their insurance business. The agency and TPA operating subsidiaries' major use of funds are operating expenses. The nature of the workers' compensation insurance business is such that claim payments are made over a longer period of time than the period over which related premiums are collected. Operating cash flows and the portion of the investment portfolio consisting of cash and liquid securities have historically met the insurance company operating subsidiaries' liquidity requirements. Operating cash flows and intercompany loans from PAULA Financial have historically met the agency and TPA subsidiaries' liquidity requirements. The Company's investments consist primarily of taxable and tax-exempt United States government and other investment grade securities and investment grade fixed maturity commercial paper and, to a lesser extent, equity securities. The Company does not generally invest in below investment grade fixed maturity securities, mortgage loans or real estate. The Company has invested in the equity securities of the two founders of PTC other than Pan Am as part of the parent company's investment portfolio. The Company's investments in fixed maturity securities are carried at market value as such securities may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. As of December 31, 1998, the carrying value of the Company's fixed maturity securities portfolio was $170.8 million and 92.5% of the portfolio was rated "A" or better by S&P, Moody's or Fitch. See "Business Investments and Investment Results". California workers' compensation insurance companies are required to maintain some of their investments on deposit with the California DOI for the protection of policyholders. Other states in which PICO is licensed have also required PICO to post deposits for the protection of those states' policyholders. Pursuant to applicable state laws, PICO had, as of December 31, 1998, securities with a book value of $83.3 million held by authorized depositories pursuant to these deposit requirements. In addition to the deposits, the insurance company operating subsidiaries must maintain capital and surplus levels related to premiums written and the risks retained by the subsidiaries. 38 YEAR 2000 CONSIDERATIONS THE FOLLOWING IS A YEAR 2000 READINESS DISCLOSURE STATEMENT. OVERVIEW. The Company's Year 2000 Project (the "Project") is steadily proceeding. The Project involves resolving the potential impact of the Year 2000 on the processing of date-sensitive information by the Company's internal computer systems and equipment and by the computer systems and equipment utilized by third parties with whom the Company maintains material relationships. The Company believes that it has identified substantially all of its own information technology systems ("IT Systems") and non-information technology (embedded technology) systems ("Non-IT Systems") which require modification in order to become Year 2000 compliant. In addition, the Company believes that it has identified those third parties whose inability to handle date-sensitive processing could materially and adversely impact the Company if corrective action is not taken in a timely manner. The Company has identified five major internal IT Systems which require attention as part of the Project: General Ledger ("GL"), Agency Operations ("Agency"), Underwriting, which includes policy issuance, maintenance of policy records, billing and auditing ("Underwriting"), Claims Adjudication ("Claims") and Third Party Administration, which includes life insurance and accident and health insurance policy issuance, maintenance and billing operations ("TPA"). The Company's approach to each of these systems differs based on the Company's use of the system and whether the system was purchased from a third party or developed in-house. GL SYSTEM. The Company has completed in-house construction and testing of a new GL system which is Year 2000 compliant. AGENCY SYSTEM. The Company has completed the process of out-sourcing its Agency System needs to James G. Parker Insurance Associates ("Parker"), one of the founders of the PAULA Trading Company. Parker utilizes an agency software system provided by a third party vendor which is Year 2000 compliant according to a written statement received from the vendor. UNDERWRITING SYSTEM. The Company's in-house Underwriting system is not yet fully Year 2000 compliant. The Company has therefore chosen to make its existing Underwriting system Year 2000 compliant using a technique known as "windowing," which is a solution that will work for many years, but not permanently. Windowing is faster and requires less testing than permanent solutions. The Company believes permanent solutions are not necessary in light of the new system under development. The Company has purchased a software tool to perform the windowing project and has retained several consultants familiar with the software tool to perform the project. The consultants will work under the supervision of the Company's information services staff. The Company has identified the programs to be modified, prioritized those programs based on their earliest expected date of failure and has begun using the software tool to perform the correction to the programs. The Company has prepared a testing environment to perform the corrective procedures and to test the results in a realistic data environment. 39 Although the windowing project is proceeding more slowly than anticipated, the Company expects the windowing project, involving correction and testing of all necessary Underwriting system programs, to be completed during the end of the second quarter of 1999. This represents a delay of approximately 45 days from the Company's prior disclosures. The Company is currently constructing a new in-house Underwriting system that will be Year 2000 compliant, but this new system is not expected to address the Company's Year 2000 issues in a timely fashion. CLAIMS SYSTEM. The Company's Claims system is licensed from a third party vendor. The Claims system uses two distinct products, one for claims telephonic reporting and one for claims adjudication. The Company has added custom features to the standard version of each of the products provided by the vendor. The Company's current version of these two system products are not Year 2000 compliant. The Company has received delivery of a standard upgrade to its Claims adjudication system which is Year 2000 compliant, according to the vendor, which is currently being tested by the Company. The Company and the vendor have identified customized features which must be added to the upgraded Claims adjudication system and the vendor has agreed to perform the customization. The Company expects the customization to be completed during June 1999 and final installation, testing and training to be complete by early in the third quarter of 1999. This represents a delay of approximately 45 days from the Company's prior disclosures. The Company has determined that it cannot modify the programs of the existing version of the Claims system to make it Year 2000 compliant. However, the Company does not believe that continuing to utilize the non-Year 2000 compliant version of the Claims adjudication system through the third quarter of 1999 will materially impair operations. The Company expects to implement the customized upgrade early during the third quarter. If necessary, the Company will commence using the "standard" version of the claims system upgrade it has already received and installed. The Company's Claims telephonic reporting system will not be made Year 2000 compliant by the vendor. As scheduled, the Company has modified its Claims telephonic reporting system to properly process claims during 1999, but this modification will not allow claims processing in 2000. The Company has chosen to move to a vendor maintained, Year 2000 compliant, mainframe-based telephonic reporting system. This is expected to be effective during the middle of the second quarter of 1999, a delay of approximately 45 days from the Company's prior disclosures. TPA SYSTEM. The Company has licensed a third party claims administration software product that the Company uses for all TPA functions. The Company has received from the vendor a Year 2000 upgrade to the version used by the Company which will be installed and tested by the end of the first quarter 1999, on schedule. NON-IT SYSTEMS. The Company has addressed its primary Year 2000 issues relating to Non-IT Systems by purchasing a new IBM mainframe computer to run its IT Systems. The Company intends to purchase a new second mainframe from IBM to extend the Company's computing capacity during the second quarter of 1999. At that time, the Company's old IBM mainframe will be relegated to a back-up role. The Company has obtained satisfactory evidence that the operating system of the Company's new mainframe computers are Year 2000 compliant from IBM's Internet website. 40 The Company is continuing to inventory its other Non-IT Systems as part of the Project. These systems include the Company's personal computer network, telephone switching equipment and other office equipment. Once these systems are inventoried, the Company will prioritize the impact of their failure due to Year 2000 issues and then begin testing and correcting to bring them into Year 2000 compliance. The Company expects the inventory and prioritization phases to be completed by the end of the first quarter of 1999 and corrective action to be completed by the end of the second quarter of 1999. The Company does not believe that it is materially exposed to any Company-specific Non-IT System Year 2000 issues other than those addressed by purchasing new mainframe computers due to the nature of the Company's business. The Company has no material property, plant or equipment. THIRD PARTY YEAR 2000 ISSUES. The Company has made good progress in obtaining Year 2000 compliance assurances from third parties with whom the Company has material trading arrangements, or upon whom the Company relies to a material extent in its normal operations. The Company will continue working to satisfy itself that each third party performing important functions for the Company has taken necessary measures to ensure that their IT and Non-IT Systems will be Year 2000 compliant in a timely manner. The Company believes it will suffer no material disruption of its operations from its trading partners' Year 2000 issues. The Company has not, and will not, attempt to assess the Year 2000 compliance of regulatory authorities, statistical rating bureaus or public utilities as the Company cannot cause such entities to increase their efforts to become Year 2000 compliant. COSTS. The total cost associated with required program modifications, software upgrades and equipment purchases to become Year 2000 compliant is not expected to be material to the Company's financial position, results of operations or cash flows. The Company's total budget for its Year 2000 compliance program, which began in 1997, is $875,000. This estimate does not include the Company's potential share of Year 2000 costs that may be incurred by the Company's trading partners which the Company may choose to bear to increase the likelihood of their timely Year 2000 compliance. Of the total budget amount, $80,000 was spent in 1997, $300,000 was spent in 1998, and $495,000 will be spent during 1999. The costs associated with the Company's new Underwriting System are not included in the Year 2000 budget. The Company is utilizing cash flow from operations to fund its Year 2000 budget needs. CONTINGENCIES. The Company continues to review its alternatives in the event that it is not able to complete its Year 2000 compliance plans in a timely manner. These alternatives include, without limitation, purchasing third party insurance company software packages, acceleration of the construction of the Company's new Underwriting system and outsourcing the non-compliant Company functions to third parties. Each of these alternatives is less advantageous to the Company than its current Year 2000 compliance plan and, if required, could have an adverse effect on the Company's financial position, results of operations or cash flows. RISKS. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, financial condition and cash flow. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of regulatory authorities, statistical rating bureaus and public utilities, the Company is unable to determine at 41 this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, financial condition or cash flows. The Company believes the Project will significantly reduce the Company's level of uncertainty about the Year 2000 problem. CONSULTANTS. The Company has not used the services of independent Year 2000 consultants to assess its IT System and Non-IT System needs, although the Company is utilizing the services of independent consultants in its Underwriting System windowing project and in constructing its new Underwriting system. The Company continues to review its Year 2000 program with its outside auditors on a regular basis. NEW ACCOUNTING STANDARDS During the first quarter of 1998, the Company adopted the provisions of Financial Accounting Standards Board ("FASB") Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires companies to report comprehensive income and its components in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital. Comprehensive income includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. In accordance with the reporting requirements of SFAS 130, the Company has included consolidated statements of comprehensive income in the accompanying consolidated financial statements. Also, during the first quarter of 1998, the Company adopted the provisions of FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information: ("SFAS 131"). This statement specifies revised guidelines for determination of an entity's operating segments and the type and level of financial information to be disclosed. Based on the guidance included in SFAS 131, the Company has determined that it operates in a single segment: the production, underwriting and servicing of workers' compensation and accident and health insurance. In 1998, the American Institute of Certified Accountants issued Statement of Position No. 98-1, "Accounting for Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 addresses the accounting for various costs associated with the development of software for internal use. SOP 98-1 requires that costs incurred in the Preliminary Project and Post-Implementation/Operation Stages be expenses as incurred while certain costs incurred in the Application Development Stage are to be capitalized. The Company adopted the provisions of SOP 98-1 effective January 1, 1998. During the fourth quarter of 1997, the American Institute of Certified Accountants issued Statement of Position No. 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SOP 97-3"). SOP 97-3 addresses the recognition and measurement of assets and liabilities related to guaranty funds and other assessments. SOP 97-3 is effective for fiscal years beginning after December 15, 1998, although early adoption is encouraged. The Company has not determined the impact of SOP 97-3. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for fiscal years beginning after June 15, 1999 and establishes standards for the reporting for derivative instruments. It requires changes in the fair value of a derivative instrument and the changes in fair value of assets or liabilities hedged by that instrument to be included in income. To the extent that the hedge transaction is effective, income is equally offset by both investments. Currently the changes in fair value of 42 derivative instruments and hedged items are reported in net unrealized gain (loss) on securities. The Company has not adopted SFAS 133. However, the effect of adoption on the consolidated financial statements at December 31, 1998 would not be material. 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 its insurance premiums and fee income, the claims experience of its insurance products, the performance of its investment portfolio, the successful completion by the Company of its Year 2000 compliance program, acquisitions of companies or blocks of business, and the ratings by major rating organizations of its insurance subsidiaries. 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 information. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. The Company's consolidated balance sheet includes a substantial amount of assets and liabilities whose fair values are subject to market risks. Due to the Company's significant level of investments in fixed maturity securities (bonds), interest rate risk represents the largest market risk factor affecting the Company's consolidated financial position, although the Company also has limited exposure to equity price risk. The following sections address the significant market risks associated with the Company's financial activities as of December 31, 1998. 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 and because unpaid losses and loss adjustment expenses and reinsurance recoverables on unpaid losses and loss adjustment expenses are not included in the hypothetical effects of changes in market conditions discussed below. As of December 31, 1998 unpaid losses and loss adjustment expenses represent 75% of the Company's total liabilities and reinsurance recoverables on unpaid losses and loss adjustment expenses represents 10% of the Company's total assets. 43 INTEREST RATE RISK The Company employees a conservative investment strategy emphasizing asset quality and the matching of maturities of its fixed maturity investments to the Company's anticipated claim payments, expenditures and other liabilities. The Company's fixed maturity portfolio includes investments in CMO's which are exposed to accelerated prepayment risk generally caused by interest rate movements. As of December 31, 1998, the Company's fixed maturity portfolio represented 67% of the Company's total assets and 96% of the Company's invested assets. Management intends to hold all of the Company's fixed maturity investments for indefinite periods of time but these investments are available for sale in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. 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. The Company strives to maintain the highest credit ratings so that the cost of debt is minimized. As of December 31, 1998, notes payable and notes payable to bank account for 1% of total liabilities. The Company's fixed maturity investments, including CMOs, notes payable and notes payable to bank are subject to interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, CMO prepayment rates, relative values of alternative investments, the liquidity of the instrument and other general market conditions. The table below summarizes the estimated effects of hypothetical increases and decreases in interest rates. It is assumed that the changes occur immediately and uniformly to each category of instrument containing interest rate risks. The hypothetical changes in market interest rates reflect what could be deemed best or worst case scenarios. The hypothetical fair values are based upon the same prepayment assumptions utilized in computing fair values as of December 31, 1998. Should interest rates decline, mortgage holders are more likely to refinance existing mortgages at lower rates. Acceleration of repayments could adversely affect future investment income, if reinvestment of the cash received from repayments is in lower yielding securities. Such changes in prepayment rates are not taken into account in the following disclosures. 44
INTEREST RATE RISK (in thousands) --------------------------------------------------------------------------------- Hypothetical Estimated Fair Percentage Value after Increase Hypothetical Change in Hypothetical (Decrease) in Fair Value at Interest Rate Change in Stockholders' December 31, 1998 (bp=basis pts.) Interest Rate Equity --------------------------------------------------------------------------------- Assets: United States government agencies and authorities $13,766 100 bp decrease $13,980 $214 100 bp increase 13,559 (207) 200 bp increase 13,356 (410) States, municipalities and political subdivisions $24,346 100 bp decrease $25,572 $1,226 100 bp increase 23,107 (1,239) 200 bp increase 21,910 (2,436) Corporate securities $79,625 100 bp decrease $83,180 $3,555 100 bp increase 76,287 (3,338) 200 bp increase 73,114 (6,511) Collateralized mortgage obligations and other asset backed securities $53,055 100 bp decrease $54,478 $1,423 100 bp increase 50,978 (2,077) 200 bp increase 48,818 (4,237) Liabilities: Notes payable $67 100 bp decrease $67 - 100 bp increase 67 - 200 bp increase 67 - Notes payable to bank $2,600 100 bp decrease $2,600 - 100 bp increase 2,600 - 200 bp increase 2,600 -
The interest rate on the Company's note payable to bank is adjustable based on certain market indices. 45 EQUITY PRICE RISK The Company generally does not invest in equity securities for trading purposes. As of December 31, 1998, equity securities represent 2% of the Company's total assets. The carrying values of publicly traded investments subject to equity price risks are based on quoted market prices as of the balance sheet date. Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of the investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the investee, the relative prices of alternative investments and general market conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the security being sold. The carrying values of privately held investments are subject to equity price risks which are based on the foregoing market price considerations and also on the underlying value of the issuer and other buyer's perceptions of such value, as well as lack of liquidity considerations. The table below summarizes the Company's equity price risks as of December 31, 1998 and shows the effects of a hypothetical 10% increase and 10% decrease in the market prices as of December 31, 1998. The selected hypothetical change does not reflect what could be considered the best or worst case scenarios.
EQUITY PRICE RISK (in thousands) --------------------------------------------------------------------------------- Hypothetical Percentage Estimated Fair Increase Value after (Decrease) in Fair Value at Hypothetical Price Hypothetical Stockholders' December 31, 1998 Change Price Change Equity --------------------------------------------------------------------------------- Preferred stock $1,040 10% increase $1,144 $104 10% decrease 936 (104) Common stock $3,219 10% increase $3,541 $322 10% decrease 2,897 (322)
46 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE ---- Independent Auditors' Report................................................................ F-2 Consolidated Balance Sheets as of December 31, 1998 and 1997................................ F-3 Consolidated Statements of Operations for each of the three years in the period ended December 31, 1998........................................................................ F-5 Consolidated Statements of Comprehensive Income (Loss) for each of the three years in the period ended December 31, 1998........................................................... F-6 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1998.................................................................. F-7 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1998........................................................................ F-9 Notes to Consolidated Financial Statements.................................................. F-11
F-1 INDEPENDENT AUDITORS' REPORT The Board of Directors PAULA Financial: We have audited the accompanying consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. 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 generally accepted auditing standards. 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, 1998 and 1997 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles. /s/ KPMG LLP Los Angeles, California March 2, 1999 F-2 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS
DECEMBER 31, 1998 1997 ---- ---- Investments: Fixed maturities, available-for-sale, at market (amortized cost $171,379 and $112,294 at December 31, 1998 and 1997, respectively).................................................... $170,792 $114,525 Preferred stock, at market (cost $999 and $3,019 at December 31, 1998 and 1997, respectively)..................................... 1,040 3,112 Common stock, at market (cost $3,252 and $5,546 at December 31, 1998 and 1997, respectively)........................ 3,219 5,545 Invested cash, at cost (approximates market)........................ 2,572 14,682 ------------- -------------- Total investments.............................................. $177,623 $137,864 ------------- -------------- Cash, unrestricted..................................................... 2,747 3,279 Cash, restricted....................................................... 1,398 1,491 Accrued investment income.............................................. 2,613 1,819 Receivables: Accounts receivable, net of allowance for uncollectible accounts ($901 and $600 at December 31, 1998 and 1997, respectively)...... 17,800 16,607 Unbilled premiums................................................... 9,046 7,713 Reinsurance recoverable on paid losses and loss adjustment expenses......................................................... 715 - Reinsurance recoverable on unpaid losses and loss adjustment expenses......................................................... 25,137 6,394 Income taxes recoverable............................................ 1,939 1,579 Other............................................................... 740 304 ------------- -------------- Total receivables.............................................. $55,377 $32,597 ------------- -------------- Property and equipment, at cost: Office furniture, fixtures and equipment............................ 8,763 7,395 Automobiles......................................................... 851 707 Leasehold improvements.............................................. 202 221 ------------- -------------- 9,816 8,323 Less accumulated depreciation....................................... (6,941) (6,152) ------------- -------------- Net property and equipment..................................... $2,875 $2,171 ------------- -------------- Other assets........................................................... 4,562 4,328 Excess of cost over net assets acquired, net........................... 1,447 1,468 Deferred income taxes.................................................. 6,306 3,247 ------------- -------------- $254,948 $188,264 ------------- -------------- ------------- --------------
(Continued) F-3 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, CONTINUED (DOLLARS IN THOUSANDS) LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, ------------------- 1998 1997 ---- ---- Unpaid losses and loss adjustment expenses............................. $136,316 $77,784 Unearned premiums...................................................... 20,234 15,390 Accrued policyholder dividends......................................... 335 - Due to underwriters and assureds....................................... 1,930 2,967 Reinsurance payable.................................................... 7,855 819 Accounts payable and accrued expenses.................................. 11,575 6,028 Notes payable.......................................................... 67 456 Note payable to bank................................................... 2,600 - ------------ ------------ $180,912 $103,444 ------------ ------------ 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 6,338,815 shares and 6,321,177 shares at December 31, 1998 and 1997, respectively............................................... 63 63 Additional paid-in capital.......................................... 67,386 67,176 Retained earnings................................................... 10,182 16,048 Accumulated other comprehensive income (loss): Net unrealized gain (loss) on investments........................ (382) 1,533 ------------ ------------ 77,249 84,820 Less: Treasury stock, at cost (409,800 shares at December 31, 1998).... (3,213) - ------------ ------------ Net stockholders' equity....................................... 74,036 84,820 Commitments and contingencies ------------ ------------ $254,948 $188,264 ------------ ------------ ------------ ------------
See accompanying notes to consolidated financial statements. F-4 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, -------------------------------- 1998 1997 1996 ---- ---- ---- Income: Net premiums earned: Workers' compensation........................ $127,997 $91,957 $54,563 Group medical and life....................... 773 878 941 Commissions..................................... 3,234 3,434 4,213 Net investment income........................... 9,540 5,582 4,701 Net realized investment gains................... 1,706 172 444 Other........................................... 842 1,047 896 ------------- ------------ ----------- $144,092 $103,070 $65,758 ------------- ------------ ----------- Expenses: Losses and loss adjustment expenses incurred.... 114,483 68,107 33,900 Dividends provided for policyholders............ 677 (2,713) 1,628 Operating....................................... 37,636 30,741 25,480 ------------- ------------ ----------- $152,796 $96,135 $61,008 ------------- ------------ ----------- Income (loss) before income tax expense (benefit).............................. (8,704) 6,935 4,750 Income tax expense (benefit)....................... (3,827) 1,776 827 ------------- ------------ ----------- Net income (loss)....................... ($4,877) $5,159 $3,923 ------------- ------------ ----------- ------------- ------------ ----------- Earning per share: Earnings (loss) per share...................... ($0.78) $1.88 $2.07 Earnings (loss) per share - assuming dilution.. ($0.78) $1.11 $1.00
See accompanying notes to consolidated financial statements. F-5 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (DOLLARS IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Net income (loss) ($4,877) $5,159 $3,923 Other comprehensive income (loss), net of tax: Unrealized holding gains (losses) arising during period (tax impact: 1998:$517, 1997: $413, 1996: $197)........................... (1,003) 803 (384) Reclassifications adjustment for realized gains (losses) included in net income (loss) (tax impact: 1998: $470, 1997: $24, 1996: $189)............................... (912) (48) (366) ------------ ---------- ---------- ($1,915) $755 ($750) ------------ ---------- ---------- Comprehensive income (loss) ($6,792) $5,914 $3,173 ------------ ---------- ---------- ------------ ---------- ----------
See accompanying notes to consolidated financial statements. F-6 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS)
NET UNREALIZED OBLIGATION ADDITIONAL GAIN (LOSS) ON NUMBER OF BOOK PAID-IN RETAINED ON TREASURY STOCK HELD SHARES VALUE CAPITAL EARNINGS INVESTMENTS STOCK BY ESOP ------ ----- ------- -------- ----------- ----- ------- Balance at December 31, 1995............ 2,266,390 $22 $1,414 $16,117 $1,528 ($4,458) ($8,200) Net income............. - - - 3,923 - - - Change in carrying value of preferred stock.. - - - (1,901) - - - Restricted stock grants 22,500 - 177 - - - - Restricted stock forfeitures......... (1,400) - (12) - - - - Retirement of common stock............... (132,098) - (10) (1,471) - 1,486 - Issuance of common stock 12,064 - 179 - - - - Net change in unrealized gain on investments (net of tax)........ - - - - (750) - - Change in obligation of stock held by ESOP.. - - - - - - (3,249) Change in guarantee of ESOP notes payable.. - - - - - - - --------------------------------------------------------------------------------------------- Balance at December 31, 1996.. 2,167,456 $22 $1,748 $16,668 $778 ($2,972) ($11,449) --------------------------------------------------------------------------------------------- Net income............. - - - 5,159 - - - Change in carrying value of preferred stock.. - - - (2,261) - - Conversion of preferred stock............... 1,882,354 19 23,641 - - - - Conversion of warrants. 139,481 1 1,481 (549) - - - Common stock awards.... 3,256 - 46 - - - - Restricted stock forfeitures......... (1,150) - (10) - - - - Retirement of common stock............... (270,534) (3) (51) (2,969) - 2,972 - Issuance of common stock 2,400,314 24 40,321 - - - - Net change in unrealized gain on investments (net of tax)........ - - - - 755 - - Elimination of obligation of stock held by ESOP - - - - - - 11,449 Change in guarantee of ESOP notes payable.. - - - - - - - --------------------------------------------------------------------------------------------- Balance at December 31, 1997.. 6,321,177 $63 $67,176 $16,048 $1,533 $ - $ - --------------------------------------------------------------------------------------------- GUARANTEE OF NOTES NET PAYABLE STOCKHOLDERS' OF ESOP EQUITY ------- ------ Balance at December 31, 1995............ ($319) $6,104 Net income............. - 3,923 Change in carrying value of preferred stock.. - (1,901) Restricted stock grants - 177 Restricted stock forfeitures......... - (12) Retirement of common stock............... - 5 Issuance of common stock - 179 Net change in unrealized gain on investments (net of tax)........ - (750) Change in obligation of stock held by ESOP.. - (3,249) Change in guarantee of ESOP notes payable.. 98 98 ----------------------------- Balance at December 31, 1996.. ($221) $4,574 ----------------------------- Net income............. - 5,159 Change in carrying value of preferred stock.. - (2,261) Conversion of preferred stock............... - 23,660 Conversion of warrants. - 933 Common stock awards.... - 46 Restricted stock forfeitures......... - (10) Retirement of common stock............... - (51) Issuance of common stock - 40,345 Net change in unrealized gain on investments (net of tax)........ - 755 Elimination of obligation of stock held by ESOP - 11,449 Change in guarantee of ESOP notes payable.. 221 221 ----------------------------- Balance at December 31, 1997.. $ - $84,820 -----------------------------
(Continued) F-7 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY, CONTINUED (DOLLARS IN THOUSANDS)
NET UNREALIZED OBLIGATION ADDITIONAL GAIN (LOSS) ON NUMBER OF BOOK PAID-IN RETAINED ON TREASURY STOCK HELD SHARES VALUE CAPITAL EARNINGS INVESTMENTS STOCK BY ESOP ------ ----- ------- -------- ----------- ----- ------- Balance at December 31, 1997.. 6,321,177 $63 $67,176 $16,048 $1,533 $ - $ - Net loss............... - - - (4,877) - - - Dividends paid ($0.16 per share).......... - - - (989) - - - Options exercised, including tax impact. 16,638 - 202 - - - - Common stock awards.... 1,000 - 8 - - - - Repurchase of common stock............... (409,800) - - - - (3,213) - Net change in unrealized gain on investments (net of tax)........ - - - - (1,915) - - -------------------------------------------------------------------------------------------- Balance at December 31, 1998.. 5,929,015 $63 $ 67,386 $10,182 ($382) ($3,213) $ - -------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------- GUARANTEE OF NOTES NET PAYABLE STOCKHOLDERS' OF ESOP EQUITY ------- ------ Balance at December 31, 1997.. $ - $84,820 Net loss............... - (4,877) Dividends paid ($0.16 per share).......... - (989) Options exercised, including tax impact. - 202 Common stock awards.... - 8 Repurchase of common stock............... - (3,213) Net change in unrealized gain on investments (net of tax)........ - (1,915) ----------------------------- Balance at December 31, 1998.. $ - $74,036 ----------------------------- -----------------------------
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, ------------------------ 1998 1997 1996 ---- ---- ---- Cash flows from operating activities: Net income (loss)................................. ($4,877) $5,159 $3,923 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization.................. 1,522 1,370 1,509 Amortization of fixed maturity premium, net 705 623 797 (Gain) loss on sale of property and equipment.. 27 16 (12) Gain on sales and calls of equity and fixed maturities................................... (1,706) (172) (444) (Increase) decrease in receivables............. (23,574) (14,032) 946 (Increase) decrease in deferred income taxes (2,072) 1,193 (282) Increase (decrease) in unpaid losses and loss adjustment expenses.......................... 58,532 22,064 (1,328) Increase (decrease) in accrued policyholder dividends.................................... 335 (3,981) (1,027) Increase (decrease) in accounts payable and accrued expenses............................. 11,546 3,747 (1,544) Increase in unearned premiums.................. 4,844 4,735 6,046 Other, net..................................... (226) (861) 80 ------------- ------------ ------------ Net cash provided by operating activities. $ 45,056 $19,861 $8,664 ------------- ------------ ------------ Cash flows from investing activities: Proceeds from sale of available for sale fixed maturities..................................... 81,687 - 17,236 Proceeds from maturities and calls of available for sale fixed maturities.......................... 8,947 14,840 7,930 Proceeds from sale of preferred stock............. 6,423 - - Proceeds from sale of common stock................ 2,516 499 - Proceeds from sale of property and equipment...... 27 1 146 Purchase of common stock.......................... - (5,138) - Purchase of preferred stock....................... (4,231) (2,013) (1,014) Purchase of available for sale fixed maturities... (149,112) (47,606) (26,456) Purchase of property and equipment................ (1,871) (1,126) (1,029) Purchase of other assets.......................... - (1,189) (703) Purchase of insurance agency...................... (388) - (38) ------------- ------------ ------------ Net cash used in investing activities..... ($56,002) ($41,732) ($3,928) ------------- ------------ ------------
(Continued) F-9 PAULA FINANCIAL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (DOLLARS IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Cash flows from financing activities: Borrowings (repayments) under line of credit agreement, net................................. $2,600 ($7,490) $1,968 Payments on notes payable......................... (389) (3,350) (1,782) Issuance of notes payable......................... - 238 269 Dividends paid.................................... (989) - - Exercise of stock options......................... 202 - - Sale of common stock.............................. - 41,278 343 Repurchase of common stock........................ (3,213) - - Retirement of common stock........................ - (60) (1,486) ------------- ------------ ------------ Net cash provided by (used in) financing activities............................. ($1,789) $30,616 ($688) ------------- ------------ ------------ Net increase (decrease) in cash and invested cash.......................... (12,735) 8,745 4,048 Cash and invested cash at beginning of period........ 19,452 10,707 6,659 ------------- ------------ ------------ Cash and invested cash at end of period.............. $ 6,717 $19,452 $10,707 ------------- ------------ ------------ ------------- ------------ ------------
Supplemental schedule of noncash financing activities: In 1996, the Company granted to employees 22,500 shares of restricted common stock for a total value of $177. Also in 1996, 1,400 shares were forfeited at a value of $12 (see note 9). In 1996, the Company purchased Guinn Sinclair Insurance Services for a total purchase price of $221. Common stock was issued to settle $176 of the purchase price (see note 12). See accompanying notes to consolidated financial statements. F-10 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 referred to as "the Company") is an integrated insurance organization specializing in the production, underwriting and servicing of workers' compensation and accident and health insurance for agribusiness clients in California, Arizona, Oregon, Idaho, Alaska, Texas, Florida and New Mexico. For the year ended December 31, 1998, California accounted for 72% of premiums earned. The Company operates from many offices located throughout prime agricultural areas and places coverage with its insurance company subsidiaries and nonaffiliated insurance companies. In 1998, the Company adopted the provisions of Financial Accounting Standards Board ("FASB") Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information ("SFAS 131"). Based on guidance included in SFAS 131, the Company has determined that it operates in a single segment: the production, underwriting and servicing of workers' compensation and accident and health insurance. 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., Agri-Comp Insurance Agency, Inc. and PAULA Trading Company Insurance Agents and Brokers, Inc. (insurance brokerages); Pan Pacific Benefit Administrators, Inc. (third-party administration operation); PAULA Mexico S.A. de C.V.; PAULA Insurance Company (casualty insurance); and PAULA Assurance Company (group accident and health and life insurance). All significant intercompany balances and transactions have been eliminated in consolidation. Where necessary, prior years' information has been reclassified to conform to the 1998 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. INVESTMENTS AND CASH At December 31, 1998 and 1997, the entire investment portfolio is classified as available-for-sale and is reflected at estimated fair value with unrealized gains and losses recorded as a separate component of stockholders' equity, net of related deferred income taxes. The premium and discount on fixed maturities and collateralized mortgage obligations are amortized using the interest method. Amortization and accretion of premiums and discounts on collateralized mortgage obligations are adjusted for principal paydowns and changes in expected maturities. Investments in which the decline in market value is deemed other than temporary are reduced to the estimated realizable value through a charge to income. F-11 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Invested cash consists primarily of commercial paper. Realized gains and losses on sales of investments are computed on the specific-identification basis. Restricted cash consists of premiums collected by the insurance brokerage subsidiaries but not yet remitted to insurance companies which is restricted as to use by law in the states in which the brokerage subsidiaries operate. For purposes of cash flow disclosure, cash and invested cash is defined as cash and invested cash that have original maturities of less than three months. REVENUE RECOGNITION Premiums are earned by the insurance subsidiaries on a monthly pro rata basis over the terms of the policies. Commission income is recorded on the effective date of the policy or the billing date, whichever is later. PROPERTY AND EQUIPMENT Depreciation and amortization is provided over the estimated useful lives of the respective assets, primarily using the modified accelerated cost recovery system (which approximates the double-declining-balance method). Principal estimated useful lives used in computing the depreciation provisions are five years for automobiles and five to seven years for furniture and equipment. Certain direct costs associated with the development of software for internal use are capitalized. Amortization on such amounts is provided on a straight-line basis over the estimated useful life of the software, generally five to seven years. Amortization begins when the related project is substantially complete. 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. EXCESS OF COST OVER NET ASSETS ACQUIRED Excess of cost over net assets acquired is amortized on a straight-line basis over seven years. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the balance over its remaining life can be recovered through the undiscounted future operating cash flows of the acquired operation. Accumulated amortization totaled $1,286 and $1,140 at December 31, 1998 and 1997, respectively. F-12 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The liability for unpaid losses and loss adjustment expenses represents (a) case basis estimates of reported losses and loss adjustment expenses and (b) estimates based on past experience of unreported losses and loss adjustment expenses, net of anticipated salvage and subrogation. Management believes that the provisions for losses and loss adjustment expenses are adequate to cover the net cost of incurred losses and loss adjustment expenses; however, the liability is by necessity based on estimates, and accordingly, there can be no assurance that the ultimate liability will not differ from such estimates. There is a high level of uncertainty inherent in the evaluation of the liability for unpaid losses and loss adjustment expenses. The ultimate costs of such claims are dependent upon future events, the outcomes of which are affected by many factors. Loss reserving procedures and settlement philosophy, current and perceived social and economic factors, inflation, current and future court rulings and jury attitudes, and many other economic, scientific, legal, political and social factors can all have significant effects on the ultimate costs of claims. Changes in Company operations and management philosophy may also cause actual developments to vary from the past. POLICYHOLDER DIVIDENDS The insurance subsidiaries underwrite workers' compensation, accident and health and life insurance policies. Participating workers' compensation policies represented approximately 28%, 46%, and 64% of net written premium for the years ended December 31, 1998, 1997 and 1996, respectively. Dividends are recorded as a liability based on estimates of ultimate amounts expected to be declared by the insurance subsidiaries' Boards of Directors, at their discretion. INCOME TAXES The Company accounts for income taxes under the asset and 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. 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. F-13 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The fair values of notes payable and note payable to bank are estimated using discounted cash flow analyses based on current market interest rates. The estimated fair values approximate the related carrying values. COMPREHENSIVE INCOME (Loss) In 1998, the Company adopted the provisions of FASB Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires companies to report comprehensive income and its components in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital. Comprehensive income includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. The Company's only component of other comprehensive income relates to unrealized gains and losses on investments. In accordance with the provisions of SFAS 130, the Company has included consolidated statements of comprehensive income (loss) in the accompanying consolidated financial statements. EARNINGS PER SHARE ("EPS") The EPS calculations for the years ended December 31, 1998, 1997 and 1996 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 to be common stock equivalents. Stock options and warrants are considered to be common stock equivalents, except when their effect is antidilutive. The following table reconciles the weighted average shares of common stock outstanding used in the EPS calculation to that used in the EPS - assuming dilution calculation. There is no difference in the earnings used in the two calculations.
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Shares used in EPS calculation.................. 6,228,479 2,737,065 1,896,464 Convertible preferred stock..................... - 1,526,512 1,882,354 Warrants........................................ - 48,804 40,114 Options......................................... - 352,130 91,783 ------------------------------------------ Shares used in EPS - assuming dilution calculation................................ 6,228,479 4,664,511 3,910,715 ------------------------------------------ ------------------------------------------
In loss periods options are excluded from the calculation of EPS-assuming dilution as the inclusion of such options would have an antidilutive effect. F-14 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (2) INVESTMENTS Investments in fixed maturities are substantially all held in investment grade securities. Fair values were obtained from published securities quotation services or from asset management professionals retained by the Company. FIXED MATURITIES The amortized cost and estimated fair value of investments in fixed maturities classified as available for sale at December 31, 1998 and 1997 are as follows:
DECEMBER 31, 1998 ----------------- GROSS GROSS ----- ----- AMORTIZED UNREALIZED UNREALIZED ESTIMATED --------- ---------- ---------- --------- COST GAINS LOSSES FAIR VALUE ---- ----- ------ ---------- U.S. Treasury securities and obligations of U.S. Government corporations and agencies........................................ $13,445 $321 $- $13,766 Obligations of states and political subdivisions.................... 24,082 337 73 24,346 Corporate securities................................................ 79,927 1,221 1,523 79,625 Collateralized mortgage obligations and other asset backed securities............................................... 53,925 282 1,152 53,055 -------------------------------------------------------- Total......................................................... $171,379 $2,161 $2,748 $170,792 -------------------------------------------------------- --------------------------------------------------------
DECEMBER 31, 1997 ----------------- GROSS GROSS ----- ----- AMORTIZED UNREALIZED UNREALIZED ESTIMATED --------- ---------- ---------- --------- COST GAINS LOSSES FAIR VALUE ---- ----- ------ ---------- U.S. Treasury securities and obligations of U.S. Government corporations and agencies........................................ $10,000 $175 ($12) $10,163 Obligations of states and political subdivisions.................... 77,817 1,738 - 79,555 Corporate securities................................................ 12,009 287 (3) 12,293 Collateralized mortgage obligations................................. 12,468 56 (10) 12,514 -------------------------------------------------------- Total......................................................... $112,294 $2,256 ($25) $114,525 -------------------------------------------------------- --------------------------------------------------------
F-15 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The amortized cost and estimated fair value of fixed maturities classified as available for sale at December 31, 1998 by the earlier of the pre-escrowed date or contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
AMORTIZED ESTIMATED --------- --------- COST FAIR VALUE ---- ---------- Due in one year or less...................................................... $7,486 $7,541 Due after one year through five years........................................ 56,024 56,205 Due after five years through ten years....................................... 48,664 48,590 Due after ten years.......................................................... 5,280 5,401 Collateralized mortgage obligations and other asset backed securities............................................................... 53,925 53,055 ------------------------ $171,379 $170,792 ------------------------ ------------------------
Fixed maturities with a book value of $83,995 were on deposit with various regulatory authorities as of December 31, 1998 as required. PREFERRED STOCK Unrealized investment gains (losses) on preferred stock at December 31, 1998 and 1997 are as follows:
DECEMBER 31, ------------ 1998 1997 ---- ---- Gross unrealized gains....................................................... $41 $93 Gross unrealized losses...................................................... - - ----------------- $41 $93 ----------------- -----------------
COMMON STOCK Unrealized investment gains (losses) on common stock at December 31, 1998 and 1997 are as follows:
DECEMBER 31, ------------ 1998 1997 ---- ---- Gross unrealized gains....................................................... $38 $- Gross unrealized losses...................................................... (71) (1) ----------------- ($33) ($1) ----------------- -----------------
F-16 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) NET INVESTMENT INCOME Net investment income is summarized as follows:
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Interest........................................ $9,396 $5,665 $4,839 Dividends....................................... 500 121 62 ---------------------------------- 9,896 5,786 4,901 Less investment expenses........................ (356) (204) (200) ---------------------------------- $9,540 $5,582 $4,701 ---------------------------------- ----------------------------------
An affiliate of a significant holder of the Company's stock also acts as one of the Company's investment advisors. Fees paid for such investment services totaled $244, $160 and $146 in 1998, 1997 and 1996, respectively. NET REALIZED INVESTMENT GAINS (LOSSES) Net realized investment gains (losses) are as follows:
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Fixed maturities: Gross realized gains......................... $1,863 $ - $449 Gross realized losses........................ (379) (1) (5) Common stock: Gross realized gains......................... 222 173 - Gross realized losses........................ - - - ------------------------------ $1,706 $172 $444 ------------------------------ ------------------------------
F-17 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (3) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES Activity in the liability for unpaid losses and loss adjustment expenses is summarized as follows:
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Balance at beginning of period.......... $77,784 $55,720 $57,049 Less reinsurance recoverable on unpaid losses and loss adjustment expenses............................ 6,394 6,427 6,775 --------------------------------------- Net balance at beginning of period...... $71,390 $49,293 $50,274 --------------------------------------- Incurred related to: Current period....................... 108,454 66,840 36,554 Prior periods........................ 6,029 1,267 (2,654) --------------------------------------- Total incurred.................... $114,483 $68,107 $33,900 --------------------------------------- Paid related to: Current period....................... 34,674 20,809 13,143 Prior periods........................ 40,020 25,201 21,738 --------------------------------------- Total paid........................ $74,694 $46,010 $34,881 --------------------------------------- Net balance at end of period............ 111,179 71,390 49,293 Plus reinsurance recoverable on unpaid losses and loss adjustment expenses............................ 25,137 6,394 6,427 --------------------------------------- Balance at end of period................ $136,316 $77,784 $55,720 ---------------------------------------
The unfavorable incurred development for prior periods in 1998 in the liability for unpaid losses and loss adjustment expenses is due to reserve development on the 1997 accident year for the California book of business in excess of what was anticipated given prior year reserving trends. The favorable incurred development for prior periods in 1996 in the liability for unpaid losses and loss adjustment expenses relates principally to reduced claim frequency and stable severity. F-18 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (4) NOTES PAYABLE A summary of notes payable at December 31, 1998 and 1997 is as follows:
DECEMBER 31 ----------- 1998 1997 ---- ---- Note payable (interest at 8.25% at December 31, 1997, due 1998), unsecured........... $- $50 Note payable (interest at 0.0% at December 31, 1998 and 1997, due 1999), unsecured.......................................................................... 67 168 Note payable (interest at 0.0% at December 31, 1997, due 1998), secured by common stock of borrower................................................................. - 238 ---------------- $67 $456 ---------------- ---------------- Aggregate annual commitments under notes payable are as follows at December 31, 1998: 1999........................................................................ $67
Total interest paid by the Company on all notes during the years ended December 31, 1998, 1997 and 1996 was $61, $1,014 and $1,300, respectively. (5) NOTE PAYABLE TO BANK On March 31, 1997, the Company entered into a $15,000 unsecured line of credit with a commercial bank. The line of credit requires no principal payments during its term and matures December 31, 1999 and, at the Company's option, converts to a two-year term note. The interest rate on the line of credit is based on various indices. The weighted average interest rate on balances outstanding at December 31, 1998 was 6.5%. The line of credit imposes certain financial covenants. At December 31, 1998, the Company's available line of credit was $12,400. F-19 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (6) INCOME TAXES The Company and its subsidiaries file a consolidated Federal income tax return. Income tax expense (benefit) for the years ended December 31, 1998, 1997 and 1996 is shown as follows:
YEARS ENDED DECEMBER 31, FEDERAL STATE TOTAL ------------------------ ------- ----- ----- 1998: Current............................................................ ($1,771) $16 ($1,755) Deferred........................................................... (2,072) - (2,072) -------------------------------------- ($3,843) $16 ($3,827) -------------------------------------- -------------------------------------- 1997: Current............................................................ $503 $80 $583 Deferred........................................................... 1,193 - 1,193 -------------------------------------- $1,696 $80 $1,776 -------------------------------------- -------------------------------------- 1996: Current............................................................ $1,079 $30 $1,109 Deferred........................................................... (282) - (282) -------------------------------------- $797 $30 $827 -------------------------------------- --------------------------------------
The total tax expense (benefit) is different from the applicable Federal income tax rate of 34% for the reasons reflected in the following reconciliation:
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Expected tax expense (benefit).......................................... ($2,959) $2,358 $1,615 Tax-exempt investment income............................................ (924) (715) (787) Nondeductible expenses.................................................. 61 80 55 State income taxes, net of Federal benefit.............................. (5) 53 20 Other, net.............................................................. - - (76) -------------------------------- ($3,827) $1,776 $827 -------------------------------- --------------------------------
F-20 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Temporary differences which give rise to a significant portion of deferred tax assets and liabilities are as follows:
DECEMBER 31 ----------- 1998 1997 ---- ---- Deferred tax assets: Loss reserve discounting........................................................... $4,461 $4,948 Unearned premiums.................................................................. 1,376 1,046 Net operating loss carry forward................................................... 2,564 - Tax on net unrealized loss on securities carried at market value................... 197 - Other.............................................................................. 1,644 1,002 -------------------------- Gross deferred tax assets..................................................... $10,242 $6,996 -------------------------- Deferred tax liabilities: Unbilled premiums.................................................................. (3,076) (2,215) Tax on net unrealized gain on securities carried at market value................... - (790) Other.............................................................................. (860) (744) -------------------------- Gross deferred tax liabilities................................................ ($3,936) ($3,749) -------------------------- Net deferred tax asset........................................................ $6,306 $3,247 -------------------------- --------------------------
The recoverability of the net deferred tax asset is demonstrated by taxes paid in prior years and available tax planning strategies. Management believes that it is more likely than not that the results of future operations and various tax planning strategies will generate sufficient taxable income in the periods necessary to realize the net deferred tax asset. The Company received Federal income tax refunds of $1,552 and made Federal income tax payments of $65 during the year ended December 31, 1998 and paid $2,300 and $1,400 of Federal income taxes during the years ended December 31, 1997 and 1996, respectively. At December 31, 1998, the Company had a tax net operating loss carry forward of $2,564 that expires in 2018. (7) REINSURANCE In the ordinary course of business, the insurance subsidiaries cede insurance for the purpose of obtaining greater risk diversification and minimizing the maximum net loss potential arising from large claims. The insurance subsidiaries, however, are contingently liable in the event that their reinsurers become unable to meet their contractual obligations. F-21 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) A large portion of the reinsurance is effected under reinsurance contracts known as treaties. PAULA Insurance Company ("PICO") maintains excess of loss and catastrophic reinsurance arrangements to protect it against losses above its retention on workers' compensation policies. Additionally, PICO has also chosen to quota-share a portion of its retained claims exposure. In a quota share reinsurance contract, the company and the reinsurer share premiums, losses and loss adjustment expenses on a proportional basis based on each parties interest in the quota-shared risk. The maximum retention for each loss occurrence on workers' compensation policies has been $250 since July 1996 and was $200 in the first half of 1996. In July 1998, PICO modified its prior existing excess of loss reinsurance treaty on the $250 excess $250 layer to retain the first $2,000 in annual aggregate losses, with a corresponding reduction in the reinsurance rate. In the fourth quarter of 1998 PICO entered into a two year excess of loss reinsurance arrangement with a retention of $50. Concurrent with this agreement, PICO entered into an excess of loss agreement which covers a portion of the losses in the $40 excess of $10 layer and a quota-share agreement which covers a portion of losses below $10. The following amounts have been deducted in the accompanying consolidated financial statements as a result of reinsurance ceded:
YEARS ENDED DECEMBER 31, 1998 1997 1996 ---- ---- ---- Premiums earned............................................... $18,834 $3,226 $2,056 Losses and loss expenses incurred............................. $22,554 $ 573 $ 940 Operating expenses............................................ $ 3,024 $ - $ -
In July 1998, the Company entered into an assumption agreement with the New Mexico Retail Association Self-Insured Group ("the SIG"). The agreement provides for the complete assumption by PICO of the SIG reserves outstanding as of July 1, 1998 as well as a 100% quota-share participation on policies in-force as of that date. The prospective piece of the treaty has been accounted for as reinsurance in the accompanying consolidated financial statements. Premiums assumed under the prospective piece of this agreement were $1,647 while loss incurred were $1,031 for the year ended December 31, 1998. The portion of the contract related to the loss portfolio transfer does not meet risk transfer requirements and has therefore been accounted for using the deposit method of accounting. At December 31, 1998, the related liability of $1,962 is included in accounts payable and accrued expenses in the accompanying consolidated financial statements. (8) STOCKHOLDERS' EQUITY On October 24, 1997, the Company completed its initial public offering by selling 2,400,314 shares of its common stock to the underwriters of the Company's initial public offering at $18.50 per share for net proceeds of $40,345 after deducting underwriting discounts and expenses of the offering. F-22 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) On September 23, 1997, the Company declared a two-for-one stock split effected in the form of a dividend to stockholders of record on September 23, 1997. All data with respect to equity classification, earnings per share and share information, including price per share, where applicable, in the consolidated financial statements and notes thereto have been retroactively adjusted to reflect the split. PAULA Financial is dependent on the transfer of funds from its subsidiaries. Dividends and advances from PICO and PAULA Assurance Company ("PACO") are restricted by law and minimum capitalization requirements and, above certain thresholds, are subject to approval by insurance regulatory authorities. Net assets of the insurance subsidiaries in the amount of $62,378 and $55,497 at December 31, 1998 and 1997, respectively, are restricted as to their availability for advances or dividends to PAULA Financial due to insurance regulatory requirements. (9) EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution employee stock ownership plan ("ESOP") covering all full-time employees, excluding hourly employees. The ESOP has assets principally comprised of 827,223 and 1,094,126 shares of the Company's common stock at December 31, 1998 and 1997, respectively. The Company can make annual contributions to the ESOP in cash or shares of the Company's common stock in amounts determined by the Company's Board of Directors, except that such contributions must be in cash to the extent the ESOP requires liquid funds to meet its obligations. The Company expensed cash contributions of $125 and $150 in the years ended December 31, 1997 and 1996, respectively. No contributions were made in 1998. 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 under the plan were $252, $224 and $208 for the years ended December 31, 1998, 1997 and 1996, respectively. Employees of the Company receive an annual year-end bonus based upon the results of the Company. Amounts expensed under bonus programs were $641, $1,068 and $1,053 for the years ended December 31, 1998, 1997 and 1996, respectively. In 1998, the Company implemented a key employee/consultant loan program which provides funds exclusively for the borrowers' purchase of Company stock. The Company has authorized loans of up to $1,000. The loans are full recourse, bear interest at the rate of 8.5% per annum, payable quarterly, have a three year maturity and are 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, 1998, the Company had extended loans in the amount of $505,000. Such amounts are included in other receivables in the accompanying consolidated financial statements. In 1994, the Company adopted a stock incentive plan, reserving 550,000 shares of common stock, which provides for granting of stock options and restricted stock bonuses to officers and directors and key employees of the Company. Options and restricted stock are granted at the discretion of the Executive Compensation Committee of the Board of Directors. Prior to the initial public offering, options were granted at fair value as F-23 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) determined by the Executive Compensation Committee of the Board of Directors. At December 31, 1998, 1,250 shares of common stock were available for issuance under the 1994 plan. In 1997, the Company adopted its 1997 Stock Incentive Plan, reserving 200,000 shares of common stock. Stock awards totaling 1,000 shares were granted in 1998 and at December 31, 1998, 199,000 shares of common stock were available for issuance under the 1997 plan. Stock options vest either immediately or over periods not to exceed five years and carry an exercise price equal to or in excess of the fair market value of the common stock on the date of grant. The stock options are generally exercisable for a ten-year term. Changes in the status of options granted under the 1994 plan are summarized as follows:
1998 ------ WEIGHTED EXERCISE AVERAGE SHARES PRICE EXERCISE PRICE ------------ -------------- ---------------- Beginning of year.................................... 402,850 $ 7.88-12.50 $ 8.78 Granted........................................ 27,000 $13.50-23.13 $19.56 Canceled....................................... (200) $9.50 $ 9.50 Exercised or redeemed.......................... (10,150) $ 7.88-9.50 $ 8.44 ------------------------------------------------------- End of year.......................................... 419,500 $ 7.88-23.13 $ 9.48 ------------------------------------------------------- ------------------------------------------------------- Exercisable.......................................... 365,525 $ 7.88-23.13 $ 9.02 ------------------------------------------------------- ------------------------------------------------------- 1997 ------ WEIGHTED EXERCISE AVERAGE SHARES PRICE EXERCISE PRICE ------------ -------------- ---------------- Beginning of year.................................... 404,650 $7.88 - 12.50 8.78 Granted........................................ - - - Canceled....................................... (1,800) 9.03 - 9.50 9.45 Exercised or redeemed.......................... - - - ------------------------------------------------------- End of year.......................................... 402,850 $7.88 - 12.50 8.78 ------------------------------------------------------- ------------------------------------------------------- Exercisable.......................................... 328,700 $7.88 - 12.50 8.58 ------------------------------------------------------- ------------------------------------------------------- 1996 ------ WEIGHTED EXERCISE AVERAGE SHARES PRICE EXERCISE PRICE ------------ -------------- ---------------- Beginning of year.................................... 115,950 $8.50 - 9.03 8.67 Granted........................................ 289,300 7.88 - 12.50 8.83 Canceled....................................... (600) 9.03 9.03 Exercised or redeemed.......................... - - - ------------------------------------------------------- End of year.......................................... 404,650 $7.88 - 12.50 8.78 ------------------------------------------------------- ------------------------------------------------------- Exercisable.......................................... 280,700 $7.88 - 12.50 8.78 ------------------------------------------------------- -------------------------------------------------------
F-24 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Pursuant to the plan, the Company granted 28,700 shares at $9.03 per share and 22,500 shares at $7.88 per share of restricted common stock in 1995 and 1996, respectively. The per share price for these awards was based on an annual independent appraisal. The restrictions lapse pursuant to various vesting schedules. Holders of restricted stock are entitled to vote such shares and receive dividends, which are not subject to restrictions. As of December 31, 1998, the restrictions on an aggregate of 13,900 shares of restricted stock have lapsed; 450, 1,150 and 1,400 shares in 1998, 1997, and 1996, respectively, were forfeited based upon voluntary termination. No restricted stock was granted in the years ended December 31, 1998 and 1997. In addition, in 1996, the Company issued options to purchase an aggregate of 316,000 shares of common stock to officers and directors of the Company outside the Plan. The options carry an exercise price of $9.50 per share. Also, outstanding is an option to purchase an aggregate of 60,000 shares of common stock to an officer of the Company outside of the plan granted at $8.50 per share in 1994. The options were granted at fair value as determined by the Executive Compensation Committee of the Board of Directors. Such options have the same terms as options granted under the plans. Options to purchase 84,000 shares of common stock were immediately exercisable with the remaining options vesting over a period of three years. In 1998 options to purchase 8,000 shares at $9.50 per share were exercised. Options to purchase 368,000 shares of common stock issued outside the plans remain outstanding as of December 31, 1998. 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"). 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:
YEARS ENDED DECEMBER 31, ------------------------------- 1998 1997 1996 ---- ---- ---- Net income (loss): As reported ($4,877) $5,159 $3,923 Pro forma ($5,366) 4,730 3,326 Earnings (loss) per share: As reported ($0.78) $1.88 $2.07 Pro forma ($0.86) 1.73 1.75 Earnings (loss) per share assuming dilution: As reported ($0.78) $1.11 $1.00 Pro forma ($0.86) 1.01 0.85
F-25 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The fair value for options granted in 1998 was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions: risk free interest rate of 5.3%, average option exercise period of seven years, and a volatility factor of 50%. The fair value for options granted prior to 1998 was estimated at the date of grant using the minimum value method. The risk free interest rate used for options granted during 1995 and 1996 was 6.4%. An average option exercise period of seven years was used. Pro forma net income (loss) does not reflect options granted prior to 1995. During the initial phase-in period of SFAS 123, the full impact of calculating compensation cost for stock options is not reflected in the pro forma net income (loss) amounts presented above because compensation cost is reflected over the options' vesting periods and compensation cost for options granted prior to January 1, 1995 is not considered. (10) STATUTORY ACCOUNTING PRACTICES The insurance subsidiaries are required to file statutory financial statements with state insurance regulatory authorities. Accounting practices used to prepare these statutory financial statements differ from generally accepted accounting principles ("GAAP"). Such differences include the following: (1) reserves for losses and loss adjustment expenses must meet certain minimum requirements, (2) reserves for policyholder dividends are recorded as a restriction on surplus until declared, (3) Federal income taxes are recorded when payable, (4) fixed maturities are carried at admitted values, (5) certain assets are non-admitted and (6) acquisition expenses are expensed when incurred. Amounts reported to regulatory authorities as compared to amounts included in the accompanying consolidated financial statements on a GAAP basis for the years ended December 31, 1998, 1997 and 1996 follow:
AS INCLUDED IN THE ACCOMPANYING CONSOLIDATED AS REPORTED FINANCIAL TO REGULATORY STATEMENTS AUTHORITIES ------------- ------------- Years ended December 31, 1998: Net loss......................................................... ($5,519) ($6,955) ------------- ----------- ------------- ----------- Stockholders' equity............................................. $67,793 $54,504 ------------- ----------- ------------- ----------- 1997: Net earnings..................................................... $6,017 $6,439 ------------- ----------- ------------- ----------- Stockholders' equity............................................. $61,974 $50,230 ------------- ----------- ------------- ----------- 1996: Net earnings..................................................... $5,770 $5,080 ------------- ----------- ------------- ----------- Stockholders' equity............................................. $45,202 $35,144 ------------- ----------- ------------- -----------
F-26 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Statutory accounting practices for the insurance subsidiaries are prescribed or permitted by the Department of Insurance of the State of California ("California DOI"). Prescribed accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC") as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state and may change in the future. Furthermore, the NAIC's project to codify statutory accounting practices was approved by the NAIC in March 1998. The approval included a provision for commissioner discretion in determining appropriate statutory accounting for insurers in their state. Consequently, prescribed and permitted accounting practices may continue to differ from state to state. The California DOI has indicated that codification will become effective on January 1, 2001. The Company has not determined how implementation will affect its insurance subsidiaries' statutory financial statements. Insurance regulatory authorities impose various restrictions on the payment of dividends and advances by insurance companies. As of December 31, 1998, the maximum dividend and advance payments that may be made during 1999 by the insurance subsidiaries to PAULA Financial without prior approval of the regulatory authorities are limited to the greater of net income for the preceding year or 10% of policyholder surplus as of the preceding December 31 and approximate $5,415. (11) COMMITMENTS AND CONTINGENCIES The Company leases buildings for its home office and certain other premises under long-term operating leases that expire in various years to 2002. Certain of these leases contain renewal provisions. In 1997 and 1996 certain of these leases are with related parties. Rent expense was $1,719, $1,613 and $1,657 for the years ended December 31, 1998, 1997 and 1996, respectively. Included in rent expense is rent paid to related parties of the Company totaling $52 and $149 for the years ended December 31, 1997 and 1996, respectively. Approximate aggregate minimum rental commitments under operating leases at December 31, 1998 are as follows: 1999..................................................................... $1,565 2000..................................................................... 659 2001..................................................................... 261 2002..................................................................... 97
In the ordinary course of business, the Company's subsidiaries are defendants in various lawsuits. Management believes that the ultimate disposition of the litigation will not result in a material impact to the financial position or operating results of the Company. F-27 PAULA FINANCIAL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The NAIC has adopted a risk-based capital formula for both property and casualty and life insurance companies. These formulas calculate a minimum level of capital and surplus which should be maintained by each insurer. At December 31, 1998, both PICO and PACO's adjusted capital and surplus exceeded their respective risk-based capital requirements. (12) ACQUISITIONS In August 1996, the Company acquired the assets of Guinn Sinclair Insurance Services, an insurance agency specializing in farm labor contractor insurance needs, for total consideration of $221. The purchase price was comprised of a $44 cash payment and the issuance of common stock for the remaining balance (11,764 shares). The acquisition has been accounted for as an asset purchase and the operations have been included in the accompanying consolidated financial statements from the date of acquisition. The purchase price has principally been allocated to the excess of cost over net assets acquired. (13) SUBSEQUENT EVENT In early 1999, the Company made an investment in the recently formed Altus Insurance Holdings, LLC, the parent company of Altus Casualty Company Ltd. ("Altus"), a specialty workers' compensation insurance company. The Company made a capital contribution of $5,500 and has the option to acquire additional equity and provide quota-share reinsurance to Altus through PICO. The Company will use the equity method to account for its investment in Altus. In March 1999, the Company announced that it had agreed to purchase the insurance agency assets of the Sacramento and Stockton, California offices of CAPAX Management & Insurance Services ("CAPAX") for approximately $3,200. The Company will fund the transaction with $2,100 in cash plus $1,100 in CAPAX securities currently held by the Company. The transaction is expected to close in April, subject to certain conditions. The acquisition will be accounted for as an asset purchase. F-28 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. F-29 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information called for by this item is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, with the Securities Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. ITEM 11. EXECUTIVE COMPENSATION. The information called for by this item is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, with the Securities Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information called for by this item is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, with the Securities Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information called for by this item is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, with the Securities Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. III-1 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. Financial Statements, Financial Statement Schedules and Exhibits: 1. Financial Statements: See the Consolidated Financial Statements included herein under Part I, Item 8. 2. Financial Statement Schedules: The following Consolidated Financial Statement schedules are attached hereto at the end of this Report on Form 10-K:
SCHEDULE DESCRIPTION - -------- ----------- NO. --- I Summary of Investments II Condensed Financial Information of Registrant III Supplementary Insurance Information IV Reinsurance V Valuation and Qualifying Accounts and Reserves VI Supplemental Property and Casualty Insurance Information
3. Exhibits:
CHEDULE DESCRIPTION - -------- ----------- NO. --- 2.1 Asset Purchase Agreement dated December 8, 1994 by and between Registrant, Oregon Ag Insurance Services, Inc., Agri-Comp. Inc., Oregon-Comp. Inc. and Oregon Risk Management, Inc.* 2.2 Asset Purchase Agreement dated November 10, 1995 by and between Pan American Underwriters, Inc. (PAU), Desert Benefits, Inc., Employee Benefits & Insurance Services, Fredric J. Klicka and Fredric J. Klicka II.* 2.3 Agreement dated July 25, 1996 by and among Registrant, PAULA Insurance Company (PICO), James G. Parker Insurance Associates (Parker) and certain individual stockholders of Parker.* 2.4 Asset Purchase Agreement dated August 23, 1996 by and among PAU, Guinn Sinclair Insurance Services, Margaret Funnell and Yolanda Ibarrez.* 2.5 Series A Preferred Stock Purchase Agreement dated March 11, 1997 by and between PICO and CAPAX Management & Insurance Services (CAPAX).* 2.6 Letter Agreement, dated March 12, 1999 by and among Registrant, PAU and CAPAX. 3.1 Certificate of Incorporation of Registrant.** 3.2 Certificate of Designations of Series B Junior Participating Cumulative Preferred Stock of Registrant*** 3.3 Bylaws of Registrant.* 4.1 Reserved. 4.2 Specimen certificate of Common Stock, including legend evidencing attached Stock Purchase Rights.***
IV-1 10.1 Lease for Registrant's Pasadena, California office, between Pasadena Gateway Plaza, as Lessor, and PAU, as Lessee, dated January 1, 1989 and last amended May 12, 1995 and the Assignment and Assumption of Lease and Consent between LACERA Gateway Property, Inc., PAU and PICO.* 10.2 Lease for Registrant's Lake Oswego, Oregon office, dated September 23, 1996 and amended May 13, 1997 between WCB Thirty-Two Limited Partnership, as Lessor, and PICO, as Lessee.* 10.3 Lease for Registrant's Fresno, California office dated October 18, 1994 and amended January 10, 1997 between Altaffer Survivor Trust, as Lessor, and PAU, as Lessee.* 10.4 Agreement of Reinsurance, No. 7448, dated February 16, 1990 and last amended July 1, 1996 between General Reinsurance Corporation and PICO.* 10.5 Workers' Compensation and Employers' Liability Excess of Loss Reinsurance Agreement, No. 380, dated July 1, 1995 and last amended July 1, 1996 between PICO and certain reinsurers named therein.* 10.6 PAULA Financial and Subsidiaries 1994 Stock Incentive Plan.* 10.7 PAULA Financial and Subsidiaries 1997 Stock Incentive Plan.* 10.8 Form of Stock Option Agreement (Immediate Vesting - Non-Plan) issued in connection with the grant of stock options under the 1994 Plan.* 10.9 Form of Stock Option Agreement (Executive - Non-Plan) issued in connection with the grant of stock options other than under the 1994 Plan.* 10.10 Form of Stock Option Agreement (Immediate Vesting) issued under the 1994 Plan.* 10.11 Form of Stock Option Agreement (Executive) issued under the 1994 Plan.* 10.12 Form of Stock Option Agreement (Stepped Vesting) issued under the 1994 Plan.* 10.13 Form of Indemnification Agreement between Registrant and each of its directors.* 10.14 Convertible Revolving Loan Note dated March 31, 1997 made by Registrant in favor of Sanwa Bank California.* 10.15 Credit Agreement dated March 31, 1997 between Registrant and Sanwa Bank California.* 10.16 Form of Credit Guaranty dated March 31, 1997 made by each of PAU, Pan American Underwriters Insurance Agents & Brokers, Inc. (PAUIAB), Agri-Comp Insurance Agency, Inc. and Pan Pacific Benefit Administrators, Inc. (PPBA).* 10.17 Series A Preferred Stock Purchase Agreement dated August 3, 1994 between Registrant and certain purchasers of Series A Preferred Stock.* 10.18 Sixth Amendment, dated May 11, 1998, and Seventh Amendment dated September 17, 1998, to the Registrant's Lease for its Pasadena, California office dated January 1, 1989, as amended and as assigned to date, between LACERA Gateway Property, Inc., as lessor and PICO, as lessee. *** 10.19 Endorsement 8, dated March 9, 1998, and Endorsement 9, dated August 28, 1998, to Agreement of Reinsurance No. 7448 dated February 16, 1990, as amended and endorsed to date, between General Reinsurance Corporation and PICO. *** 10.20 Limited Liability Company Operating Agreement of Altus Insurance Holdings, LLC dated as of March 12, 1999 among the several members and Registrant. 10.21 Asset Management Agreement dated February 1, 1995 between PICO and Conning.* 10.22 Agency and Affiliates Cost Allocation and Reimbursement Agreement dated March 1, 1992 and last amended December 1, 1996 between PAU and PAUIAB, as Agency, and PICO, PACO and PPBA, as Affiliates.* 10.23 PAULA Insurance Company Insurance Carrier and Affiliates Cost Allocation and Reimbursement Agreement dated March 1, 1992 and last amended December 9, 1994 between PICO, as Carrier, and PACO, PAU, PAUIAB and PPBA, as Affiliates.*
IV-2 10.24 PAULA Financial Parent and Affiliates Cost Allocation and Reimbursement Agreement dated January 1, 1993 and last amended December 9, 1994 between Registrant, as Parent, and PICO, PACO, PAU, PAUIAB and PPBA, as Affiliates.* 10.25 Managing Agreement dated January 1, 1993 and last amended April 28, 1995 between PACO and PPBA, as Manager.* 10.26 Federal Income Tax Allocation Agreement dated April 10, 1997 between Registrant and its subsidiaries.* 10.27 Agency Agreement dated March 1, 1992 and last amended April 1, 1997 between PAU and PICO.* 10.28 Agency Agreement dated March 1, 1992 and last amended April 1, 1997 between PAUIAB and PICO.* 10.29 Agency Agreement dated December 8, 1994 and last amended April 1, 1997 among Agri-Comp Insurance Agency, Inc. and PICO.* 10.30 Purchase Option dated March 11, 1997 between Registrant and CAPAX.* 10.31 Plan of Reorganization and Agreement of Merger dated September 22, 1997 between PAULA Financial (Delaware) and PAULA Financial (California).** 10.32 Paula Insurance Company Workers Compensation Quota Share Reinsurance Agreement 1998 Placement Slip effective October 1, 1998 between PICO and Reliance Insurance Company 10.33 Paula Insurance Company Workers Compensation First and Second Excess of Loss Reinsurance Agreement 1998 Placement Slip effective October 1, 1998 between PICO and Reliance Insurance Company 10.34 Change of Control Agreement dated as of November 1, 1998 between the Registrant and Jeffrey A. Snider. 11 Statement re computation of per share earnings. 21 List of subsidiaries of PAULA Financial.* 23 Consent of KPMG LLP. 27 Financial Data Schedule - Year Ended December 31, 1998.
_______ * Incorporated by reference from the exhibit of the same number filed as an exhibit to the Company's Registration Statement on Form S-1 (Reg. No. 333-33159) filed on August 8, 1997 under the 1933 Act (the "Registration Statement"). ** Incorporated by reference from the exhibit of the same number filed as an exhibit to Amendment No. 1 to the Registration Statement. *** Incorporated by reference from the exhibit of the same number filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ending September 30, 1998. (b) REPORTS ON FORM 8-K. The Company filed no reports on Form 8-K during the fourth quarter of 1998. IV-3 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PAUL FINANCIAL By: /s/ James A. Nicholoson ------------------------------ SENIOR VICE PRESIDENT, CFO MARCH 30, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ Jeffrey A. Snider Chairman of the Board, President and March 30, 1999 --------------------- Chief Executive Officer Jeffrey A. Snider (Principal Executive Officer) /s/ James A. Nicholson Senior Vice President and Chief March 30, 1999 ---------------------- Financial Officer (Principal Financial James A. Nicholson and Principal Accounting Officer) /s/ John B. Clinton Director March 30, 1999 ------------------- John B. Clinton /s/ Jerry M. Miller Director March 30, 1999 ------------------- Jerry M. Miller /s/ Robert Puccinelli Director March 30, 1999 --------------------- Robert Puccinelli /s/ Bradley K. Serwin Director March 30, 1999 --------------------- Bradley K. Serwin /s/ Andrew M. Slavitt Director March 30, 1999 --------------------- Andrew M. Slavitt /s/ Gerard Vecchio Director March 30, 1999 ---------------------- Gerard Vecchio /s/ Ronald W. Waisner Director March 30, 1999 --------------------- Ronald W. Waisner
IV-4 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.6 Letter Agreement, dated March 8, 1999 by and among Registrant, PAU and CAPAX. 10.20 Limited Liability Company Operating Agreement of Altus Insurance Holdings, LLC dated as of March 12, 1999 among the several members and Registrant. 10.32 Paula Insaurance Company Workers Compensation Quota Share Reinsurance Agreement 1998 Placement Slip effective October 1, 1998 between PICO and Reliance Insurance Company 10.33 Paula Insurance Company Workers Compensation First and Second Excess of Loss Reinsurance Agreement 1998 Placement Slip effective October 1, 1998 between PICO and Reliance Insurance Company 10.34 Change of Control Agreement dated as of November 1, 1998 between the Registrant and Mr. Jeffrey A. Snider 11 Statement re computation of per share earnings. 23 Consent of KPMG LLP. 27 Financial Data Schedule - Year Ended December 31, 1998.
INDEPENDENT AUDITORS' REPORT The Board of Directors PAULA Financial: Under date of March 2, 1999, we reported on the consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998 which are included in the Annual Report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules in the Annual Report on Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Los Angeles, California March 2, 1999 S-1 SCHEDULE I PAULA FINANCIAL AND SUBSIDIARIES SUMMARY OF INVESTMENTS (IN THOUSANDS)
AS OF DECEMBER 31, 1998 ------------------------ COLUMN A COLUMN B COLUMN C COLUMN D AMOUNT AT WHICH SHOWN TYPE OF INVESTMENTS COST VALUE IN THE BALANCE SHEET - ------------------- ----- ----- --------------------- Fixed maturities: Bonds: U.S. Treasury securities and obligations of U.S. Government corporations and agencies............. $ 13,445 $ 13,766 $ 13,766 States, municipalities and political subdivisions.. 24,082 24,346 24,346 Corporate securities............................... 79,927 79,625 79,625 Collateralized mortgage obligations and other asset backed securities.......................... 53,925 53,055 53,055 ---------------- -------------- -------------- Total fixed maturities........................ 171,379 170,792 170,792 Equity securities: Common stock....................................... 3,252 3,219 3,219 Nonredeemable preferred stock...................... 999 1,040 1,040 ---------------- -------------- -------------- Total equity securities....................... 4,251 4,259 4,259 Short-term investments................................ 2,572 2,572 2,572 ---------------- -------------- -------------- Total investments............................. $178,202 $177,623 $177,623 ---------------- -------------- -------------- ---------------- -------------- --------------
S-2 SCHEDULE II.1 PAULA FINANCIAL AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAULA FINANCIAL BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31, -------------- 1998 1997 --------------- ---------------- ASSETS Common stock, at market (cost $1,018 and $5,138 in 1998 and 1997).......... $ 1,057 $ 5,138 Cash and invested cash...................................................... 1,624 13,647 Property and equipment, net................................................. 3 43 Investment in subsidiaries.................................................. 71,731 65,137 Deferred income taxes....................................................... 1,627 11 Other assets................................................................ 1,072 1,885 --------------- ---------------- --------------- ---------------- $77,114 $85,861 --------------- ---------------- --------------- ---------------- LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Notes payable............................................................... $ 2,667 $ 406 Accounts payable and other liabilities...................................... 411 635 ---------------- ----------------- 3,078 1,041 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, 6,338,815 shares in 1998 and 6,321,177 shares in 1997........... 63 63 Additional paid-in capital.................................................. 67,386 67,176 Retained earnings........................................................... 10,182 16,048 Accumulated other comprehensive income: Net unrealized gain on investments....................................... (382) 1,533 ---------------- ----------------- 77,249 84,820 Treasury stock (409,800 shares in 1998)..................................... (3,213) - ---------------- ----------------- Net stockholders' equity.............................................. 74,036 84,820 --------------- ---------------- --------------- ---------------- $77,114 $85,861 --------------- ---------------- --------------- ----------------
See notes to condensed financial information S-3 SCHEDULE II.2 PAULA FINANCIAL AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAULA FINANCIAL STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, 1998 1997 1996 ----------- ---------- ---------- Income: Net investment income...................................... $ 858 $ 169 $ 31 Service fees............................................... 1,403 977 871 Other...................................................... 20 293 112 ---------------- -------------- -------------- 2,281 1,439 1,014 Expenses: Interest expense........................................... 35 747 635 Service fees............................................... 668 910 865 Operating.................................................. 1,716 721 1,649 ---------------- -------------- -------------- 2,419 2,378 3,149 Loss from operations before income tax benefit and equity in net income of subsidiaries................................. (138) (939) (2,135) Income tax benefit......................................... (6) (309) (727) ---------------- -------------- -------------- Loss from operations before equity in net income of subsidiaries (132) (630) (1,408) Equity in net income of subsidiaries.......................... (4,745) 5,789 5,331 ---------------- -------------- -------------- ---------------- -------------- -------------- Net income (loss)..................................... ($4,877) $ 5,159 $ 3,923 ---------------- -------------- -------------- ---------------- -------------- -------------- Earnings (loss) per share..................................... ($0.78) $1.88 $ 2.07 Weighted average shares outstanding........................... 6,228,479 2,737,065 1,896,464 Earnings (loss) per share - assuming dilution................. ($0.78) $ 1.11 $ 1.00 Weighted average shares outstanding - assuming dilution....... 6,228,479 4,664,511 3,910,715
See notes to condensed financial information S-4 SCHEDULE II.3 PAULA FINANCIAL AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAULA FINANCIAL STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 ---- ---- ---- Cash flows from operating activities: Net income (loss)............................................... ($4,877) $5,159 $3,923 Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization................................. 12 31 45 (Income) loss from subsidiaries............................... 4,745 (5,789) (5,331) Dividends received from subsidiaries.......................... - - 820 Loss on sales of securities................................... 212 - - Loss on sale of fixed assets.................................. - 6 5 (Increase) decrease in other assets........................... 813 (1,703) (539) Increase (decrease) in accounts payable and other liabilities. (224) (351) 536 Other, net.................................................... (937) (111) (195) ---------------- ---------------- ---------------- Net cash used in operating activities..................... ($256) ($2,758) ($736) ---------------- ---------------- ---------------- Cash flows from investing activities: Purchase of common stock..................................... - (5,138) - Proceeds from sale of common stock........................... 3,908 - - Proceeds from sale of property and equipment................. 28 13 88 Purchase of property and equipment........................... - - (74) Capital contribution to subsidiary........................... (13,964) (10,000) - ---------------- ---------------- ---------------- Net cash provided by (used in) investing activities........ ($10,028) ($15,125) $ 14 ---------------- ---------------- ---------------- Cash flows from financing activities: Borrowings (repayments) under line of credit agreement, net.. 2,600 (7,490) 2,268 Payments on notes payable.................................... (339) (2,975) (1,627) Issuance of notes payable.................................... - 238 269 Dividends paid............................................... (989) - Exercise of stock options.................................... 202 - Sale of common stock......................................... - 41,278 343 Repurchase of common stock................................... (3,213) Retirement of common stock................................... - (60) - ---------------- ---------------- ---------------- Net cash provided (used in) financing activities........... ($1,739) $ 30,991 $ 1,253 ---------------- ---------------- ---------------- Net increase (decrease) in cash and invested cash............... (12,023) 13,108 531 Cash and invested cash at beginning of period................... 13,647 539 8 ---------------- ---------------- ---------------- Cash and invested cash at end of period......................... $ 1,624 $ 13,647 $ 539 ---------------- ---------------- ---------------- ---------------- ---------------- ---------------- Supplemental disclosure of cash flow information: Cash paid during the period for income taxes.................. $ 1 $ 1 $ 1 ---------------- ---------------- ---------------- ---------------- ---------------- ---------------- Cash paid during the period for interest...................... $ 35 $ 1,007 $ 557 ---------------- ---------------- ---------------- ---------------- ---------------- ----------------
See notes to condensed financial information S-3 SCHEDULE II.4 PAULA FINANCIAL AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT PAULA FINANCIAL NOTES TO CONDENSED FINANCIAL INFORMATION DECEMBER 31, 1998 AND 1997 (IN THOUSANDS) 1. BASIS OF PRESENTATION In accordance with the requirements of Regulation S-X of the Securities and Exchange Commission, the financial statements of the registrant are condensed and omit many disclosures presented in the consolidated financial statements and the notes thereto. 2. NOTES PAYABLE The following is a summary of the notes payable balances at period end:
DECEMBER 31, 1998 1997 ---- ---- Note payable to bank............................................. $2,600 $ - Note payable..................................................... 67 406 ------------ ------------ ------------ ------------ Balance at end of period......................................... $2,667 $ 406 ------------ ------------ ------------ ------------
Maturities of notes payable for the next five years are as follows:
FISCAL YEAR DECEMBER 31, 1998 - ----------- ----------------- 1999................................................................. $67
3. DIVIDENDS FROM SUBSIDIARIES During 1998 and 1997, no cash dividends were paid to PAULA Financial by its consolidated subsidiaries. During 1996, a cash dividend of $820 was paid to PAULA Financial by its consolidated subsidiaries. 4. CONTINGENCIES The Company is subject to various litigation which arises in the ordinary course of business. Based upon discussions with counsel, management is of the opinion that such litigation will not have a material adverse effect on the consolidated financial position of the Company or its consolidated results of operations. S-6 SCHEDULE III PAULA FINANCIAL AND SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION (IN THOUSANDS)
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN A B C D E F - - - - - - FUTURE POLICY OTHER BENEFITS, POLICY DEFERRED LOSSES, CLAIMS POLICY CLAIMS AND AND ACQUISITION LOSS UNEARNED BENEFITS PREMIUM COSTS EXPENSES PREMIUM PAYABLE REVENUE ------------ ----------- --------- ---------- ----------- 1998 Workers Compensation.... $2,533 $135,939 $20,234 $- $127,997 Group A&H............... - 278 - - 490 Group Life.............. - 99 - - 283 ------------ ----------- --------- ---------- ----------- Total................ $2,533 $136,316 $20,234 $- $128,770 ------------ ----------- --------- ---------- ----------- ------------ ----------- --------- ---------- ----------- 1997 Workers Compensation.... $2,191 $77,441 $15,390 $- $91,957 Group A&H............... - 242 - - 563 Group Life.............. - 101 - - 315 ------------ ----------- --------- ---------- ----------- Total................ $2,191 $77,784 $15,390 $- $92,835 ------------ ----------- --------- ---------- ----------- ------------ ----------- --------- ---------- ----------- 1996 Workers Compensation.... $1,330 $55,187 $10,655 $- $54,563 Group A&H............... - 400 - - 551 Group Life.............. - 133 - - 390 ------------ ----------- --------- ---------- ----------- ------------ ----------- --------- ---------- ----------- Total................ $1,330 $55,720 $10,655 $- $55,504 ------------ ----------- --------- ---------- ----------- ------------ ----------- --------- ---------- -----------
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN A G H I J K - - - - - - BENEFITS, AMORTIZA- CLAIMS, TION OF LOSSES DEFERRED NET AND POLICY OTHER INVESTMENT SETTLEMENT ACQUISI- OPERATING PREMIUMS INCOME EXPENSES TION COSTS EXPENSES WRITTEN ------------- ----------- ---------- ----------- ------------ 1998 Workers Compensation.... $8,156 $114,118 $18,909 $33,672 $151,675 Group A&H............... 144 235 - 229 490 Group Life.............. 136 130 - 112 283 ------------- ---------- ----------- ----------- ------------ Total................ $8,436 $114,483 $18,909 $34,013 $152,448 ------------- ---------- ----------- ----------- ------------ ------------- ---------- ----------- ----------- ------------ 1997 Workers Compensation.... $5,066 $ 67,915 $ 9,074 $24,544 $ 99,919 Group A&H............... 155 98 - 278 563 Group Life.............. 139 94 - 131 315 ------------- ---------- ----------- ----------- ------------ Total................ $5,360 $ 68,107 $ 9,074 $24,953 $100,797 ------------- ---------- ----------- ----------- ------------ ------------- ---------- ----------- ----------- ------------ 1996 Workers Compensation.... $4,288 $ 33,293 $ 2,421 $17,256 $ 60,609 Group A&H............... 152 407 - 338 551 Group Life.............. 145 200 - 234 390 ------------- ---------- ----------- ----------- ------------ Total................ $4,585 $ 33,900 $ 2,421 $17,828 $ 61,550 ------------- ---------- ----------- ----------- ------------ ------------- ---------- ----------- ----------- ------------
S-7 SCHEDULE IV PAULA FINANCIAL AND SUBSIDIARIES REINSURANCE (DOLLARS IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F -------- -------- -------- -------- -------- -------- CEDED TO ASSUMED FROM ASSUMED TO NET DESCRIPTION OTHER OTHER PERCENTAGE OF GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT AMOUNT ------------- ----------- ------------ ----------- -------------- YEAR ENDED DECEMBER 31, 1998 Premiums: Workers' compensation insurance............... $144,328 $18,834 $2,503 $127,997 2.0% Group A&H..................................... 490 - - 490 0.0% Group Life.................................... 283 - - 283 0.0% -------------------------------------------------------------------------- Total Premiums................................ $145,101 $18,834 $2,503 $128,770 2.0% -------------------------------------------------------------------------- -------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1997 Premiums: Workers' compensation insurance............... $94,603 $3,226 $580 $91,957 0.6% Group A&H..................................... 563 - - 563 0.0% Group Life.................................... 315 - - 315 0.0% -------------------------------------------------------------------------- Total Premiums................................ $95,481 $3,226 $580 $92,835 0.6% -------------------------------------------------------------------------- -------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1996 Premiums: Workers' compensation insurance............... $56,197 $2,056 $422 $54,563 0.8% Group A&H..................................... 551 - - 551 0.0% Group Life.................................... 390 - - 390 0.0% -------------------------------------------------------------------------- Total Premiums................................ $57,138 $2,056 $422 $55,504 0.8% -------------------------------------------------------------------------- --------------------------------------------------------------------------
S-8 SCHEDULE V PAULA FINANCIAL AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E -------- -------- -------- -------- -------- ADDITIONS BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END OF PERIOD EXPENSE ACCOUNTS DEDUCTIONS OF PERIOD ---------- ---------- ---------- ---------- ----------- YEAR ENDED DECEMBER 31, 1998 Allowance for uncollectible accounts............. $600 $301 $ - $ - $901 ---------- ---------- --------- --------- -------- ---------- ---------- --------- --------- -------- YEAR ENDED DECEMBER 31, 1997 Allowance for uncollectible accounts............. $500 $100 $ - $ - $600 ---------- ---------- --------- --------- -------- ---------- ---------- --------- --------- -------- YEAR ENDED DECEMBER 31, 1996 Allowance for uncollectible accounts............. $358 $142 $ - $ - $500 ---------- ---------- --------- --------- -------- ---------- ---------- --------- --------- --------
S-9 SCHEDULE VI PAULA FINANCIAL AND SUBSIDIARIES SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION (IN THOUSANDS)
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN A B C D E F - - - - - - DISCOUNT IF ANY, DEDUCTED IN RESERVES RESERVES FOR UNPAID FOR UNPAID DEFERRED CLAIMS AND CLAIMS AND POLICY CLAIMS CLAIM ACQUISITION ADJUSTMENT ADJUSTMENT UNEARNED EARNED COSTS EXPENSE EXPENSES PREMIUM PREMIUM ------------ ------------- ------------- ---------- ---------- 1998 Workers Compensation... $2,533 $135,939 $- $20,234 $127,997 1997 Workers Compensation... $2,191 $ 77,441 $- $15,390 $91,957 1996 Workers Compensation... $1,330 $ 55,187 $- $10,655 $54,563
COLUMN COLUMN COLUMN COLUMN COLUMN COLUMN A G H I J K - - - - - - CLAIMS AND CLAIM ADJUSTMENT EXPENSES INCURRED RELATED TO: ----------------- AMORTIZA- TION OF PAID DEFERRED CLAIMS & NET POLICY CLAIM NVESTMENT CURRENT PRIOR ACQUISI- ADJUSTMENT PREMIUMS INCOME YEAR YEAR TION COSTS EXPENSES WRITTEN ----------- -------- ------- ------------ ----------- ---------- 1998 Workers Compensation... $8,156 $107,850 $ 6,268 $18,909 $74,363 $151,675 1997 Workers Compensation... $5,066 $66,330 $ 1,586 $ 9,074 $45,629 $ 99,919 1996 Workers Compensation... $4,288 $35,938 $(2,646) $ 2,421 $34,514 $ 60,609
S-10 EX-2.6 2 LETTER AGREEMENT DATED MARCH 12, 1999 [Letterhead of Paula Financial] March 12, 1999 Mr. Joel Geddes Chairman CAPAX Management and Insurance Services Modesto, CA VIA FAX Re: Revised Offer to Purchase the Assets of CAPAX' Stockton and Sacramento Offices Dear Joel: Pan American Underwriters, Inc. ("PAU") is pleased to offer to purchase all of the respective interests of CAPAX Management and Insurance Services and its subsidiaries (collectively, "CAPAX") in the book of business serviced from their Stockton and Sacramento offices, other than those portions of the book identified on Exhibit A hereto (the "Excluded Book") on the following terms: 1. PAU will purchase all interests of CAPAX (as well as the interest of its employees, employed or directly contracted producers, officers, directors and affiliates (collectively, the "Seller")) in the book of insurance business (other than the Excluded Book) being produced and/or serviced by the Seller from or through CAPAX' Stockton and Sacramento California locations (the "Offices") as defined below (the "Book of Business"). The Book of Business will include, without limitation, all policies with respect to which the Seller is named as the broker or agent of record, all such prospective policies which have been submitted to carriers for quotation and all such prospective policies with respect to which the Seller has actively solicited quotations in the past 12 months, other than the Excluded Book. The Book of Business will also include, without limitation, all of the Seller's interest in those policies being produced and/or serviced from the Offices actually produced by independent agents (the "Sub-Producers") and brokered through the Seller (the "Sub-Produced Business"), other than the Excluded Book. The following individuals are not considered Sub-Producers and their business is not considered "Sub-Produced Business": Messrs. Seawall, Van Noate and Duckworth and Ms. Michaels. 2. PAU will pay a combination of cash and other consideration for the Book of Business in an amount equal to 1.335x (A) Seller's annual commission revenues, and fee revenue received in lieu of commission, but excluding contingent commissions and interest income, relating to the portion of the Book of Business which is in-force on 1 the closing and renews or is replaced and is in force at the end of the 24 month measurement period, less (B) the portion of that annual commission revenue, and fee revenue received in lieu of commission, relating to the Sub-Produced Business that is passed through to the Sub-Producers, less $80,000. 3. The estimated purchase price will be 1.335x $2,426,240 = $3,239,030 - $80,000 = $3,159,030. This estimate will be adjusted prior to closing if the 1998 commission and fee revenue relating to the Book of Business (other than the Excluded Book) differs from $2,426,240. Such adjustment will be made at the completion of due diligence. 4. At closing, PAU will pay to CAPAX $2,008,141 (less any downward adjustment required by paragraph 3 above and plus any upward adjustment required by paragraph 3 above) in cash. At closing, PAULA Financial will tender all of its Series A Preferred Stock in CAPAX, duly endorsed for transfer, and CAPAX will redeem such stock for the sum of $955,624 to be paid as part of the promissory note discussed below from CAPAX to PAULA (the "CAPAX Note"). Incidental thereto, the Series A Preferred Stock Purchase Agreement dated March 11, 1997 along with all exhibits thereto will be canceled and terminated. Notwithstanding the foregoing, CAPAX will remain a PAULA Trading Company founder entitled to all related rights thereto and nothing herein is intended to alter the existing working relationship among Jeff Snider, Jim Parker and Joel Geddes. At closing PAULA Financial will exchange the outstanding term loan due from Giddings, Corby, Hynes, Inc. to PAULA in the principal amount of $195,265, plus accrued, but unpaid, interest to date, for a like interest in the CAPAX Note. All existing collateral for the Giddings term loan shall be released upon the execution of the new CAPAX Note. 5. At closing CAPAX will execute the CAPAX Note in favor of PAULA Financial with the following terms: A. Principal balance will be the sum of the amounts due above from CAPAX and Giddings to PAULA ($955,624 + $195,265 + accrued but unpaid interest on the old note); B. Interest will accrue from the closing to maturity at 7.5% per year payable at maturity; provided however that if maturity is extended as discussed below, the CAPAX Note will continue to bear interest at 7.5% on the unpaid balance; C. Maturity will be coincidental with the final payment of the purchase price for the Book of Business by PAU (24 months after closing); 2 D. Note will be repaid, to the extent possible, by offset against the final payment of the purchase price for the Book of Business by PAU; provided that in the event the final payment by PAU is less than the principal and interest due under the CAPAX Note, such excess shall be payable over the succeeding 36 months in 36 equal monthly payments which will fully amortize the principal and interest remaining due under the CAPAX Note; E. In the event that the CAPAX Note becomes payable in 36 equal monthly payments, PAULA Financial will have the option to convert the outstanding balance of the CAPAX Note into CAPAX voting common stock at a price of $20 per share at any time until the CAPAX Note is paid in full. If PAULA converts any portion of the balance into CAPAX stock, such stock will be governed by the applicable provisions of the then existing CAPAX Shareholders' Agreement; and F. The CAPAX Note will be secured by a perfected senior security interest in all of the assets of CAPAX and its subsidiaries; provided that PAULA will permit CAPAX and its subsidiaries, in the aggregate, to borrow up to $300,000 in debt which will have a senior call on the following categories of secured assets: accounts receivables and property, plant and equipment; provided further, that CAPAX can incur additional indebtedness on an unsecured or secured but subordinated (to PAULA's interests) basis without restriction. G. The CAPAX Note will provide for cross-defaults in the event CAPAX or its subsidiaries has a payment or any other default under any other debt instrument and the other lender begins to foreclose on any CAPAX assets. 6. The total purchase price will be adjusted at the end of 24 months from closing based on the actual amount of commissions invoiced by PAU on the Book of Business (which is still in force) (other than the Excluded Book) during the 12 months beginning with the 10th full month after closing and ending with the 21st full month after closing, plus the actual annual amount of new commissions invoiced by PAU generated from the former CAPAX producers during such 12 month period, less the amount passed through to Sub-Producers during such 12 month period. In the event that payment of any measured commissions is not received by the end of the 24 month period, the commissions not paid will not be considered "invoiced" for this purpose. In no event will new production by CAPAX producers increase the purchase price above the adjusted estimated purchase price defined in Paragraph 3 above. PAU will pay the difference between the total adjusted purchase price and the initial cash payment at the end of such 24 month period. PAU will pay interest on the actual amount of the final payment calculated at the rate of 7 1/2% per year from the closing to the payment date. Interest will be payable at the same time that the final payment is paid. PAU will grant CAPAX a first priority security interest in the Book of Business and 3 related files as security for its obligation to make the foregoing payment. 7. In the event that PAU sells or otherwise disposes of any portion of the Book of Business prior to the end of the 24 month period, for purposes of calculating the adjusted purchase price, the said portion of the Book of Business will be treated as if it was still in force and held by PAU and that PAU received during the 12 month measurement period an amount of commissions and fees equal to the amount of commissions and fees received by PAU and/or CAPAX for the twelve months immediately prior to the sale of such accounts by PAU. 8. In the event that PAU negligently fails to maintain the Book of Business after the closing due to a change of control of PAU and/or PAULA and CAPAX is damaged by such failure, CAPAX shall be entitled to recover its damages caused by such negligence upon presentation of proof of such negligence and such damages. This right of recovery will not prejudice any other right to recovery that CAPAX may have in law or equity. 9. The parties agree that the Seller will be entitled to retain any and all commissions and fees relating to the Book of Business invoiced prior to the closing of the transaction in the ordinary course for items having an inception date before closing, whether agency bill or direct bill. PAU will be entitled to retain any and all commissions and fees relating to the Book of Business invoiced after the closing of the transaction in the ordinary course for items having an inception date before or after closing, whether agency bill or direct bill. The Seller will pay over to PAU any and all commissions and fees received by the Seller relating to commissions and fees relating to the Book of Business invoiced after the closing of the transaction in the ordinary course for items having an inception date before or after the closing, whether agency bill or direct bill. Notwithstanding the foregoing PAU does not agree to the foregoing formulation unless during PAU's due diligence, PAU determines that its estimated 1999 GAAP revenue from the Book of Business will at least equal its estimated 1999 GAAP expenses from the Book of Business. In the event due diligence cannot confirm this, the parties will work in good faith to determine an alternative method of sharing commissions and fees which is acceptable to all parties. 10. The Seller will remain obligated for all liabilities relating to the Book of Business for the period ending on the closing date, including without limitation, carrier payables, client payables, errors and omissions liabilities and obligations to service the policies with respect to those changes, additions and deletions requested/required as of, or prior to the closing date. PAU will assume all such responsibilities on the day after the closing date. Each of the parties agrees to purchase E&O cover for its retained liabilities in amounts and with deductibles reasonably acceptable to the other party. Each party agrees to provide evidence of such cover prior to closing and to maintain such cover 4 in PAU's case until PAU's purchase price final payment is made and in CAPAX' case until the CAPAX Note is paid in full. 11. The Seller will provide PAU with a blanket broker of record letter addressed to all markets with which the Seller has placed a portion of the Book of Business. Seller does not represent that such markets will accept the Broker of Record letter, but Seller will use its best efforts to accomplish such objective. In the event any such letter is rejected, the Seller will allow PAU to broker the applicable portion of the Book of Business through the Seller to such market without additional compensation, for a period of 24 months. 12. The Seller will transfer to PAU all files and other records of the Seller relating to the Book of Business which are necessary or helpful to PAU's obligation to service the Book of Business going forward. Seller shall have unlimited access to such files for all valid purposes. The Seller can copy any and all of such files prior to closing and the documented out-of-pocket cost of such copying will be shared by PAU and CAPAX equally. PAU will exercise the same degree of care with the transferred files as it uses with respect to its own files. 13. PAU will hire only those producers and staff persons currently operating from the Offices which PAU, in its sole discretion chooses to hire, and agrees to review those existing consulting agreements with Seawell, Van Noate, Duckworth and Michaels with a view to assuming them. PAU will notify CAPAX of its decision in this regard at the completion of its due diligence. CAPAX will retain all obligations to pay Buck and any other person for the purchase of their interests in the Book of Business. All retained producers and staff persons will be offered compensation packages either equal to that set forth in Mr. Jaques Presentation Book or the compensation packages they had with CAPAX at December 31, 1998, PAU's choice, which will be made on an individual basis. CAPAX agrees to pay to all former employees of the Offices all ESOP, vacation and other accrued employee benefits due to them under CAPAX policies or applicable law relating to their separation from CAPAX, if any. Such persons will be treated as new hires by PAU for all purposes except that PAU will provide to those persons hired credit for service in the minimum amount necessary to provide such persons with eligibility for PAU's normal medical, dental, life and disability insurance benefits and PAU's 401(k) plan. In the event PAU terminates any producer formerly working in the Offices for any reason prior to the end of the measurement period set forth in Section 6 above, any portion of the Book of Business being serviced by such terminated producer at the time of termination will be "frozen" for purposes of valuing the commissions and fees from that portion of the Book of Business for purposes of Section 6. The value of the frozen portion will equal the invoiced commissions and fees for the 12 months immediately prior to the producer's termination which are actually paid. Voluntary terminations will not result in any freezing of the value of the Book of Business serviced by the separating producer. 5 14. PAU will assume CAPAX' leasehold obligations on the Offices and related office equipment (except the Sacramento computers) as of the closing date. PAU will receive, for no additional consideration, all office equipment and furniture housed in the Offices at December 31, 1998 except for computers and related accessories located in the Sacramento office at December 31, 1998. CAPAX will deliver all transferred personal property free from all liens and encumbrances other than leasehold obligations. In the event such leases are not assumable, PAU will reimburse CAPAX for all continuing lease obligations for the transferred items. 15. The Seller will pay all fees due to John H. Jaques, Inc. as finder. Each party shall pay their own professional fees and other expenses related to this transaction. 16. The Seller will transfer all rights to the name "Sacramento Valley Insurance" at closing as part of the transaction. The Seller will cause its existing corporate subsidiary to change its name to something which does not conflict with the sold name prior to closing, will cease operating under the sold name upon closing and will cooperate with PAU to allow PAU to become licensed to sell insurance under the sold name as a "dba." PAU agrees to broker any of Seller's retained insurance business through PAU for no cost to the extent that such business must be brokered due to PAU's use of the sold name as a dba for a period of 24 months after closing. 17. Closing is contingent upon the following: A. Completion of PAU's due diligence on the Book of Business to PAU's satisfaction; B. Receipt of applicable consents to the transaction, including, but not limited to, Boards, shareholders and landlords, as required by any participating entity; C. Release of all liens and other interests on or in the Book of Business held by CAPAX' banks, shareholders, producers and any other persons; D. Execution of a definitive agreement in form and substance satisfactory to all parties which will include, among other things, standard representations and warranties for transactions of this type; E. Delivery of an opinion of counsel reasonably satisfactory to PAU as to the authority of CAPAX to consummate the sale of the Book of Business, the release of liens and security interests in and on the Book of Business, CAPAX' right to redeem the Series A Preferred Stock under the California general corporation law and the due authorization of the consummation of the transactions by CAPAX, its subsidiaries and shareholders. F. Execution of a producer and severance agreement between PAU and Jim Chenu in form and substance mutually acceptable to both parties no later than the end of the due diligence period discussed below. In the event such 6 execution does not occur, any party may terminate its participation in this transaction without liability to any other party. 18. PAU agrees to conclude its due diligence within 15 working days from the date this term sheet is executed by the Seller. In the event that PAU has not satisfied all of its due diligence issues by such date, any party can terminate its participation in the transaction without any obligation to the other parties. Assuming that no party terminates after the end of the due diligence period, the transaction will close within two weeks of the end of the due diligence period. In the event that the transaction does not close by such date, any party may terminate its participation in the transaction without any obligation to the other parties. The parties also agree to finalize the material provisions of the definitive agreement by the end of the due diligence period. In the event that this has not been done by that time, any party can terminate its participation in the transaction without obligation to any other party. 19. The definitive document will contain a provision stating that disputes will be settled by binding arbitration before a panel of arbitrators, all of whom will meet minimum qualifications regarding their insurance industry experience, and will be in form and substance mutually acceptable to the parties. In the event the foregoing is agreeable to you, with the intent to be bound hereby, subject to the foregoing conditions, please signify agreement by causing an authorized representative of the Seller to execute a duplicate of this letter in the space below and returning it to me. This document will not be binding on any party until executed by all parties. PAN AMERICAN UNDERWRITERS, INC. PAULA FINANCIAL By: /s/ James A. Nicholson By: /s/ James A. Nicholson --------------------------- -------------------------- CAPAX MANAGEMENT AND INSURANCE SERVICES, on behalf of itself and its affiliates By: /s/ Joel W. Geddes ---------------------------- 7 EX-10.20 3 LIMITED LIABILITY OPERATING AGREEMENT Exhibit 10.20 LIMITED LIABILITY COMPANY OPERATING AGREEMENT OF ALTUS INSURANCE HOLDINGS, LLC TABLE OF CONTENTS
PAGE ---- ARTICLE 1 DEFINITIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 ARTICLE 2 THE COMPANY. . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.1. Formation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.2. Name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.3. Purpose; Powers. . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.4. Principal Place of Business. . . . . . . . . . . . . . . . . . . . 14 2.5. Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.6. Filings; Agent for Service of Process. . . . . . . . . . . . . . . 14 2.7. Title to Property. . . . . . . . . . . . . . . . . . . . . . . . . 15 2.8. Payments of Individual Obligations . . . . . . . . . . . . . . . . 15 ARTICLE 3 MEMBERS' CAPITAL CONTRIBUTIONS . . . . . . . . . . . . . . . . . . 15 3.1. Original Capital Contributions . . . . . . . . . . . . . . . . . . 15 3.2. Interest on Capital Contributions. . . . . . . . . . . . . . . . . 15 3.3. Optional Additional Capital Contributions. . . . . . . . . . . . . 15 3.4. Withdrawal of Capital. . . . . . . . . . . . . . . . . . . . . . . 16 3.5. Loans by Members . . . . . . . . . . . . . . . . . . . . . . . . . 17 ARTICLE 4 ALLOCATIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4.1. Profits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4.2. Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4.3 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 ARTICLE 5 DISTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . 19 5.1. Net Cash Flow. . . . . . . . . . . . . . . . . . . . . . . . . . . 19 5.2. Minimum Distributions. . . . . . . . . . . . . . . . . . . . . . . 19 5.3. Amounts Withheld . . . . . . . . . . . . . . . . . . . . . . . . . 19 5.4. Limitations on Distributions . . . . . . . . . . . . . . . . . . . 20 ARTICLE 6 MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 6.1. Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 6.2. Powers of Board of Managers. . . . . . . . . . . . . . . . . . . . 22 6.3. Duties and Obligations of the Managers . . . . . . . . . . . . . . 22 6.4. Reimbursements . . . . . . . . . . . . . . . . . . . . . . . . . . 23 6.5. Indemnification of the Managers. . . . . . . . . . . . . . . . . . 23 6.6. Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 6.7. Miscellaneous. . . . . . . . . . . . . . . . . . . . . . . . . . . 25 ARTICLE 7 ROLE OF MEMBERS. . . . . . . . . . . . . . . . . . . . . . . . . . 26 7.1. Rights or Powers . . . . . . . . . . . . . . . . . . . . . . . . . 26
i 7.2. Voting Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . 26 7.3. Meetings of the Members. . . . . . . . . . . . . . . . . . . . . . 26 7.4. Required Member Consents . . . . . . . . . . . . . . . . . . . . . 27 7.5. Withdrawal/Resignation . . . . . . . . . . . . . . . . . . . . . . 28 7.6. Member Compensation. . . . . . . . . . . . . . . . . . . . . . . . 28 7.7. Members Liability. . . . . . . . . . . . . . . . . . . . . . . . . 28 7.8. Partition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 7.9. Confidentiality. . . . . . . . . . . . . . . . . . . . . . . . . . 28 7.10. Transactions Between a Member and the Company . . . . . . . . . . 29 7.11. Other Instruments . . . . . . . . . . . . . . . . . . . . . . . . 29 7.12. Guarantee of Company Indebtedness . . . . . . . . . . . . . . . . 29 7.13 Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 ARTICLE 8 REPRESENTATIONS AND WARRANTIES . . . . . . . . . . . . . . . . . . 30 8.1. In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 8.2. Representations and Warranties . . . . . . . . . . . . . . . . . . 30 ARTICLE 9 ACCOUNTING, BOOKS AND RECORDS. . . . . . . . . . . . . . . . . . . 31 9.1. Accounting, Books, and Records . . . . . . . . . . . . . . . . . . 31 9.2. Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 9.3. Accountants. . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 9.4. Tax Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 ARTICLE 10 AMENDMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10.1. Amendments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 ARTICLE 11 TRANSFERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 11.1. Restrictions on Transfers . . . . . . . . . . . . . . . . . . . . 34 11.2. Permitted Transfers . . . . . . . . . . . . . . . . . . . . . . . 34 11.3. Conditions to Permitted Transfers . . . . . . . . . . . . . . . . 34 11.4. Right of First Refusal. . . . . . . . . . . . . . . . . . . . . . 35 11.5. PAULA Change of Control . . . . . . . . . . . . . . . . . . . . . 37 11.6 Prohibited Transfers . . . . . . . . . . . . . . . . . . . . . . . 37 11.7 Rights of Unadmitted Assignees . . . . . . . . . . . . . . . . . . 38 11.8 Admission of Substituted Members . . . . . . . . . . . . . . . . . 38 11.9 Representations Regarding Transfers; Legend. . . . . . . . . . . . 39 11.10 Distributions and Allocations in Respect of Transferred Membership Interest . . . . . . . . . . . . . . . . . . . . . . . 39 11.11 Membership Interest . . . . . . . . . . . . . . . . . . . . . . . 40 ARTICLE 12 ADVERSE ACT . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 12.1. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 12.2. Adverse Act Purchase. . . . . . . . . . . . . . . . . . . . . . . 41 12.3. Net Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 12.4. Gross Appraised Value . . . . . . . . . . . . . . . . . . . . . . 43
ii 12.5. Extension of Time . . . . . . . . . . . . . . . . . . . . . . . . 43 ARTICLE 13 DISSOLUTION AND WINDING UP. . . . . . . . . . . . . . . . . . . . 44 13.1. Dissolution Events. . . . . . . . . . . . . . . . . . . . . . . . 44 13.2. Winding Up. . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 13.3. Compliance With Certain Requirements of Regulations; Deficit Capital Accounts. . . . . . . . . . . . . . . . . . . . . 46 13.4. Rights of Members . . . . . . . . . . . . . . . . . . . . . . . . 46 13.5. Notice of Dissolution/Termination . . . . . . . . . . . . . . . . 46 13.6. Allocations During Period of Liquidation. . . . . . . . . . . . . 47 13.7. Character of Liquidating Distributions. . . . . . . . . . . . . . 47 13.8. The Liquidator. . . . . . . . . . . . . . . . . . . . . . . . . . 47 13.9. Form of Liquidating Distributions . . . . . . . . . . . . . . . . 47 ARTICLE 14 POWER OF ATTORNEY . . . . . . . . . . . . . . . . . . . . . . . . 48 14.1. Managers as Attorneys-In-Fact . . . . . . . . . . . . . . . . . . 48 14.2. Nature of Special Power . . . . . . . . . . . . . . . . . . . . . 48 ARTICLE 15 MISCELLANEOUS . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.1. Notices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.2. Binding Effect. . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.3. Construction. . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.4. Time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.5. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.6. Severability. . . . . . . . . . . . . . . . . . . . . . . . . . . 49 15.7. Incorporation by Reference. . . . . . . . . . . . . . . . . . . . 49 15.8. Variation of Terms. . . . . . . . . . . . . . . . . . . . . . . . 50 15.9. Governing Law . . . . . . . . . . . . . . . . . . . . . . . . . . 50 15.10. Payment of Fees and Expenses . . . . . . . . . . . . . . . . . . 50 15.11. Waiver of Jury Trial . . . . . . . . . . . . . . . . . . . . . . 50 15.12. Counterpart Execution. . . . . . . . . . . . . . . . . . . . . . 50 15.13. Specific Performance . . . . . . . . . . . . . . . . . . . . . . 50 EXHIBIT A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 EXHIBIT B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 EXHIBIT C. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 EXHIBIT D. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
iii LIMITED LIABILITY COMPANY OPERATING AGREEMENT OF ALTUS INSURANCE HOLDINGS, LLC This OPERATING AGREEMENT is entered into as of March 12, 1999, by and between PAULA Financial, a Delaware corporation, R. Steven Clark, an individual resident in the State of Washington, Edward A. Lopit, an individual resident in the State of Washington, Lawrence A. Riggs, an individual resident in the State of Washington and John R. Snyder, an individual resident in the State of Washington, as Members pursuant to the provisions of the Act, on the following terms and conditions: ARTICLE 1 DEFINITIONS 1.1 Capitalized words and phrases used in this Agreement have the following meanings: "ACCEPTING OFFEREES" shall have the meaning set forth in Section 11.4(d) hereof. "ACT" means the Delaware Limited Liability Company Act, 6 Del. C. Section 18-101, ET SEQ., as amended from time to time (or any corresponding provisions of succeeding law). "ADDITIONAL CAPITAL CONTRIBUTIONS" means, with respect to each Member, the Capital Contributions made by such Member pursuant to Section 3.1 and Section 3.3 hereof. "ADVERSE ACT" means, with respect to any Member, any of the following: (i) a failure by such Member to make any Capital Contribution required pursuant to any provision of the Agreement; (ii) A determination that such Member has committed a material breach of any material covenant contained in this Agreement or materially defaulted on any material obligation provided for in this Agreement and such breach or default continues for thirty (30) days after the date written notice thereof has been given to such Member by any other Member, PROVIDED that, if such breach or default is not a failure to pay money and is of such a nature that it cannot reasonably be cured within such thirty (30) day period, but is curable and such Member in good faith begins efforts to cure it within such thirty (30) day period and continues diligently to do so, such Member shall have a reasonable additional period thereafter to effect the cure (which shall not exceed an additional ninety (90) days unless otherwise approved by the Board of Managers), and PROVIDED FURTHER THAT, if within thirty (30) days after written notice of such breach or default has been given to such Member, such Member delivers written notice (the "CONTEST NOTICE") to each other Member and each Manager that it contests such notice of breach or default, such breach or default shall not constitute an Adverse Act unless and until (and assuming that such breach or default has not theretofore been cured in full and that any applicable grace period has expired) there is a Final Determination that such Member's actions or failures to act constituted such a breach or default; 4 (iii) A Transfer of all or any portion of such Member's Interest except as expressly permitted or required by this Agreement; or (iv) The Bankruptcy of such Member or the occurrence of any other event which would permit a trustee or receiver to acquire control of the affairs or assets of such Member. "ADVERSE MEMBER" is any Member with respect to whom an Adverse Act has occurred. "AFFILIATE" means, with respect to any Person (i) any Person directly or indirectly controlling, controlled by, or under common control with such Person (ii) any officer, director, partner, member, or trustee of such Person or (iii) any Person who is an officer, director, partner, member, or trustee of any Person described in clauses (i) or (ii) of this sentence. For purposes of this definition, the terms "controlling," "controlled by" or "under common control with" shall mean the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a Person or entity, whether through the ownership of voting securities, by contract or otherwise, or the power to elect at least 50% of the directors, managers, or persons exercising similar authority with respect to such Person or entities. "AGREEMENT" means this Limited Liability Company Operating Agreement of Altus Insurance Holdings, LLC, including all Exhibits attached hereto, as amended from time to time. Words such as "herein," "hereinafter," "hereof," "hereto" and "hereunder" refer to this Agreement as a whole, unless the context otherwise requires. "APPROVAL OF THE MEMBERS" means the approval of a majority in interest of the Management Members and the approval of PAULA; provided that at such time as PAULA becomes entitled to be allocated seventy five percent (75%) of the Profits pursuant to Article 4, Approval of the Members shall mean the approval of Members entitled to be allocated a majority of the Profits pursuant to Article 4. "BANKRUPTCY" means, with respect to any Person, a "Voluntary Bankruptcy" or an "Involuntary Bankruptcy." A "VOLUNTARY BANKRUPTCY" means, with respect to any Person (i) the inability of such Person generally to pay its debts as such debts become due, or an admission in writing by such Person of its inability to pay its debts generally or a general assignment by such Person for the benefit of creditors, or (ii) the filing of any petition or answer by such Person seeking to adjudicate itself as bankrupt or insolvent, or seeking for itself any liquidation, winding up, reorganization, arrangement, adjustment, protection, relief, or composition of such Person or its debts under any law relating to bankruptcy, insolvency or reorganization or relief of debtors, or seeking, consenting to, or acquiescing in the entry of an order for relief or the appointment of a receiver, trustee, custodian or other similar official for such Person or for any substantial part of its Property. An "INVOLUNTARY BANKRUPTCY" means, with respect to any Person, without the consent or acquiescence of such Person, the entering of an order for relief or approving a petition for relief or reorganization or any other petition seeking any reorganization, arrangement, composition, readjustment, liquidation, dissolution or other similar relief under any present or future bankruptcy, insolvency or similar statute, law or 5 regulation, or the filing of any such petition against such Person which petition shall not be dismissed within ninety (90) days, or without the consent or acquiescence of such Person, the entering of an order appointing a trustee, custodian, receiver or liquidator of such Person or of all or any substantial part of the Property of such Person which order shall not be dismissed within ninety (90) days. "BOARD OF MANAGERS" means the Board of Managers referred to in Section 6.1(a). "BUSINESS" means the business of managing the business of the Subsidiary holding all of the capital stock of the Subsidiary and matters incidental thereto. "BUSINESS DAY" means a day of the year other than a Saturday, a Sunday, or a banking holiday in the State of Washington or in Bermuda. "BUY-SELL NOTICE" shall have the meaning set forth in Section 11.5(b). "BUY-SELL PRICE" shall have the meaning set forth in Section 12.2(a) hereof. "CALENDAR QUARTER" means (i) the period commencing on the Effective Date and ending on March 31, 1999, (ii) any subsequent three-month period commencing on each of April 1, July 1, October 1 and January 1 and ending on the last date before the next such date, and (iii) the period commencing on the immediately preceding January 1, April 1, July 1, or October 1, as the case may be, and ending on the date on which all Property is distributed to the Members pursuant to Section 13 hereof. "CALENDAR YEAR" means (i) the period commencing on the Effective Date and ending on December 31, 1999, (ii) any subsequent twelve (12) month period commencing on January 1 and ending on December 31, (iii) any portion of the period described in clauses (i) or (ii) for which the Company is required to allocate Profits, Losses, and other items of Company income, gain, loss or deduction pursuant to Section 4 hereof or (iv) the period commencing on the immediately preceding January 1 and ending on the date on which all Property is distributed to the Members pursuant to Section 13 hereof. "CAPITAL ACCOUNT" means, with respect to any Member, the Capital Account maintained for such Member in accordance with the following provisions: (i) To each Member's Capital Account there shall be credited (A) such Member's Capital Contributions, (B) such Member's distributive share of Profits as provided for in Sections 4.1 and 4.3, and (C) the amount of any Company liabilities assumed by such Member or which are secured by any Property distributed to such Member; (ii) To each Member's Capital Account there shall be debited (A) the amount of money and the Gross Asset Value of any Property distributed to such Member pursuant to any provision of this Agreement, (B) such Member's distributive share of Losses as provided for in Section 4.2, and (C) the amount of any liabilities of such Member assumed by the Company or which are secured by any Property contributed by such Member to the Company; 6 (iii) In the event a Membership Interest is Transferred in accordance with the terms of this Agreement, the transferee shall succeed to the Capital Account of the transferor to the extent it relates to the Transferred Membership Interest; and (iv) In determining the amount of any liability for purposes of subparagraphs (i) and (ii) above there shall be taken into account Code Section 752(c) and any other applicable provisions of the Code and Regulations. The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with Regulations Section 1.704-1(b), and shall be interpreted and applied in a manner consistent with such Regulations. In the event the Members shall determine that it is prudent to modify the manner in which the Capital Accounts, or any debits or credits thereto (including, without limitation, debits or credits relating to liabilities which are secured by contributed or distributed property or which are assumed by the Company or any Members), are computed in order to comply with such Regulations, the Members may make such modification, PROVIDED that it is not likely to have a material effect on the amounts distributed to any Person pursuant to Section 13 hereof upon the dissolution of the Company. The Members also shall (i) make any adjustments that are necessary or appropriate to maintain equality between the Capital Accounts of the Members and the amount of capital reflected on the Company's balance sheet, as computed for book purposes, in accordance with Regulations Section 1.704-1(b)(2)(iv)(G), and (ii) make any appropriate modifications in the event unanticipated events might otherwise cause this Agreement not to comply with Regulations Section 1.704-1(b). "CAPITAL CONTRIBUTIONS" means, with respect to any Member, the amount of money contributed to the Company with respect to the Membership Interest in the Company held or purchased by such Member, including ADDITIONAL CAPITAL CONTRIBUTIONS. "CAUSE" means the occurrence or existence of any of the following with respect to an officer of the Company as determined by the Board of Managers: (i) a material breach by the officer of any of his obligations under the then effective employment agreement, if any, between the officer and the Company or, in the event that there is no employment agreement, a material breach of any duties and responsibilities assigned to the officer, PROVIDED, HOWEVER, that in each case Cause shall not be deemed to exist until the Company shall have given written notice specifying the claimed material breach and the officer fails to correct the claimed breach within thirty (30) days after the receipt of the applicable notice, PROVIDED, HOWEVER, that the failure by the Company to achieve performance targets shall not, in and of itself, constitute Cause; (ii) any misappropriation, embezzlement, intentional fraud or similar conduct involving the Company; (iii) the conviction or the plea of nolo contendere or the equivalent in respect of a felony or a crime involving moral turpitude; or (iv) the repeated non-prescription use of any controlled substance or the repeated use of alcohol or any other non-controlled substance which, in any case described in this clause (iv), the Board of Managers reasonably determines renders the officer unfit to serve in his capacity as an officer of the Company, except to the extent such determination would be reasonably related to illness, disability or medical emergency affecting the officer or a member of their immediate family. 7 "CERTIFICATE" means the certificate of formation filed with the Secretary of State of the State of Delaware pursuant to the Act to form the Company, as originally executed and amended, modified, supplemented or restated from time to time, as the context requires. "CERTIFICATE OF CANCELLATION" means a certificate filed in accordance with 6 Del. C. Section 18-203. "CHIEF EXECUTIVE OFFICER" means the Chief Executive Officer of the Company, including any interim Chief Executive Officer. "CLARK" means R. Steven Clark, an individual resident in the State of Washington. "CODE" means the United States Internal Revenue Code of 1986, as amended from time to time. "COMPANY" means the limited liability company formed pursuant to this Agreement and the Certificate and the limited liability company continuing the business of this Company in the event of dissolution of the Company as herein provided. "DEPARTING MEMBERS" shall have the meaning set forth in Section 6.6(f) hereof. "DEPRECIATION" means, for each Calendar Year, an amount equal to the depreciation, amortization, or other cost recovery deduction allowable with respect to an asset for such Calendar Year, except that if the Gross Asset Value of an asset differs from its adjusted basis for federal income tax purposes at the beginning of such Calendar Year, Depreciation shall be an amount which bears the same ratio to such beginning Gross Asset Value as the federal income tax depreciation, amortization, or other cost recovery deduction for such Calendar Year bears to such beginning adjusted tax basis; PROVIDED, HOWEVER, that if the adjusted basis for federal income tax purposes of an asset at the beginning of such Calendar Year is zero, Depreciation shall be determined with reference to such beginning Gross Asset Value using any reasonable method selected by the Members. "DISSOLUTION EVENT" shall have the meaning set forth in Section 13.1(a) hereof. "EFFECTIVE DATE" shall have the meaning set forth in Section 2.5 hereof. "ELECTION NOTICE" shall have the meaning set forth in Section 12.2(a) hereof. "EXECUTIVE COMMITTEE" means the Executive Committee of the Board of Managers. "FINAL DETERMINATION" means (i) a determination set forth in a binding settlement agreement between the Company and the Member alleged to have committed an ADVERSE ACT, which settlement agreement has been approved by the Board of Managers, or (ii) a final judicial determination, not subject to further appeal, by a court of competent jurisdiction. "FIRM OFFER" shall have the meaning set forth in Section 11.4(b) hereof. 8 "GAAP" means generally accepted accounting principles in effect in the United States of America from time to time. "GROSS APPRAISED VALUE" shall have the meaning set forth in Section 12.4(a) hereof. "GROSS ASSET VALUE" means with respect to any asset, the asset's adjusted basis for federal income tax purposes, except as follows: (i) The Gross Asset Values of all Company assets shall be adjusted to equal their respective gross fair market values (taking Code Section 7701(g) into account), as determined by the Board of Managers as of the following times: (A) the acquisition of a Membership Interest in the Company by any new or existing Member in exchange for more than a DE MINIMIS Capital Contribution; (B) the distribution by the Company to a Member of more than a DE MINIMIS amount of Company property as consideration for Membership Interest; (C) the liquidation of the Company within the meaning of Regulations Section 1.704-1(b)(2)(ii)(g)[; and (D) the happening of a Valuation Event,] PROVIDED that an adjustment described in clauses (A) and (B) of this paragraph shall be made only if the Board of Managers reasonably determines that such adjustment is necessary to reflect the relative economic interests of the Members in the Company; (ii) The Gross Asset Value of any item of Company assets distributed to any Member shall be adjusted to equal the gross fair market value (taking Code Section 7701(g) into account) of such asset on the date of distribution as determined by the Board of Managers; and (iii) The Gross Asset Values of Company assets shall be increased (or decreased) to reflect any adjustments to the adjusted basis of such assets pursuant to Code Section 734(b) or Code Section 743(b), but only to the extent that such adjustments are taken into account in determining Capital Accounts pursuant to Regulations Section 1.704-1(b)(2)(iv)(m) and subparagraph (vi) of the definition of "PROFITS" and "LOSSES"; PROVIDED, HOWEVER, that Gross Asset Values shall not be adjusted pursuant to this subparagraph (iii) to the extent that an adjustment pursuant to subparagraph (ii) is required in connection with a transaction that would otherwise result in an adjustment pursuant to this subparagraph (iii). If the Gross Asset Value of an asset has been determined or adjusted pursuant to subparagraph (ii) or (iii), such Gross Asset Value shall thereafter be adjusted by the Depreciation taken into account with respect to such asset, for purposes of computing Profits and Losses. "INVESTED CAPITAL" means with respect to each Member the Capital Contributions made by such Member, net of any liabilities assumed by the Company as a result of such Capital Contribution or to which any contributed Property is subject. "INVOLUNTARY BANKRUPTCY" has the meaning set forth in the definition of Bankruptcy. "LIQUIDATION PERIOD" has the meaning set forth in Section 13.6 hereof. "LIQUIDATOR" has the meaning set forth in Section 13.8(a) hereof. 9 "LOPIT" means Edward A. Lopit, an individual resident in the State of Washington. "LOSSES" has the meaning set forth in the definition of "Profits" and "Losses." "MANAGEMENT MEMBERS" means Clark, Lopit, Riggs and Snyder. "MANAGEMENTS' INCENTIVE INTEREST" shall be expressed as a percentage and calculated as set forth on EXHIBIT A and is intended to represent Management's interest in the Company derived from the performance of the Company and to be independent of Management's interest in the Company derived from its Proportion of Capital. "MANAGEMENTS' INITIAL INTEREST" shall be calculated as set forth on EXHIBIT A. "MANAGEMENTS' TOTAL INTEREST" has the meaning set forth in Section 4.3(b). "MANAGER" means any of the individuals elected to serve as a Manager pursuant to the terms of this Agreement and "MANAGERS" means all of such individuals. "MEMBER" means any Person (i) who is referred to as such on EXHIBIT B to this Agreement, or who has become a substituted Member pursuant to the terms of this Agreement and (ii) who has not ceased to be a Member. "MEMBERS" means all such Persons. "MEMBERSHIP INTEREST" means an ownership interest in the Company by a Member as reflected on EXHIBIT B, including any and all benefits to which the holder of such Membership Interest may be entitled as provided in this Agreement, together with all obligations of such Person to comply with the terms and provisions of this Agreement. "NET CASH FLOW" means the gross cash proceeds of the Company less the portion thereof used to pay or establish reserves for all Company expenses, debt payments, capital improvements, replacements, and contingencies, all as determined by the Board of Managers. "Net Cash Flow" shall not be reduced by depreciation, amortization, cost recovery deductions, or similar allowances, but shall be increased by any reductions of reserves previously established pursuant to the first sentence of this definition. "NET EQUITY" shall have the meaning set forth in Section 12.3 hereof. "NET EQUITY NOTICE" shall have the meaning set forth in Section 12.3 hereof. "OFFER NOTICE" shall have the meaning set forth in Section 11.4(b) hereof. "OFFER PERIOD" shall have the meaning set forth in Section 11.4(c) hereof. "OFFER PRICE" shall have the meaning set forth in Section 11.4(a) hereof. "OFFERED INTEREST" shall have the meaning set forth in Section 11.4 hereof. 10 "OFFEREES" shall have the meaning set forth in Section 11.4(b) hereof. "PAULA" means PAULA Financial, a Delaware corporation. "PAULA CHANGE OF CONTROL" means with respect to PAULA (i) any sale, transfer, or other conveyance, whether direct or indirect, of all or substantially all of the assets of PAULA, on a consolidated basis, in one transaction or a series of related transactions, (ii) any transaction as a result of which any "Person" or "group" (as such terms are used for the purposes of Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, whether or not applicable) obtains possession of fifty percent (50%) of the voting securities of PAULA by contract, family relationship, or otherwise, (iii) a reorganization, merger (not including a merger to effectuate a reincorporation of PAULA) or consolidation of PAULA as a result of which all the outstanding voting securities of PAULA are exchanged for or converted into cash, property and/or securities not issued by PAULA, or (iv) a point in time at which Jeffrey A. Snider and any one of James A. Nicholson, Andrew M. Slavitt or Bradley K. Serwin are no longer members of the PAULA Board of Directors; and the date of any such PAULA Change of Control shall be the closing date of the transaction(s) that constitute the PAULA Change of Control. "PERMITTED TRANSFER" has the meaning set forth in Section 11.2 hereof. "PERSON" means any individual, partnership, limited liability company, corporation, trust, estate, association, nominee, or other entity. "PROFITS" and "LOSSES" mean, for each Calendar Year, an amount equal to the Company's taxable income or loss for such Calendar Year, determined in accordance with Code Section 703(a) (for this purpose, all items of income, gain, loss, or deduction required to be stated separately pursuant to Code Section 703(a)(1) shall be included in taxable income or loss), with the following adjustments (without duplication): (i) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Profits or Losses pursuant to this definition of "Profits" and "Losses" shall be added to such taxable income or loss; (ii) Any expenditures of the Company described in Code Section 705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures pursuant to Regulations Section 1.704-1(b)(2)(iv)(i), and not otherwise taken into account in computing Profits or Losses pursuant to this definition of "Profits" and "Losses" shall be subtracted from such taxable income or loss; (iii) In the event the Gross Asset Value of any Company asset is adjusted pursuant to subparagraphs (i) or (ii) of the definition of Gross Asset Value, the amount of such adjustment shall be treated as an item of gain (if the adjustment increases the Gross Asset Value of the asset) or an item of loss (if the adjustment decreases the Gross Asset Value of the asset) from the disposition of such asset and shall be taken into account for purposes of computing Profits or Losses; 11 (iv) Gain or loss resulting from any disposition of Property with respect to which gain or loss is recognized for federal income tax purposes shall be computed by reference to the Gross Asset Value of the Property disposed of, notwithstanding that the adjusted tax basis of such Property differs from its Gross Asset Value; (v) In lieu of the depreciation, amortization, and other cost recovery deductions taken into account in computing such taxable income or loss, there shall be taken into account Depreciation for such Calendar Year, computed in accordance with the definition of Depreciation; and (vi) To the extent an adjustment to the adjusted tax basis of any Company asset pursuant to Code Section 734(b) is required, pursuant to Regulations Section 1.704-(b)(2)(iv)(m)(4), to be taken into account in determining Capital Accounts as a result of a distribution other than in liquidation of a Member's interest in the Company, the amount of such adjustment shall be treated as an item of gain (if the adjustment increases the basis of the asset) or loss (if the adjustment decreases such basis) from the disposition of such asset and shall be taken into account for purposes of computing Profits or Losses. "PROPERTY" means all real and personal property acquired by the Company, including cash, and any improvements thereto, and shall include both tangible and intangible property. "PROPORTION OF CAPITAL" means for each Member the ratio the numerator of which is such Member's Invested Capital and the denominator of which is the Invested Capital of all Members. "PURCHASE NOTICE" shall have the meaning set forth in Section 12.2(b) hereof. "PURCHASE OFFER" shall have the meaning set forth in Section 11.4(a) hereof. "PURCHASER" shall have the meaning set forth in Section 11.4(a) hereof. "PURCHASING MEMBERS" shall have the meaning set forth in Section 12.2(b) hereof. "RECIPIENT" shall have the meaning set forth in Section 11.5(c). "RECONSTITUTION PERIOD" has the meaning set forth in Section 13.1(b) hereof. "REGULATIONS" means the Income Tax Regulations, including temporary regulations, promulgated under the Code, as such regulations are amended from time to time. "RELATIONSHIP" has the meaning set forth in Section 6.6(f) hereof. "RIGGS" means Lawrence A. Riggs, an individual resident in the State of Washington. "SELLER" shall have the meaning set forth in Section 11.4 hereof. "SENDER" shall have the meaning set forth in Section 11.5(c) hereof. 12 "SECURITIES ACT" means the Securities Act of 1933, as amended. "SNYDER" means John R. Snyder, an individual resident in the State of Washington "SUBSIDIARY" means Altus Casualty Company Ltd., a Bermuda company. "TAX MATTERS MEMBER" has the meaning set forth in Section 9.4(a) hereof. "TRANSFER" means, as a noun, any voluntary or involuntary transfer, sale, pledge or hypothecation or other disposition and, as a verb, voluntarily or involuntarily to transfer, sell, pledge or hypothecate or otherwise dispose of. "VALUATION EVENT" means (i) any Dissolution Event; (ii) the sale of all or substantially all the assets of the Company; or (iii) any other event determined to be a Valuation Event by the Board of Managers. "VOLUNTARY BANKRUPTCY" has the meaning set forth in the definition of "Bankruptcy." "WHOLLY OWNED AFFILIATE" of any Person means an Affiliate of such Person (i) one hundred percent (100%) of the voting stock or beneficial ownership of which is owned directly by such Person, or by any Person who, directly or indirectly, owns one hundred percent (100%) of the voting stock or beneficial ownership of such Person, (ii) an Affiliate to such Person who, directly or indirectly, owns one hundred percent (100%) of the voting stock or beneficial ownership of such Person, and (iii) any Wholly Owned Affiliate of any Affiliate described in clause (i) or clause (ii). ARTICLE 2 THE COMPANY 2.1 FORMATION. The Members hereby agree to form the Company as a limited liability company under and pursuant to the provisions of the Act and upon the terms and conditions set forth in this Agreement. The fact that the Certificate is on file in the office of the Secretary of State, State of Delaware, shall constitute notice that the Company is a limited liability company. Simultaneously with the execution of this Agreement and the formation of the Company, each of the Members shall be admitted as members of the Company. The rights and liabilities of the Members shall be as provided under the Act, the Certificate and this Agreement. 2.2 NAME. The name of the Company shall be Altus Insurance Holdings, LLC and all business of the Company shall be conducted in such name. The Managers may change the name of the Company upon ten (10) Business Days notice to the Members. 2.3 PURPOSE; POWERS. (a) The purposes of the Company are (i) to operate the Business, (ii) to engage in any and all activities related or incidental to the purposes set forth in clause (i). The purposes of the Company may be supplemented or changed by Approval of the Members. 13 (b) The Company has the power to do any and all acts necessary, appropriate, proper, advisable, incidental or convenient to or in furtherance of the purposes of the Company set forth in Section 2.3 hereof and has, without limitation, any and all powers that may be exercised on behalf of the Company by the Managers pursuant to Article 6 hereof. 2.4 PRINCIPAL PLACE OF BUSINESS. The principal place of business of the Company shall be at Bellevue, Washington or at such other location determined by the Board of Managers. The Board of Managers may change the principal place of business of the Company to any other place within or without the State of Delaware upon ten (10) Business Days notice to the Members. The registered office of the Company in the State of Delaware initially is located at National Registered Agents, Inc., 9 East Loockerman Street, Dover, County of Kent, DE 19901. 2.5 TERM. The term of the Company shall commence from the date of filing the Certificate in the office of the Secretary of State of the State of Delaware in accordance with the Act (the "EFFECTIVE DATE") and shall continue until the winding up and liquidation of the Company and its business is completed following a Dissolution Event, as provided in Section 13 hereof. 2.6 FILINGS; AGENT FOR SERVICE OF PROCESS. (a) The Board of Managers are hereby authorized to and shall cause the Certificate to be filed in the office of the Secretary of State of the State of Delaware in accordance with the Act. The Managers shall take any and all other actions reasonably necessary to perfect and maintain the status of the Company as a limited liability company under the laws of the State of Delaware, including the preparation and filing of such amendments to the Certificate and such other assumed name certificates, documents, instruments and publications as may be required by law, including, without limitation, action to reflect: (i) a change in the Company name; (ii) a correction of false or erroneous statements in the Certificate or the desire of the Members to make a change in any statement therein in order that it shall accurately represent the agreement among the Members; or (iii) a change in the time for dissolution of the Company as stated in the Certificate and in this Agreement. (b) The Members and the Board of Managers shall execute and cause to be filed original or amended certificates and shall take any and all other actions as may be reasonably necessary to perfect and maintain the status of the Company as a limited liability company or similar type of entity under the laws of any other jurisdictions in which the Company engages in business. 14 (c) The registered agent for service of process on the Company in the State of Delaware shall be National Registered Agents, Inc. or any successor as appointed by the Members in accordance with the Act. (d) Upon the dissolution and completion of the winding up and liquidation of the Company in accordance with Section 13, the Board of Managers shall promptly cause to be executed and cause to be filed a certificate of cancellation in accordance with the Act and the laws of any other jurisdictions in which the Board of Managers deem such filing necessary or advisable. 2.7 TITLE TO PROPERTY. All Property owned by the Company shall be owned by the Company as an entity and no Member shall have any ownership interest in such Property in such Member's individual name, and each Member's interest in the Company shall be personal property for all purposes. At all times after the Effective Date, the Company shall hold title to all of its Property in the name of the Company and not in the name of any Member. 2.8 PAYMENTS OF INDIVIDUAL OBLIGATIONS. The Company's credit and assets shall be used solely for the benefit of the Company, and no asset of the Company shall be Transferred or encumbered for, or in payment of, any individual obligation of any Member. ARTICLE 3 MEMBERS' CAPITAL CONTRIBUTIONS 3.1 ORIGINAL CAPITAL CONTRIBUTIONS. Each Member shall forthwith deliver to the Company the money, set forth beside such Member's name on EXHIBIT B. 3.2 INTEREST ON CAPITAL CONTRIBUTIONS. No Member shall be entitled to receive any interest on such Member's Capital Contribution. 3.3 OPTIONAL ADDITIONAL CAPITAL CONTRIBUTIONS. (a) PAULA shall have the option to make each of the following additional capital contributions: (i) $2 million at any time between January 1, 2000 and December 31, 2000; (ii) $5 million at any time between January 1, 2001 and December 31, 2001; (iii) $5 million at any time between January 1, 2002 and December 31, 2002; (iv) $5 million at any time between January 1, 2003 and December 31, 2003; (v) $2.5 million at any time between January 1, 2004 and December 31, 2004; and each such option shall be distinct and may be exercised at any time prior to the expiration time noted by delivering a certified check for its Additional Capital Contribution and a written notice of exercise to the principal place of business of the Company. The Members acknowledge their intent that during the course of the year during which a foregoing option may be exercised, PAULA will not be expected to consider exercising such option unless and until the Company's operating needs indicate that the Additional Capital Contribution is required by the Company. 15 If agreed by PAULA and the Company, the exercise dates of the foregoing options may be accelerated so that PAULA may provide the Company with an Additional Capital Contribution on an as needed basis. In the event that PAULA does not exercise a particular option at a time that the Board of Managers determines that the Company needs to raise the additional funds which would have been provided by PAULA's exercise of such option, the Members each agree to cooperate fully with the Company's efforts to raise such funds from other sources. Further, the Members acknowledge that in such event no Member has any right of first refusal to match any third party investment proposal. (b) Each of Clark, Lopit, Riggs and Snyder shall have the option to make an Additional Capital Contribution of $10,000 for each $1 million Capital Contribution that PAULA makes pursuant to an option referred to in Section 3.3(a). The Company shall provide each of Clark, Lopit, Riggs and Snyder with notice of any Capital Contribution made by PAULA pursuant to Section 3.3(a) and they shall each have a period of 30 days from the date such notice is sent to them to exercise the option granted to each of them pursuant to this Section 3.3(b) by delivering a certified check for their Additional Capital Contribution and a written notice of exercise to the principal place of business of the Company. In the event that any or all of Clark, Lopit, Riggs or Snyder do not exercise a particular option at a time that the Board of Managers determines that the Company needs to raise the additional funds which would have been provided by the exercise of such respective options, the Members each agree to cooperate fully with the Company's efforts to raise such funds from other sources. Further, the Members acknowledge that in such event no Member has any right of first refusal to match any third party investment proposal. (c) Provided that the Management Member in question is not in default of any terms or conditions of this Agreement, PAULA agrees to loan to each Management Member a sum equal to 80% of any amount that the Management Member agrees to contribute pursuant to Section 3.3(b). Such loan shall (i) have a ten-year term with no principal payments due until maturity; (ii) shall provide for the acceleration of the maturity of the principal amount thereof to the earlier of (A) the closing date of any Dissolution Event or (B) the closing of any sale of the Membership Interest purchased by the Management Member borrower in part with the funds provided by the applicable loan; (iii) bear market rates of interest for corporate ten-year term loans which interest shall be payable quarterly in arrears; (iv) secured by the Membership Interest held by the Member in form and substance satisfactory to PAULA; (v) be a personal obligation of the Member with full recourse to other assets of the Member; (vi) be documented and executed in form and substance satisfactory to PAULA; (vii) be subject to the irrevocable exercise by such Management Member of the option in Section 3.3(b) of this Agreement to which the loan relates; and (viii) be available to a Management Member on written notice on the business day following satisfaction of the foregoing terms and conditions: 3.4 WITHDRAWAL OF CAPITAL. Except in connection with proceedings to dissolve the Company in accordance with the procedures set forth in Section 13 of this Agreement, no Member may withdraw any portion of such Member's Capital Contribution, or any portion of such Member's Capital Account, from the Company without the approval of the Board of Managers. 16 3.5 LOANS BY MEMBERS. A Member may take a loan or advance money or property to or on behalf of the Company, only upon such terms that have received the Approval of the Members. Such loan or advance shall not increase the lending Member's Capital Account, entitle the lending Member to any greater share of Company distributions or entitle or subject such lending Member to any greater proportion of Company Profits or Losses. The amount of such loans or advances shall be a debt owed by the Company to the lending Member, and any interest paid to the lending Member shall be charged as any other expense against income of the Company. ARTICLE 4 ALLOCATIONS 4.1 PROFITS. Subject to adjustment pursuant to Section 4.3, Profits for any Calendar Year shall be allocated to the Members as follows: (i) first, to the Members up to and in proportion to Losses allocated to the Members pursuant to clause 4.2(ii) for all prior periods; and (ii) second, to the Members as set out on EXHIBIT B. 4.2 LOSSES. Losses for any Calendar Year shall be allocated to the Members as follows: (i) first, to the Members up to and in proportion to Profits allocated to the Members pursuant to clause 4.1(ii) for all prior periods; and (ii) second, to the Members in proportion to their Capital Account balances in effect immediately before any allocations under this clause 4.2(ii). 4.3 ADJUSTMENTS. (a) For each $960,000 Additional Capital Contribution that PAULA makes pursuant to the exercise of the options granted in Section 3.3(a) of this Agreement in excess of any Additional Capital Contributions made by the Management Members pursuant to Section 3.3(b), the allocation of Profits set out on EXHIBIT B shall be adjusted such that PAULA's allocation of Profits shall be increased by an aggregate of 3.104% and each Management Member's allocation of Profits shall be decreased by 0.776%. In the case of Additional Capital Contributions by PAULA in an amount in excess of that made by the Management Members that is less than or greater than $960,000 the adjustments referred to in this Section 4.3(a) shall be decreased or increased proportionally. The Members acknowledge that the following example represents the intended operation of the foregoing adjustment provision: if PAULA exercises the option referred to in Section 3.3(a)(i) and makes an additional capital contribution of $2 million and each of the Management Members exercise their corresponding option in Section 3.3(b) and the Management Members collectively make an aggregate Additional Capital Contribution of $80,000, PAULA's allocation of Profits shall each be increased by 6.208% to a total of 27.416% 17 and each Management Member's allocation of Profits shall be decreased by 1.552% to a total of 18.146%. (b) Upon the happening of a Valuation Event, the Profits for the current Calendar Year shall be allocated as follows: (i) First, the Management Members shall be allocated an amount of Profit equal to: (A) the product of aggregate Net Equity, measured as of the date of the Valuation Event, and Management's Incentive Interest, plus (B) Losses allocated to the Management Members pursuant to clause 4.2(ii) for all prior Calendar Years, minus (C) Profits allocated to the Management Members pursuant to clause 4.1(ii) for all prior Calendar Years (this aggregate amount of Profit to be allocated among the Management Members equally); and (ii) Second, any remaining Profits shall be allocated to the Members on the basis of each Member's Proportion of Capital. The ratio, the numerator of which is the sum of each Management Members Capital Account following the allocations provided for in this Section 4.3(b), and the denominator of which is the sum of each Members Capital Account following the allocations provided for in this Section 4.3(b) is hereinafter referred to as "MANAGEMENTS' TOTAL INTEREST." (c) Following the happening of a Valuation Event, the allocation of Profits shall henceforth be adjusted such that: (i) PAULA's allocation shall be equal to the percentage equal to one hundred percent (100%) minus Managements' Total Interest; and (ii) each Management Member's allocation shall be equal to the percentage equal to the product of (A) .25 and (B) Managements' Total Interest. (d) In the event that an officer who was a Management Member was terminated for Cause or voluntarily terminated his employment with the Company during the periods set out below, such Member's allocation of Profits, determined following the application of the adjustments provided for in this Section 4.3 shall be reduced by the following proportion of the amounts allocated to such Member in relation to such Members share of Managements' Incentive Interest pursuant to clause 4.3(b)(i).
Reduction of Member's Managements' Date of Termination Incentive Interest ------------------- ---------------------------------- (i) Prior to January 1, 2000 100% (ii) After December 31, 1999 and 80% prior to January 1, 2001 (iii) After December 31, 2000 and 60% prior to January 1, 2002 (iv) After December 31, 2001 and 40%
18 prior to January 1, 2003 (v) After December 31, 2002 and 20% prior to January 1, 2004 (vi) After January 1, 2004 No adjustment
provided that no adjustments shall be made pursuant to this Section 4.3(d) in the event that the officer in question was terminated without Cause, died, was permanently disabled or retired at the Company's regular retirement age. The unallocated proportion of Profits resulting from the operation of the adjustments provided for in this Section 4.3(d) shall be allocated to the Members not subject to the adjustments provided for in this Section 4.3(d) on a basis proportional to the then existing allocation of Profits specified in Section 4.3(c). (e) In the event that any Dissolution Event referred in Section 13.1(a)(iv) occurs, each Management Members allocation of Profits shall be reduced to such Member's Proportion of Capital and PAULA's allocation of Profits shall be increased by the same aggregate amount. (f) The adjustments provided for in this Section 4.3 are to be cumulative and shall apply to successive events resulting in any adjustment pursuant to this Section 4.3. (g) The examples set out on EXHIBIT C represent the intended operation of the adjustments provided for by Section 4.3(b) and Section 4.3(d). ARTICLE 5 DISTRIBUTIONS 5.1 NET CASH FLOW. Except as otherwise provided in Article 13 hereof, Net Cash Flow, if any, shall be distributed to the Members in the proportions that Profits are allocated to Members pursuant to Article 4 at such times as approved by the Board of Managers. 5.2 MINIMUM DISTRIBUTIONS. Notwithstanding Section 5.1 hereof, prior to April 15th (or March 15th in the case of a Member that is a Subchapter C Corporation) following the Calendar Year to which the taxes contemplated by this Section 5.2 relate, the Company shall distribute to each Member an amount of Net Cash Flow equal to the product of the highest United States federal tax rate for individuals and the Profits and other items of Company income and gains allocated to such Member for the Calendar Year pursuant to Section 4 hereof. The aggregate amounts distributed to a Member under this Section 5.2 will reduce the amounts otherwise distributable to the Member under Section 5.1. 5.3 AMOUNTS WITHHELD. All amounts withheld pursuant to the Code or any provision of any state, local, or foreign tax law with respect to any payment, distribution, or allocation to the Company or the Members shall be treated as amounts paid or distributed, as the case may be, to the Members with respect to which such amount was withheld pursuant to this Section 5.3 for all purposes under this Agreement. The Company is authorized to withhold from payments and distributions, or with respect to allocations to the Members, and to pay over to any federal, 19 state and local government or any foreign government, any amounts required to be so withheld pursuant to the Code or any provisions of any other federal, state or local law or any foreign law, and shall allocate any such amounts to the Members with respect to which such amount was withheld. 5.4 LIMITATIONS ON DISTRIBUTIONS. (a) The Company shall make no distributions to the Members except as provided in this Section 5 and Article 13 hereof. (b) A Member may not receive a distribution from the Company to the extent that, after giving effect to the distribution, all liabilities of the Company, other than liabilities to Members on account of their Capital Contributions, would exceed the lower of the book value or the fair value of the Company's assets. ARTICLE 6 MANAGEMENT 6.1 MANAGERS. (a) The management of the Company shall be vested in a Board of eight Managers, seven of whom will be voting and one of whom will be non-voting. Managers may, but need not be, Members of the Company. The Management Members shall have the right to appoint four voting Managers. PAULA shall have the right to appoint three voting Managers and one non-voting Manager. The non-voting Manager shall have all of the rights and responsibilities of a voting Manager except that the non-voting Manager shall not be entitled to vote at meetings of or proceedings of the Board of Managers. (b) The initial Managers of the Company shall be Clark, Lopit, Riggs, Snyder, Jeffrey A. Snider, Andrew M. Slavitt, James A. Nicholson and Bradley K. Serwin. Bradley K. Serwin shall serve as the non-voting Manager. Clark, Lopit, Riggs and Snyder shall be considered nominees of the Management Members on the board of Managers. Jeffrey A. Snider, Andrew M. Slavitt, James A. Nicholson and Bradley K. Serwin shall be considered nominees of PAULA on the Board of Managers. In the event that the Management Members cease to hold the right to be allocated a majority of Profits pursuant to Article 4, then: (i) the Management Members shall then be entitled to appoint three voting Managers and one non-voting Manager, (ii) PAULA shall be entitled to appoint four voting Managers, and (iii) the non-voting Manager appointed by PAULA shall be entitled to voting rights as a Manager without the need for any further action on the seventh day following such event; and (iv) the Management Members shall notify the Company and PAULA in writing within seven days of such event which of their nominees to the Board of Managers will serve as a non-voting Manager and failing which the nominee Manager of the Management Members that is youngest in age shall become the non-voting Manager. (c) The Board of Managers shall have the following Committees and the initial members of such committees shall be as follows: 20
Committee Members ------------------------- --------------------------------------- (i) Executive: Clark and Jeffrey A. Snider; (ii) Audit: Snyder and James A. Nicholson; (iii) Compensation: Jeffrey A. Snider, Andrew M. Slavitt and Clark (ex officio basis); and (iv) Investment/M&A/Capital Riggs, Snyder, Jeffrey A. Snider and Planning: James A. Nicholson;
and such Committees will continue to exist and perform the delegated functions so long as this Agreement continues in force or until they are changed in accordance with the terms hereof. (d) Committees of the Board of Managers shall have the responsibilities set out below and such other responsibilities as may be determined by the Board of Managers from time to time: (i) the Audit Committee shall recommend to the Board of Managers whether the financial statements of the Company and the Subsidiary are to be reviewed or audited and which firm of accountants is to be engaged as the Company's auditor or accounting advisors and shall monitor compliance with relevant standards and policies; (ii) The Investment/M&A/Capital Planning Committee will recommend standards to the Board of Managers to be utilized by the Company's management to evaluate potential transactions prior to bringing any such transactions forward to the Board of Managers for approval and; (iii) the Compensation Committee will review and recommend to the Board of Managers compensation packages for the officers of the Company; (e) A Manager shall serve as such until the earliest of (i) the resignation of such Manager for any reason, or (ii) the removal of such Manager from that position by the Members so entitled. (f) Each Manager shall perform his duties as a Manager in good faith, in a manner that is in the best interests of the Company and the Members, and with such care as an ordinarily prudent person in a like position would use under similar circumstances. A Manager shall not be liable to the Company or the Members for monetary damages for breach of any duty as a Manager unless it is demonstrated by way of a final judicial determination, not subject to further appeal, by a court of competent jurisdiction that such breach of duty involved fraud, intentional misconduct, gross negligence or a knowing violation of any law or regulation material to the breach of duty. 21 (g) A Manager shall not be liable under a judgment, decree or order of court, or in any other manner, for a debt, obligation or liability of the Company. 6.2 POWERS OF BOARD OF MANAGERS. (a) Except as otherwise provided in this Agreement, the Board of Managers shall have the powers to control and manage the Business and affairs of the Company and may exercise all powers of the Company and take all actions that the Board of Managers deem necessary, useful, or appropriate for the management and conduct of the Business, provided that the power of the Board of Managers shall in all cases be subject to approval by the Members as required by statute, the Certificate or this Agreement. (b) The Board of Managers shall act by majority consent, and no individual Manager may act on behalf of the Company without the approval of the Board of Managers by majority consent. (c) The Board of Managers shall have the power to delegate authority to officers, employees, agents, and representatives of the Company as they may from time to time deem appropriate. Any delegation of authority to take any action must be approved in the same manner as would be required for the Board of Managers to approve such action directly. (d) The Board of Managers may establish policies and guidelines for the hiring of employees to permit the Company to act as an operating company with respect to its Business. The Board of Managers may adopt appropriate management incentive plans and employee benefit plans. (e) The Board of Managers shall have the power to approve any non-typical excess of loss reinsurance treaty arrangements. 6.3 DUTIES AND OBLIGATIONS OF THE MANAGERS. (a) The Board of Managers shall cause the Company to conduct its Business and operations separate and apart from that of any Member, Manager, or any Affiliate of any Member or Manager, including, without limitation, (i) segregating Company assets and not allowing funds or other assets of the Company to be commingled with the funds or other assets of, held by, or registered in the name of, any Member, Manager, or any Affiliate of any Member or Manager, (ii) maintaining books and financial records of the Company separate from the books and financial records of any Member, Manager, or any Affiliate of any Member or Manager, and observing all Company procedures and formalities, including, without limitation, maintaining minutes of Company meetings and acting on behalf of the Company when required only pursuant to due authorization of the Members, (iii) causing the Company to pay its liabilities from assets of the Company, and (iv) causing the Company to conduct its dealings with third parties in its own name and as a separate and independent entity. (b) The Board of Managers shall take all actions that may be necessary or appropriate (i) for the continuation of the Company's valid existence as a limited liability company under the 22 laws of the State of Delaware and of each other jurisdiction in which such existence is necessary to protect the limited liability of the Members or to enable the Company to conduct the Business and (ii) for the accomplishment of the Company's purposes, including the acquisition, development, maintenance, preservation, and operation of the Business or Property in accordance with the provisions of this Agreement and applicable laws and regulations. 6.4 REIMBURSEMENTS. The Company shall reimburse the Members and Managers for all reasonable expenses incurred and paid by any of them in the organization of the Company and in the conduct of the Company's business. Such expenses shall not include any expenses incurred in connection with a Member's or Manager's exercise of its rights as a Member or a Manager apart from the authorized conduct of the Company's business. Such reimbursement shall be treated as expenses of the Company and shall not be deemed to constitute distributions to any Member of Profit, Loss or capital of the Company. 6.5 INDEMNIFICATION. (a) Unless otherwise provided in Section 6.5(d) hereof, the Company, its receiver, or its trustee (in the case of its receiver or trustee, to the extent of Company Property) shall indemnify, save harmless, and pay all judgments and claims against any Manager or officer of the Company relating to any liability or damage incurred by such Manager or officer by reason of any act performed or omitted to be performed by any Manager or officer of the Company in connection with the Business, including reasonable attorneys' fees incurred by the Manager or officer in connection with the defense of any action based on any such act or omission, which attorneys' fees may be paid as incurred. (b) Unless otherwise provided in Section 6.5(d) hereof, in the event of any action by a Member against any Manager or officer of the Company, including a Company derivative suit, the Company shall indemnify, save harmless, and pay all expenses of such Manager or officer, including reasonable attorneys' fees incurred in the defense of such action. (c) Unless otherwise provided in Section 6.5(d) hereof, the Company shall indemnify, save harmless, and pay all expenses, costs, or liabilities of any Manager or officer of the Company, if for the benefit of the Company and in accordance with this Agreement said Manager or officer makes any deposit or makes any other similar payment of personal funds or assumes any personal obligation in connection with any Property proposed to be acquired by the Company and suffers any personal financial loss as the result of such action. (d) Notwithstanding the provisions of Sections 6.5(a), 6.5(b) and 6.5(c) above, no Manager or officer of the Company shall be indemnified or held harmless pursuant to this Section 6.5 if it is demonstrated by way of a final judicial determination, not subject to further appeal, by a court of competent jurisdiction that the fraud, intentional misconduct, gross negligence or knowing violation of any law or regulation by such Manager or officer of the Company contributed materially to such liability or claim. Any reduction in the indemnification otherwise provided for in this Section 6.5 by virtue of the operation of this Section 6.5(d) shall be 23 made in proportion to the contribution of the fraud, intentional misconduct, gross misconduct or knowing violation of law or regulation to the aggregate liability or damage in question. 6.6 OFFICERS. (a) The officers of the Company, the holders of such offices and the duties associated with such offices shall be determined by the Board of Managers of the Company from time to time. Until the Board of Managers of the Company otherwise determines the offices of the Company, the holders of such offices and the duties associated with such offices shall be as provided in this Section 6.6. (b) The initial offices of the Company shall include a Chief Executive Officer, President, Executive Vice President, Senior Vice President - Operations, Chief Financial Officer, Treasurer and Corporate Secretary. Clark shall be the initial President and Chief Executive Officer of the Company. Snyder shall be the initial Chief Financial Officer and Treasurer of the Company. Riggs shall be the initial Executive Vice President of the Company. Lopit shall be the initial Senior Vice President - Operations of the Company. Bradley K. Serwin shall be the initial Secretary of the Company. Only the Board of Managers can remove or otherwise change such officers. (c) The officers of the Company shall be responsible for the day-to-day operations of the Company including without limitation matters related to: (i) underwriting, (ii) claims, (iii) distribution force, (iv) investments within investment guidelines approved by the Board of Managers, (v) hiring and termination of employees subject to any guidelines approved by the Board of Managers; (vi) reinsurance arrangements within guidelines approved by the Board of Managers; (vii) quota-share reinsurance arrangements with PAULA; (viii) the submission of a monthly financial report to the Board of Managers consisting of a statement of profit and loss, balance sheet and managements' discussion and analysis; and (ix) the preparation and submission to the Board of Managers for approval of an annual business plan relating to the budget, planned acquisitions and capital expenditures. (d) The Company will purchase life insurance in respect of each of the officers of the Company on terms determined by the Executive Committee of the Board of Managers. Each Management Member represents and warrants that to the best of their knowledge any such life insurance can be obtained by the Company on commercially reasonable terms. (e) At such time as PAULA acquires the right to be allocated a majority of the Profits pursuant to Article 4, PAULA and each Management Member who is an officer of the Company shall commence good faith negotiations related to a separation agreement that will govern the relationship between such officer and the Company in the event that such officer ceases to be an employee of the Company. Subject to the terms of any such separation agreement, in the event that a Dissolution Event specified in Section 13.1(a)(iv)(A) of this Agreement takes place, the Company shall pay each Management Member who ceases to be an officer of the Company severance of not less than an amount equal to ninety days pay. In the event that a Dissolution Event specified in Section 13.1(a)(iv)(B) or (C) of this Agreement takes place, the Company 24 may, but shall not be obligated to, pay to each Management Member who ceases to be an officer of the Company severance equal to ninety days pay. (f) In the event that: (i) a majority of the Management Members ("DEPARTING MEMBERS") cease to be officers of the Company and become employees of, consultants to or enter into a similar relationship (collectively a "RELATIONSHIP") with any entity or entities engaged in the casualty insurance business; and (ii) customers of the Company who were customers of the Company when any such Departing Members were officers of the Company do not renew any insurance policies with the Company and place such insurance with an entity that a Departing Member has a Relationship with within thirteen months of the date that the Departing Member in question ceased to be an officer of the Company, then the Departing Members on a joint and several basis shall pay to the Company compensation for the lost business determined through a procedure to be agreed upon within 90 days of the date that the Department Members ceased to be officers of the Company. Such procedure will be agreed upon by one representative of the Departing Members and one representative of the Company. In the event that such persons cannot agree on a procedure during the 90 day period, they must agree on a third person or entity which will make the procedural determination on behalf of the parties within the 90 day period. The Departing Members on the one hand and the Company on the other will split the cost of any such necessary third party. Such third party will be asked to render its determination within 30 days after his, her or its appointment. 6.7. MISCELLANEOUS. (a) The parties acknowledge that they each contemplate and expect that: (i) the Subsidiary and PAULA Insurance Company, an Affiliate of PAULA, will enter into a quota - share reinsurance agreement following the Effective Date on commercially reasonable terms for the purpose of providing underwriting capacity and surplus to the Subsidiary, and (ii) the Subsidiary will operate at approximately a 2.5:1 net writings to surplus ratio. Any such agreement approved by the Board of Managers shall be deemed to have received the Approval of the Members. (b) Each of the Management Members and PAULA shall have the right to request that the Executive Committee of the Board of Managers review any of the terms of this Agreement if such Member believes that such term(s) are materially unfair to the requesting Member. In order to exercise such right a Member shall submit a written request for review to each member of the Executive Committee specifying the terms that such Member believes to be unfair and the reasons related thereto. The Executive Committee shall respond in writing to all Members and to the Board of Managers within 30 days of receipt of such written request. The response of the Executive Committee shall be non-binding but all Members and the Board of 25 Managers shall make reasonable best efforts to consider such response including the commencement of good faith negotiations to implement the recommendations contained in such response. (c) It is the intention of the Members that the Subsidiary will be continued or reincorporated in a United States jurisdiction as soon as practicable following the Effective Date. (d) To the extent practicable, the board of directors of the Subsidiary shall be organized in the same fashion as the Board of Managers, including without limitation the membership thereof. ARTICLE 7 ROLE OF MEMBERS 7.1 RIGHTS OR POWERS. Except as specifically set forth herein, the Members as such shall not have any right or power to take part in the management or control of the Company or its business and affairs or to act for or bind the Company in any way. Notwithstanding the foregoing, the Members have all the rights and powers specifically set forth in this Agreement and, to the extent not inconsistent with this Agreement, in the Act. 7.2 VOTING RIGHTS. (a) No Member has any voting right except with respect to those matters specifically reserved for a Member vote which are set forth in this Agreement and as required in the Act. (b) Unless a provision of this Agreement specifically provides otherwise, matters that may or must be approved by the Members pursuant to this Agreement will be approved upon a vote in favor that constitutes the Approval of the Members. 7.3 MEETINGS OF THE MEMBERS. (a) Meetings of the Members may be called upon the written request of any Member. The call shall state the location of the meeting and the nature of the business to be transacted. Notice of any such meeting shall be given to all Members not less than seven (7) Business Days nor more than thirty (30) days prior to the date of such meeting. Members may vote in person, by proxy or by telephone at such meeting and may waive advance notice of such meeting. Whenever the vote or consent of Members (whether Extraordinary or otherwise) is permitted or required under the Agreement, such vote or consent may be given at a meeting of the Members or may be given in accordance with the procedure prescribed in this Section 7.3. (b) Each Member may authorize any Person or Persons to act for it by proxy on all matters in which a Member is entitled to participate, including waiving notice of any meeting, or voting or participating at a meeting. Every proxy must be signed by the Member or its attorney-in-fact. No proxy shall be valid after the expiration of eleven (11) months from the date thereof unless otherwise provided in the proxy. Every proxy shall be revocable at the pleasure of the Member executing it. 26 (c) Notwithstanding this Section 7.3, the Company may take any action contemplated under this Agreement as approved by the Members in writing, or by telephone or facsimile, if such telephone conversation or facsimile is followed by a written summary of the telephone conversation or facsimile communication sent by registered or certified mail, postage and charges prepaid, addressed as described in Section 15.1 hereof, or to such other address as such Person may from time to time specify by notice to the Members and Managers. 7.4 REQUIRED MEMBER CONSENTS. (a) Notwithstanding any other provision of this Agreement, no action may be taken by the Company (whether by the Board of Managers, or otherwise) in connection with any of the following matters without the Approval of the Members: (i) Any activity that is not consistent with the purposes of the Company as set forth in Section 2.3 hereof; (ii) Any act in contravention of this Agreement; (iii) Confession of a judgment against the Company (other than in the ordinary course of business); (iv) A material change in the nature of the Business; (v) a material change in the manner in which the Business is conducted, including without limitation any amendment to the Memorandum of Association or By-Laws of the Subsidiary or any change in the composition of the Board of Directors of the Subsidiary; (vi) Any sale of assets of the Company not in the ordinary course of business or involving total consideration in excess of $100,000; (vii) Issuance of additional Membership Interests or any other equity or any equity-based security by the Company other than any adjustment to Capital Accounts and allocations of Profits, Losses or Net Cash Flow contained in this Agreement; (viii) Any capital expenditures in excess of $250,000; (ix) Any transaction in excess of $10,000 between the Company and any Member, Manager, or Affiliate thereof; or (x) Any acquisition by the Company not in the ordinary course of business or involving total consideration in excess of $500,000. (xi) Any transaction by the Company involving the incurrence of any indebtedness for borrowed money not in the ordinary course of business or in excess of $250,000 or any guaranty or other contingent liability of the Company in respect of any obligation of any third party (other than in the ordinary course of business); 27 (xii) the payment of any distribution to the Members; (xiii) Dissolution, liquidation, or winding up of the Company; or (xiv) Merger or consolidation of the Company, or sale of the Company or all or substantially of all of its assets; provided however that such transaction will not be consummated until after the expiration of the Management Members' rights under Section 11.4(g) below. 7.5 WITHDRAWAL/RESIGNATION. Except as otherwise provided in Articles 5 and 13 hereof, no Member shall demand or receive a return on or of such Member's Capital Contributions or withdraw from the Company without the consent of all Members. Under circumstances requiring a return of any Capital Contributions, no Member has the right to receive Property other than cash except as may be specifically provided herein. 7.6 MEMBER COMPENSATION. No Member shall receive any interest, salary, or drawing with respect to its Capital Contributions or its Capital Account or for services rendered on behalf of the Company, or otherwise, in its capacity as a Member, except as otherwise provided in this Agreement. 7.7 MEMBERS LIABILITY. No Member shall be liable under a judgment, decree or order of a court, or in any other manner for the debts or any other obligations or liabilities of the Company. A Member shall be liable only to make its Capital Contributions and shall not be required to restore a deficit balance in its Capital Account or to lend any funds to the Company or, after its Capital Contributions have been made, to make any additional contributions, assessments, or payments to the Company, provided that a Member may be required to repay distributions made to it as provided in Section 18-607 of the Act. The Managers shall not have any personal liability for the repayment of any Capital Contributions of any Member. 7.8 PARTITION. While the Company remains in effect or is continued, each Member agrees and waives its rights to have any Company Property partitioned, or to file a complaint or to institute any suit, action or proceeding at law or in equity to have any Company Property partitioned, and each Member, on behalf of itself, its successors and its assigns hereby waives any such right. 7.9 CONFIDENTIALITY. Except as contemplated hereby or required by a court of competent authority, each Member shall keep confidential and shall not disclose to others and shall use its reasonable efforts to prevent such Member's Affiliates, and any present or former employees, agents, and representatives of such Member or such Member's Affiliates from disclosing to others without the prior written consent of all Members any information that (i) pertains to this Agreement, any negotiations pertaining thereto, any of the transactions contemplated hereby, 28 or the Business of the Company, or (ii) pertains to confidential or proprietary information of any Member or the Company or that any Member has labeled in writing as confidential or proprietary. No Member shall use, and each Member shall use its best efforts to prevent any Affiliate of such Member from using, any information that (i) pertains to this Agreement, any negotiations pertaining hereto, any of the transactions contemplated hereby, or the Business of the Company, or (ii) pertains to the confidential or proprietary information of any Member or the Company or which any Member has labeled in writing as confidential or proprietary, except in connection with the transactions contemplated hereby. The term "confidential information" is used in this Section 7.9 to describe information that is confidential, non-public, or proprietary in nature, was provided to such Member or its representatives by the Company, any other Member, or such Persons' agents, representatives and employees, and relates either directly, or indirectly to the Company or the Business. Information which (i) is available, or becomes available, to the public through no fault or action by such Member, its agents, representatives or employees or (ii) becomes available on non-confidential basis from any source other than the Company, any other Member, or such Persons' agents, representatives or employees and such source is not prohibited from disclosing such information, shall not be deemed confidential information. 7.10 TRANSACTIONS BETWEEN A MEMBER AND THE COMPANY. Except as otherwise provided by applicable law and as otherwise provided herein, any Member may upon the approval of the Members, but shall not be obligated to, lend money to the Company, act as surety for the Company, and transact other business with the Company. A Member has the same rights and obligations when transacting business with the Company as a Person or entity who is not a Member. A Member, any Affiliate thereof, or an employee, stockholder, agent, director or officer of a Member or any Affiliate thereof, may also be an employee or be retained as an agent of the Company. The existence of these relationships and acting in such capacities will not result in the Member being deemed to be participating in the control of the business of the Company or otherwise affect the limited liability of the Member. 7.11 OTHER INSTRUMENTS. Each Member hereby agrees to execute and deliver to the Company within five (5) days after receipt of a written request therefor, such other and further documents and instruments, statements of interest and holdings, designations, powers of attorney and other instruments and to take such other action as may be necessary, useful or appropriate to comply with any laws, rules or regulations as may be necessary to enable the Company to fulfill its responsibilities under this Agreement. 7.12 GUARANTEE OF COMPANY INDEBTEDNESS. Except for arrangements expressly described in this Agreement, no Member shall enter into (or permit any Person related to the Member to enter into) any arrangement with respect to any liability of the Company that would result in such Member (or a Person related to such Member under Regulations Section 1.752-4(b)) bearing the economic risk of loss (within the meaning of Regulations Section 1.752-2) with respect to such liability unless such arrangement has received the Approval of the Members. To the extent a Member is permitted to guarantee the repayment of any Company indebtedness under this Agreement, each of the other Members shall be afforded the opportunity to guarantee such Members pro rata share of such indebtedness. This Section 7.12 shall not prohibit a Member from making a loan described in Section 3.5. 7.13 LITIGATION. If the Company and any Member are joint defendants in litigation relating to the Company, the Company shall pay the legal fees and expenses of one counsel for the Company and the Member or Members in question to the extent that the claim asserted 29 against the Company is also asserted against the Member. To the extent that the claim asserted against a Member is materially different from that asserted against the Company and results from such Member's willful or grossly negligent failure to act in conformity with Company policies or procedures, the Member shall be responsible for retaining independent counsel and for paying the fees and expenses of such counsel. In the event any Management Member recovers the cost of counsel or judgments or settlements through indemnification from third parties, such Management Member will share such recoveries with the Company to offset the Company's defense costs on a proportionate basis. ARTICLE 8 REPRESENTATIONS AND WARRANTIES 8.1 IN GENERAL. As of the date hereof, each Member hereby makes each of the representations and warranties applicable to such Member as set forth in Section 8.2 hereof, and such warranties and representations shall survive the execution of this Agreement. 8.2 REPRESENTATIONS AND WARRANTIES. Each Member hereby represents and warrants that: (a) Such Member understands and acknowledges that such Member's Membership Interest has not been registered under the Securities Act of 1933 or any state securities laws. (b) Such Member understands and acknowledges that Membership Interests may not be sold unless they are registered under the Securities Act of 1933 and applicable state securities laws, or pursuant to an exemption from such registration requirements. (c) The limitations on transfer contained in this Section 8.2 and in Article 11 of this Agreement create an economic risk that such Member is capable of bearing. (d) Except for an action by Lumbermen's Mutual against the Company and the Management Members in the Superior Court of Washington for King County, there are no actions, suits, proceedings, or investigations pending or, to the knowledge of such Member, threatened against or affecting such Member or any of his properties, assets, or businesses in any court or before or by any governmental department, board, agency, or instrumentality, domestic or foreign, or any arbitrator which could, if adversely determined (or, in the case of an investigation could lead to any action, suit, or proceeding, which if adversely determined could) reasonably be expected to materially impair such Member's ability to perform its obligations under this Agreement or to have a material adverse effect on the financial condition of such Member. (e) Such Member is acquiring its Membership Interest based upon its own investigation, and the exercise by such Member of its rights and the performance of its obligations under this Agreement will be based upon its own investigation, analysis, and expertise. Such Member's acquisition of its Membership Interest is being made for its own account for investment, and not with a view to the sale or distribution thereof. Such Member is a 30 sophisticated investor possessing an expertise in analyzing the benefits and risks associated with acquiring investments that are similar to the acquisition of its Membership Interest. (f) Such Member understands that taxable income and gain allocated to such Member by the Company under this Agreement and the tax on the portion thereof allocated to such Member hereunder for any Calendar Year may exceed the cash distributions from the Company to such Member and, that such Member may have to look to sources other than distributions from the Company to pay such tax. ARTICLE 9 ACCOUNTING, BOOKS AND RECORDS 9.1 ACCOUNTING, BOOKS, AND RECORDS. (a) The Company shall keep on site at its principal place of business each of the following: (i) Separate books of account for the Company which shall show a true and accurate record of all costs and expenses incurred, all charges made, all credits made and received, and all income derived in connection with the conduct of the Company and the operation of the Business in accordance with this Agreement. (ii) A current list of the full name and last known business, residence, or mailing address of each Member and Manager, both past and present; (iii) A copy of the Certificate and all amendments thereto, together with executed copies of any powers of attorney pursuant to which any amendment has been executed; (iv) Copies of the Company's federal, state, and local income tax returns and reports, if any, for the three most recent years; (v) Copies of this Agreement; (vi) Copies of any writings permitted or required under Section 18-502 of the Act regarding the obligation of a Member to perform any enforceable promise to contribute cash or property or to perform services as consideration for such Member's Capital Contribution; (vii) Unless contained in this Agreement, a statement prepared and certified as accurate by the Managers of the Company which describes: (A) The amount of cash and a description and statement of the agreed value of the other property or services contributed by each Member and which each Member has agreed to contribute in the future; (B) The times at which or events on the happening of which any Additional Capital Contributions agreed to be made by each Member are to be made; 31 (C) If agreed upon, the time at which or the events on the happening of which a Member may terminate his Membership Interest in the Company and the amount of, or the method of determining, the distribution to which he may be entitled respecting his Membership Interest and the terms and conditions of the termination and distribution; (D) Any right of a Member to receive distributions, which include a return of all or any part of a Member's contribution; (viii) Any written consents obtained from Members pursuant to Section 18-302 of the Act regarding action taken by Members without a meeting. (b) The Company shall use the accrual method of accounting in preparation of its financial reports and for tax purposes and shall keep its books and records accordingly. Any Member or its designated representative has the right to have reasonable access to and inspect and copy the contents of such books or records and shall also have reasonable access during normal business hours to such additional financial information, documents, books and records. The rights granted to a Member pursuant to this Section 9.1 are expressly subject to compliance by such Member with the safety, security, and confidentiality procedures and guidelines of the Company, as such procedures and guidelines may be established from time to time. 9.2 REPORTS. (a) The chief financial officer (or other officer appointed by the Managers) of the Company shall be responsible for causing the preparation of financial reports of the Company and the coordination of financial matters of the Company with the Company's accountants. (b) The Company shall cause to be delivered to each Member the financial statements listed in clauses (i) and (ii) below, prepared, in each case (other than with respect to Member's Capital Accounts, which shall be prepared in accordance with this Agreement) in accordance with GAAP consistently applied and such other reports as any Member may reasonably request from time to time; PROVIDED THAT, if the Board of Managers so determine within thirty (30) days thereof, such other reports shall be provided at such requesting Member's sole cost and expense. The quarterly financial statements referred to in clause (ii) below may be subject to normal year-end audit adjustments. (i) As soon as practicable following the end of each Calendar Year (and in any event not later than sixty (60) days after the end of such Calendar Year) and at such time as distributions are made to the Members pursuant to Section 13 hereof following the occurrence of a Dissolution Event, a balance sheet of the Company as of the end of such Calendar Year and the related statements of operations, Members' Capital Accounts and changes therein, and cash flows for such Calendar Year, together with appropriate notes to such financial statements and supporting schedules, all of which shall be audited and certified, or not audited but reviewed, by the Company's accountants, as determined by the Board of Managers following receipt of the recommendation of the Audit Committee, and in each case, to the extent the Company was in existence, setting forth in comparative form the corresponding figures for the immediately 32 preceding Calendar Year end (in the case of the balance sheet) and the two (2) immediately preceding Calendar Years (in the case of the statements). (ii) As soon as practicable following the end of each of the first three Calendar Quarters of each Calendar Year (and in any event not later than thirty (30) days after the end of each such Calendar Quarter), a balance sheet of the Company as of the end of such Calendar Quarter and the related statements of operations and cash flows for such Calendar Quarter and for the Calendar Year to date, in each case, to the extent the Company was in existence, setting forth in comparative form the corresponding figures for the prior Calendar Year's Calendar Quarter and the interim period corresponding to the Calendar Quarter and the interim period just completed. The quarterly statements described in clause (ii) above shall be accompanied by a written certification of the chief financial officer (or other officer appointed by the Managers)of the Company that such statements have been prepared in accordance with GAAP consistently applied or this Agreement, as the case may be. 9.3 ACCOUNTANTS. The Company's and the Subsidiary's accountants shall be such accountants approved by the Board of Managers following receipt of a recommendation of the Audit Committee of the Board of Managers. 9.4 TAX MATTERS. (a) TAX ELECTIONS. The Board of Managers shall, without any further consent of the Members being required (except as specifically required herein), make or delegate responsibility to the officers of the Company to make any and all elections for federal, state, local, and foreign tax purposes including, without limitation, any election, if permitted by applicable law: (i) to adjust the basis of Property pursuant to Code Sections 754, 734(b) and 743(b), or comparable provisions of state, local or foreign law, in connection with Transfers of Membership Interest and Company distributions; (ii) with the consent of all of the Members, to extend the statute of limitations for assessment of tax deficiencies against the Members with respect to adjustments to the Company's federal, state, local or foreign tax returns; and (iii) to the extent provided in Code Sections 6221 through 6231 and similar provisions of federal, state, local, or foreign law, to represent the Company and the Members before taxing authorities or courts of competent jurisdiction in tax matters affecting the Company or the Members in their capacities as Members, and to file any tax returns and execute any agreements or other documents relating to or affecting such tax matters, including agreements or other documents that bind the Members with respect to such tax matters or otherwise affect the rights of the Company and the Members. Snyder is specifically authorized to act as the "Tax Matters Member" under the Code and in any similar capacity under state or local law until such time as PAULA is entitled to be allocated a majority of the Profits pursuant to Article 4, and thereafter PAULA is specifically authorized to act as the "Tax Matters Member" under the Code. 33 (b) TAX INFORMATION. Necessary tax information shall be delivered to each Member as soon as practicable after the end of each Calendar Year of the Company but not later than two and one-half (21/2) months after the end of each Calendar Year. (c) PARTNERSHIP TREATMENT. It is the intention of the Members that the Company shall be treated as a partnership for tax purposes. ARTICLE 10 AMENDMENTS 10.1 AMENDMENTS. (a) Amendments to this Agreement may be proposed by the Board Managers or any Member. Following such proposal, the Board of Managers shall submit to the Members a verbatim statement of any proposed amendment, providing that counsel for the Company shall have approved of the same in writing as to form, and the Board of Managers shall include in any such submission a recommendation as to the proposed amendment. The Board of Managers shall seek the written vote of the Members on the proposed amendment or shall call a meeting to vote thereon and to transact any other business that it may deem appropriate. A proposed amendment shall be adopted and be effective as an amendment hereto if it receives the Approval of the Members. (b) Notwithstanding Section 10.1(a) hereof, this Agreement shall not be amended without the consent of each Member adversely affected if such amendment would modify the limited liability of a Member, or (ii) alter the interest of a Member in Profits, Losses, other items, or any Company distributions. ARTICLE 11 TRANSFERS 11.1 RESTRICTIONS ON TRANSFERS. Except as otherwise permitted by this Agreement, no Member shall Transfer all or any portion of such Member's Membership Interest or any other interest in the Company. 11.2 PERMITTED TRANSFERS. Subject to the conditions and restrictions set forth in Section 11.3 hereof, a Member may at any time Transfer all or any portion of its Membership Interest to (a) any Wholly Owned Affiliate of the transferor Member, (b) any Purchaser in accordance with Section 11.4 hereof, and (c) as provided in Section 11.5 hereof (any such Transfer being referred to in this Agreement as a "PERMITTED TRANSFER"). 11.3 CONDITIONS TO PERMITTED TRANSFERS. A Transfer shall not be treated as a Permitted Transfer under Section 11.2 hereof unless and until the following conditions are satisfied: (a) The transferor and transferee shall execute and deliver to the Company (i) such documents and instruments of conveyance as may be necessary or appropriate in the opinion of 34 counsel to the Company to effect such Transfer. In all cases, the Company shall be reimbursed by the transferor and/or transferee for all costs and expenses that it reasonably incurs in connection with such Transfer. (b) The transferor and transferee shall furnish the Company with the transferee's taxpayer identification number, sufficient information to determine the transferee's initial tax basis in the Membership Interest transferred, and any other information reasonably necessary to permit the Company to file all required federal and state tax returns and other legally required information statements or returns. Without limiting the generality of the foregoing, the Company shall not be required to make any distribution otherwise provided for in this Agreement with respect to any transferred Membership Interest until it has received such information. (c) The Transfer would not cause the Company to be (i) treated as a "publicly traded partnership" within the meaning of Code Section 7704 or (ii) classified as a corporation for state income tax purposes within the meaning of Code Section 7701(a) or any similar state tax provision. (d) Unless otherwise approved by all the Members, no Transfer of a Membership Interest shall be made except upon terms which would not, in the opinion of counsel chosen by and mutually acceptable to all the Members, result in the termination of the Company within the meaning of Section 708 of the Code or cause the application of the rules of Sections 168(f)(5) and 168(i)(7) of the Code or similar rules to apply to the Company. (e) No notice or request initiating the procedures contemplated by Section 11.4 may be given by any Member, while any notice, purchase or Transfer is pending under Section 11.4 or Section 12, as the case may be, or after a Dissolution Event has occurred. If any Member is an Adverse Member, the other Members shall not be offered any portion of the Adverse Member's Membership Interest pursuant to Section 11.4, during the period that the Company is pursuing any remedy specified in Section 12.1 with respect to such Member's status as an Adverse Member. No Member may sell any portion of its Membership Interest pursuant to Section 11.4 during any period that, as provided above, it may not give the notice initiating the procedures contemplated by such Section or thereafter until it has given such notice and otherwise complied with the provisions of such Section. 11.4 RIGHT OF FIRST REFUSAL. In addition to the other limitations and restrictions set forth in this Section 11, except as permitted by Section 11.2 hereof, no Member shall Transfer all or any portion of its Membership Interest (the "OFFERED INTEREST") unless such Member (the "SELLER") first offers to sell the Offered Interest pursuant to the terms of this Section 11.4. (a) LIMITATION ON TRANSFERS. No Transfer may be made under this Section 11.4 unless the Seller has received a bona fide written offer (the "PURCHASE OFFER") from a Person (the "PURCHASER") to purchase the Offered Interest for a purchase price (the "OFFER PRICE") denominated and payable in United States dollars at closing or according to specified terms, with or without interest, which offer shall be in writing signed by the Purchaser and shall be 35 irrevocable for a period ending no sooner than the Business Day following the end of the Offer Period, as hereinafter defined. (b) OFFER NOTICE. Prior to making any Transfer that is subject to the terms of this Section 11.4, the Seller shall, subject to the terms and conditions of this Agreement, give to the Company and each other Member written notice (the "OFFER NOTICE") which shall include a copy of the Purchase Offer and an offer (the "FIRM OFFER") to sell the Offered Membership Interest to the other Members (the "OFFEREES") for the Offer Price, payable according to the same terms as (or more favorable terms than) those contained in the Purchase Offer, PROVIDED that the Firm Offer shall be made without regard to the requirement of any earnest money or similar deposit required of the Purchaser prior to closing, and without regard to any security (other than the Offered Interest) to be provided by the Purchaser for any deferred portion of the Offer Price. (c) OFFER PERIOD. The Firm Offer shall be irrevocable for a period (the "OFFER PERIOD") ending at 11:59 P.M., local time at the Company's principal place of business, on the thirtieth (30th) day following the day of the Offer Notice. (d) ACCEPTANCE OF FIRM OFFER. At any time during the Offer Period, any Offeree may accept the Firm Offer as to all or any portion of the Offered Interest, by giving written notice of such acceptance to the Seller and each other Offeree, which notice shall indicate the maximum proportion of the Offered Interest that such Offeree is willing to purchase. If the Seller is a Management Member, Members who are Management Members shall have a first priority on a pro rata basis to purchase all of the Offered Interest, PROVIDED that if Management Members do not agree to purchase all of the Offered Interest, the Company shall have the right to purchase any of the Offered Interest that Management Members have not agreed to purchase, and PROVIDED FURTHER that if Management Members and the Company do not agree to purchase all of the Offered Interest, PAULA shall have the right to purchase any of the Offered Interest that the Management and the Company have not agreed to purchase. If the Seller is PAULA, the Management Members shall have the right to purchase the Offered Interest on a pro rata basis. In the event that Offerees ("ACCEPTING OFFEREES"), in the aggregate, accept the Firm Offer with respect to all of the Offered Interest, the Firm Offer shall be deemed to be accepted and each Accepting Offeree shall be deemed to have accepted the Firm Offer to the extent set out above. If Offerees do not accept the Firm Offer as to all of the Offered Interest during the Offer Period, the Firm Offer shall be deemed to be rejected only with respect to the Offered Interest that the Offerees have declined to purchase. (e) CLOSING OF PURCHASE PURSUANT TO FIRM OFFER. In the event that any portion of the Firm Offer is accepted, the closing of the sale of the Offered Interest shall take place within thirty (30) days after the Firm Offer is accepted or, if later, the date of closing set forth in the Purchase Offer. The Seller and all Accepting Offerees shall execute such documents and instruments as may be necessary or appropriate to effect the sale of the Offered Interest pursuant to the terms of the Firm Offer and this Section 11. (f) SALE PURSUANT TO PURCHASE OFFER IF FIRM OFFER REJECTED. If any portion of the Firm Offer is not accepted in the manner hereinabove provided, the Seller may sell the remaining 36 Offered Interest to the Purchaser at any time within sixty (60) days after the last day of the Offer Period, provided that such sale shall be made on terms no more favorable to the Purchaser than the terms contained in the Purchase Offer and provided further that such sale complies with other terms, conditions, and restrictions of this Agreement that are not expressly made inapplicable to sales occurring under this Section 11.4. In the event that the Offered Interest is not sold in accordance with the terms of the preceding sentence, the Offered Interest shall again become subject to all of the conditions and restrictions of this Section 11.4. (g) FIRST REFUSAL RIGHTS UPON MERGER PROPOSAL. In the event the Company entertains a BONA FIDE offer to merge, consolidate, sell or sell substantially all of the assets of, the Company in a transaction which will not trigger rights under Section 11.5 below, the Management Members shall have a right of first refusal to match such offer in accordance with the applicable notice and timing provisions of this Section 11.4. 11.5 PAULA CHANGE OF CONTROL. (a) In the event that a PAULA Change of Control occurs, PAULA shall forthwith give notice of such occurrence to all the Management Members. (b) At any time up to thirty days, following the occurrence of a PAULA Change of Control, either PAULA or, the Management Members if the Management Members unanimously agree, may deliver, in the case of PAULA to the Management Members collectively, and in the case of the Management Members to PAULA, a notice in writing ("BUY-SELL NOTICE") offering to purchase such Member or Members Membership Interest at the purchase price and on the terms specified in the Buy-Sell Notice. (c) The recipient of the Buy-Sell Notice (the "RECIPIENT") may accept the Buy-Sell Notice by delivering to the sender of the Buy-Sell Notice (the "SENDER") written notice of acceptance. The Recipients may reject the Buy-Sell Notice by delivering written notice of rejection to the Sender, whereupon the Recipient shall be deemed to have agreed to purchase and the Sender shall be deemed to have agreed to sell all of the Sender's Membership Interest based on the terms specified in the Buy-Sell Notice. If the Management Members are deemed to have agreed to purchase PAULA's Membership Interest pursuant to this Section 11.5(c) they shall do so on a pro rata basis, unless a different proportion is unanimously agreed upon by the Management Members and communicated in writing to PAULA. (d) If the Recipient fails to accept or reject the Buy-Sell Notice within fifteen days of receipt of the Buy-Sell Notice, the Recipient shall be deemed to have accepted the Buy-Sell Notice and the Recipient shall be deemed to have agreed to sell and the Sender shall be deemed to have agreed to purchase all of the Recipient's Membership Interest on the terms specified in the Buy-Sell Notice. (e) Unless otherwise agreed by the Sender and the Recipient, the transaction related to the Buy-Sell Notice shall in all events be completed within forty five (45) days of the date that the Buy-Sell Notice is accepted, rejected or deemed accepted pursuant to this Section 11.5. 37 11.6 PROHIBITED TRANSFERS. Any purported Transfer of Membership Interest that is not a Permitted Transfer shall be null and void and of no force or effect whatever; PROVIDED that, if the Company is required to recognize a Transfer that is not a Permitted Transfer (or if all of the Managers, in their sole discretion, elect to recognize a Transfer that is not a Permitted Transfer), the Membership Interest Transferred shall be strictly limited to the transferor's rights to allocations and distributions as provided by this Agreement with respect to the transferred Membership Interest, which allocations and distributions may be applied (without limiting any other legal or equitable rights of the Company) to satisfy any debts, obligations, or liabilities for damages that the transferor or transferee of such Membership Interest may have to the Company. In the case of a Transfer or attempted Transfer of Membership Interest that is not a Permitted Transfer, the parties engaging or attempting to engage in such Transfer shall be liable to indemnify and hold harmless the Company and the other Members from all cost, liability, and damage that any of such indemnified Members may incur (including, without limitation, incremental tax liabilities, lawyers' fees, and expenses) as a result of such Transfer or attempted Transfer and efforts to enforce the indemnity granted hereby. 11.7 RIGHTS OF UNADMITTED ASSIGNEES. A Person who acquires a Membership Interest but who is not admitted as a substituted Member pursuant to Section 11.8 hereof shall be entitled only to allocations and distributions with respect to such Membership Interest in accordance with this Agreement, and shall have no right to any information or accounting of the affairs of the Company, shall not be entitled to inspect the books or records of the Company, and shall not have any of the rights of a Member under the Act or this Agreement. 11.8 ADMISSION OF SUBSTITUTED MEMBERS. Subject to the other provisions of this Article 11, a transferee of a Membership Interest may be admitted to the Company as a substituted Member only upon satisfaction of the conditions set forth in this Section 11.8: (a) The Membership Interest with respect to which the transferee is being admitted was acquired by means of a Permitted Transfer; (b) The transferee of the Membership Interest (other than, with respect to clauses (i) and (ii) below, a transferee that was a Member prior to the Transfer) shall, by written instrument in form and substance reasonably satisfactory to the Board of Managers (and, in the case of clause (iii) below, the transferor Member), (i) make representations and warranties to each nontransferring Member equivalent to those set forth in Article 8, (ii) accept and adopt the terms and provisions of this Agreement, including this Article 11, and (iii) assume the obligations of the transferor Member under this Agreement with respect to the transferred Membership Interest. The transferor Member shall be released from all such assumed obligations except (x) those obligations or liabilities of the transferor Member arising out of a breach of this Agreement, (y) in the case of a Transfer to any Person other than a Member or any of its Wholly Owned Affiliates, those obligations or liabilities of the transferor Member based on events occurring, arising, or maturing prior to the date of Transfer, and (z) in the case of a Transfer to any of its Wholly Owned Affiliates, any Capital Contribution or other financing obligation of the transferor Member under this Agreement; 38 (c) The transferee pays or reimburses the Company for all reasonable legal, filing, and publication costs that the Company incurs in connection with the admission of the transferee as a Member with respect to the Transferred Membership Interest; and (d) If required by the Board of Managers, the transferee (other than a transferee that was a Member prior to the Transfer) shall deliver to the Company evidence of the authority of such Person to become a Member and to be bound by all of the terms and conditions of this Agreement, and the transferee and transferor shall each execute and deliver such other instruments as the Board of Managers reasonably deems necessary or appropriate to effect, and as a condition to, such Transfer, including amendments to the Certificate or any other instrument filed with the State of Delaware or any other state or governmental authority. 11.9 REPRESENTATIONS REGARDING TRANSFERS; LEGEND. (a) Each Member hereby represents and warrants to the Company and the Members that such Member's acquisition of a Membership Interest hereunder is made as principal for such Member's own account and not for resale or distribution of such Membership Interest. Each Member further hereby agrees that the following legend may be placed upon any counterpart of this Agreement, the Certificate, or any other document or instrument evidencing ownership of Membership Interests: The Company Membership Interests represented by this document have not been registered under any securities laws and the transferability of such Membership Interests are restricted. Such Membership Interests may not be sold, assigned, or transferred, nor will any assignee, vendee, transferee, or endorsee thereof be recognized as having acquired any such Membership Interest by the Company for any purposes, unless (1) a registration statement under the Securities Act of 1933, as amended, with respect to such Membership Interest shall then be in effect and such transfer has been qualified under all applicable state securities laws, or (2) the availability of an exemption from such registration and qualification shall be established to the satisfaction of counsel to the Company. The Membership Interests represented by this document are subject to further restriction as to their sale, transfer, hypothecation, or assignment as set forth in this Agreement and agreed to by each Member. Said restriction provides, among other things, that no Membership Interest may be transferred without first offering such Membership Interest to the other Members. 11.10 DISTRIBUTIONS AND ALLOCATIONS IN RESPECT OF TRANSFERRED MEMBERSHIP INTEREST. If any Membership Interest is Transferred during any Calendar Year in compliance with the provisions of this Article 11, Profits, Losses, and all other items attributable to the Transferred Membership Interest for such Calendar Year shall be divided and allocated between the transferor and the transferee by taking into account their varying Percentage Interests during the Calendar Year in accordance with Code Section 706(d), using any conventions permitted by law and selected by the Board of Managers. All distributions on or before the date of such Transfer shall be made to the transferor, and all distributions thereafter shall be made to the 39 transferee. Solely for purposes of making such allocations and distributions, the Company shall recognize such Transfer not later than the end of the calendar month during which it is given notice of such Transfer, PROVIDED that, if the Company is given notice of a Transfer at least ten (10) Business Days prior to the Transfer, the Company shall recognize such Transfer as of the date of such Transfer, and PROVIDED FURTHER that if the Company does not receive a notice stating the date such Membership Interest were transferred and such other information as the Managers may reasonably require within thirty (30) days after the end of the Calendar Year during which the Transfer occurs, then all such items shall be allocated, and all distributions shall be made, to the Person who, according to the books and records of the Company, was the owner of the Membership Interest on the last day of such Calendar Year. Neither the Company nor any Member shall incur any liability for making allocations and distributions in accordance with the provisions of this Section 11.10, whether or not any Manager or the Company has knowledge of any Transfer of ownership of any Membership Interest. 11.11 MEMBERSHIP INTEREST. Any sale, transfer or other disposition of a Membership Interest pursuant to Article 11 and Article 12 must be with respect to the same proportion of a Member's Capital Account and allocation of Profits. ARTICLE 12 ADVERSE ACT 12.1 REMEDIES. (a) If an Adverse Act has occurred or is continuing with respect to any Member, any non-Adverse Member may elect: (i) To cause the Company to commence the procedures specified in Section 12.2 for the purchase of the Adverse Member's Membership Interest; or (ii) To seek to enjoin such Adverse Act or to obtain specific performance of the Adverse Member's obligations or Damages (as defined and subject to the limitations specified below) in respect of such Adverse Act. The foregoing remedies shall not be deemed to be mutually exclusive, and, subject to the requirements of this Section 12.1(a) regarding the timing of the election of such remedies, selection or resort to any thereof shall not preclude selection or resort to the others. Notwithstanding anything to the contrary contained in this Article 12, the remedy specified in clause (i) above and the right to seek Damages under clause (ii) above may not be pursued and Section 12.1(b) will not apply to an Adverse Act specified in clause (ii) of the term "Adverse Act" in Section 1 until such time as there is a Final Determination that the Member's actions or failure to act constituted an Adverse Act, if the affected Member timely delivered a Contest Notice. The election of a remedy specified in clause (i) or (ii) above may be exercised by notice given to the Adverse Member within ninety (90) days after the Member making such election 40 obtains actual knowledge of the occurrence of such Adverse Act, including, if applicable, that any cure period has expired; PROVIDED that, if an election pursuant to clause (ii) above is made to seek an injunction, specific performance or other equitable relief and a final judgment in such action is rendered denying such equitable remedy and no election was made pursuant to clause (i) above, then, by notice given within ten (10) days after such final judgment is rendered, the non-Adverse Member may elect to pursue the remedies specified in clause (i) above unless (x) prior to the giving of such notice, the Adverse Member has cured in full (or caused to be cured in full) the Adverse Act in question and no other Adverse Act with respect to such Adverse Member has occurred and is continuing or (y) the final judgment denying equitable relief specifically held that there was no Adverse Act. Except as provided in Section 12.1(b), the failure to elect a remedy with respect to the subject Adverse Act within the time periods provided in the preceding paragraph shall be conclusively presumed to be a waiver of the remedies provided in this Section 12 with respect to the subject Adverse Act. Unless resort to such remedy has been waived as set forth in the immediately preceding paragraph, the Company shall be entitled to recover from the Adverse Member in an appropriate proceeding any and all damages, losses and expenses (including reasonable attorneys' fees and disbursements) (collectively, "DAMAGES") suffered or incurred by the Company as a result of such Adverse Act; PROVIDED that the Company shall not have or assert any claim against the Adverse Member for punitive Damages or for indirect, special, or consequential Damages suffered or incurred by the Company as a result of an Adverse Act; and PROVIDED FURTHER that the amount the Company may recover in any action for Damages shall be reduced by an amount equal to any positive difference between the Net Equity of the Adverse Member's Membership Interest and the applicable Buy-Sell Price. The resort to any remedy pursuant to this Section 12.1(a) shall not for any purpose be deemed to be a waiver of any remedy not described in this Section 12.1(a) and otherwise available hereunder or under applicable law. (b) If the Company is dissolved pursuant to Section 13.1(a) at any time as a result of a Dissolution Event that occurs prior to a remedy having been elected pursuant to Section 12.1(a) with respect to any Adverse Member, the time periods for such election shall thereupon expire and the Liquidator shall deduct from any amounts to be paid to such Adverse Member pursuant to Section 13.2 that amount which it reasonably estimates to be sufficient to compensate the non-Adverse Members for Damages incurred by them as a result of the Adverse Act (subject to the limitations of Section 12.1(a)) and shall pay the same to the non-Adverse Members on behalf of the Adverse Member. 12.2 ADVERSE ACT PURCHASE. (a) DETERMINATION OF NET EQUITY OF ADVERSE MEMBER'S MEMBERSHIP INTEREST. If any Member makes an election pursuant to Section 12.1(a)(i) to commence the purchase procedures set forth in this Section 12.2, the Net Equity of the Adverse Member's Membership Interest shall 41 be determined in accordance with this Section 12.2 as of the last day of the Calendar Quarter immediately preceding the Calendar Quarter in which notice of such election (the "ELECTION NOTICE") was given to the Adverse Member, and the Adverse Member shall be obligated to sell to the Members in the manner provided herein all but not less than all of the Adverse Member's Membership Interest in accordance with this Section 12.2 at a purchase price (the "BUY-SELL PRICE") equal to (A) in the case of any Adverse Act other than an Adverse Act identified in clause (iv) of the definition of "Adverse Act" in Section 1, ninety percent (90%) of the Net Equity thereof as so determined, and (B) in the case of an Adverse Act specified in clause (iv), the Net Equity thereof. (b) ELECTION TO PURCHASE MEMBERSHIP INTEREST OF ADVERSE MEMBER. For a period ending at 11:59 p.m. (local time at the Company's principal office) on the thirtieth (30th) day following the day on which notice of the Adverse Member's Net Equity is given pursuant to Section 12.3 (the "ELECTION PERIOD"), each Member who is not an Adverse Member, may elect, by notice to the Adverse Member (the "PURCHASE NOTICE"), to purchase, or designate a third party to purchase, all or any portion of the Membership Interest of the Adverse Member, which notice shall state the maximum Membership Interest that such non-Adverse Member, or such designated third party (in each case, the "PURCHASING MEMBER"), is willing to purchase (each a "PURCHASE COMMITMENT"). If the aggregate Purchase Commitments made by the Purchasing Members are equal to at least one hundred percent (100%) of the Adverse Member's Membership Interest, then subject to Section 11.12 and the following sentence, each Purchasing Member shall be obligated to purchase, and the Adverse Member shall be obligated to sell to such Purchasing Member, that portion of the Adverse Member's Membership Interest that corresponds to the ratio of the allocation of Profits to such Purchasing Member to the aggregate allocation of Profits to all Purchasing Members; PROVIDED that, if any Purchasing Member's Purchase Commitment was for an amount less than its proportionate share of the Adverse Member's Membership Interest as so determined, the portion of the Adverse Member's Membership Interest not so committed to be purchased shall be allocated to the other Purchasing Members; and PROVIDED FURTHER, that each other Purchasing Member shall not be obligated to purchase in excess of the proportion of the Membership Interest set forth in the Purchase Commitment delivered by such other Purchasing Member. If the other Members do not elect to purchase the entire Membership Interest of the Adverse Member, the Adverse Member shall be under no obligation to sell any portion of its Membership Interest to any Member. (c) TERMS OF PURCHASE; CLOSING. Unless the Purchasing Members and the Adverse Member otherwise agree, the closing of the purchase and sale of the Adverse Member's Membership Interest shall occur at the principal office of the Company at 10:00 a.m. (local time at the place of the closing) on the first Business Day occurring on or after the thirtieth (30th) day following the last day of the Election Period (subject to Section 12.5). At the closing, the Purchasing Members shall pay to the Adverse Member, by cash or other immediately available funds, the purchase price for the Adverse Member's Membership Interest and the Adverse Member shall deliver to the Purchasing Members good title, free and clear of any liens or encumbrances (other than those created by this Agreement) to the Adverse Member's Membership Interest thus purchased. 42 At the closing, the Members shall execute such documents and instruments of conveyance as may be necessary or appropriate to effectuate the transactions contemplated hereby, including the Transfer of the Adverse Member's Membership Interest to the Purchasing Members and the assumption by each Purchasing Member of the Adverse Member's obligations with respect to the Adverse Member's Membership Interest Transferred to such Purchasing Member. The Company and each Member shall bear its own costs of such Transfer and closing, including attorneys' fees and filing fees. The cost of determining Net Equity shall be borne one-half by the Adverse Member and one-half by the Purchasing Member. 12.3 NET EQUITY. The "Net Equity" of a Member's Membership Interest, as of any day, shall be the amount that would be distributed to such Member in liquidation of the Company pursuant to Section 13.2 if (i) the Company's business were sold substantially as an entirety for Gross Appraised Value, (ii) the Company paid, or established reserves pursuant to Section 13.2 for the payment of, all Company liabilities and (iii) the Company distributed the remaining proceeds to the Members in liquidation, all as of such day. The Net Equity of a Member's Membership Interest shall be determined, without audit or certification, from the books and records of the Company by the Company's accountants. The Net Equity of a Member's Membership Interest shall be determined within thirty (30) days of the day upon which the accountants are apprised in writing of the Gross Appraised Value of the Company's Property, and the amount of such Net Equity shall be disclosed to the Company and each of the Members by written notice ("NET EQUITY NOTICE"). The Net Equity determination of the accountants shall be final and binding in the absence of a showing of manifest error. 12.4 GROSS APPRAISED VALUE. (a) "GROSS APPRAISED VALUE," as of any day, shall be equal to the fair market value of Company Property as of such day. As used herein, as of any day, "fair market value" of the Property means the price at which a willing seller would sell, and a willing buyer would buy, the Property, free and clear of all liens, security interests or other encumbrances, in an arm's length transaction for cash, without time constraints and without being under any compulsion to buy or sell. (b) The Executive Committee shall retain a qualified and independent valuer to make a determination of Gross Appraised Value when any such determination is required hereunder and to report thereon to the Executive Committee. Such report will not be binding on the Executive Committee who shall make the final determination of the Gross Appraised Value within 30 days of receipt of the report of the valuer. Notwithstanding, the foregoing provisions of this Section 12.4(b), in the event that an independent transaction has taken place within the previous twelve months which in the reasonable opinion of the Executive Committee establishes a reasonable basis for the determination of the Gross Appraised Value, the Executive Committee shall not be required to retain a valuer and shall independently establish the Gross Appraised Value within 60 days of a request to do so hereunder. The Executive Committee shall apprise the Company's accountants in writing of the Gross Appraised Value forthwith after it is determined. 43 12.5 EXTENSION OF TIME. If any Transfer of a Member's Membership Interest in accordance with this Article 12 or Article 11 requires the consent, approval, waiver, or authorization of any governmental authority or of the stockholders of a Member or any of its Affiliates as a condition to the lawful and valid Transfer of such Member's Membership Interest to the proposed transferee thereof, then each of the time periods provided in this Article 12 or Article 11, as applicable, for the closing of such Transfer shall be suspended for the period of time during which any such consent, approval, waiver, or authorization is being diligently pursued; PROVIDED HOWEVER, that in no event shall the suspension of any time period pursuant to this Section 12.5 extend for more than three hundred sixty-five (365) days other than in the case of a purchase of an Adverse Member's Membership Interest. Each Member agrees to use its diligent efforts to obtain, or to assist the affected Member or the Managers in obtaining, any such consent, approval, waiver, or authorization and shall cooperate and use its diligent efforts to respond as promptly as practicable to all inquiries received by it, by the affected Member or by the Managers from any governmental authority for initial or additional information or documentation in connection therewith. Any extension of time pursuant to this Section 12.5 will not otherwise effect the terms of the Transfer in question including without limitation any determination of Gross Appraised Value or Net Equity in connection therewith and any such determination shall remain in effect and will be utilized in connection with the ultimate completion of the Transfer in question. ARTICLE 13 DISSOLUTION AND WINDING UP 13.1 DISSOLUTION EVENTS. (a) DISSOLUTION. The Company shall dissolve and shall commence winding up and liquidating upon the first to occur of any of the following (each a "DISSOLUTION EVENT"): (i) A judicial determination that an event has occurred that makes it unlawful, impossible, or impractical to carry on the Business; (ii) The Bankruptcy, dissolution, retirement, resignation, or expulsion of any Member; PROVIDED that any such event will not be deemed a Dissolution Event in the event that there are at least two remaining Members and each remaining Member agrees to continue the business of the Company within ninety (90) days after the occurrence of such an event. (iii) The Approval of the Members; or (iv) If the Subsidiary has not: (A) recorded premium income in excess of $0.00 for the six month period following the Effective Date; (B) recorded premium income in excess of $5 million for the twelve month period following the Effective Date; or 44 (C) recorded premium income in excess of $10 million for the eighteen month period following the Effective Date. The Members hereby agree that, notwithstanding any provision of the Act, the Company shall not dissolve prior to the occurrence of a Dissolution Event. (b) RECONSTITUTION. If it is determined, by a court of competent jurisdiction, that the Company has dissolved prior to the occurrence of a Dissolution Event, then within an additional ninety (90) days after such determination (the "RECONSTITUTION PERIOD"), all of the Members may elect to reconstitute the Company and continue its business on the same terms and conditions set forth in this Agreement by forming a new limited liability company on terms identical to those set forth in this Agreement. Unless such an election is made within the Reconstitution Period, the Company shall liquidate and wind up its affairs in accordance with Section 13.2 hereof. If such an election is made within the Reconstitution Period, then: (i) The reconstituted limited liability company shall continue until the occurrence of a Dissolution Event as provided in this Section 13.1(a); (ii) Unless otherwise agreed by way of an Approval of the Members, the Certificate and this Agreement shall automatically constitute the Certificate and Agreement of such new Company. All of the assets and liabilities of the dissolved Company shall be deemed to have been automatically assigned, assumed, conveyed and transferred to the new Company. No bond, collateral, assumption or release of any Member's or the Company's liabilities shall be required; PROVIDED that the right of the Members to select successor managers and to reconstitute and continue the Business shall not exist and may not be exercised unless the Company has received an opinion of counsel that the exercise of the right would not result in the loss of limited liability of any Member and neither the Company nor the reconstituted limited liability company would cease to be treated as a partnership for federal income tax purposes upon the exercise of such right to continue. 13.2 WINDING UP. Upon the occurrence of (i) a Dissolution Event or (ii) the determination by a court of competent jurisdiction that the Company has dissolved prior to the occurrence of a Dissolution Event (unless the Company is reconstituted pursuant to Section 13.1(b) hereof), the Company shall continue solely for the purposes of winding up its affairs in an orderly manner, liquidating its assets, and satisfying the claims of its creditors and Members, and no Member shall take any action that is inconsistent with, or not necessary to or appropriate for, the winding up of the Company's business and affairs, PROVIDED that all covenants contained in this Agreement and obligations provided for in this Agreement shall continue to be fully binding upon the Members until such time as the Property has been distributed pursuant to this Section 13.2 and the Certificate has been canceled pursuant to the Act. The Liquidator shall be responsible for overseeing the winding up and dissolution of the Company, which winding up and dissolution shall be completed as soon as practicable after the occurrence of the applicable Dissolution Event. The Liquidator shall take full account of the Company's liabilities and Property and shall cause the Property or the proceeds from the sale 45 thereof (as determined pursuant to Section 13.9 hereof), to the extent sufficient therefor, to be applied and distributed, to the maximum extent permitted by law, in the following order: (a) First, to creditors (including Members and Managers who are creditors, to the extent otherwise permitted by law) in satisfaction of all of the Company's debts and other liabilities (whether by payment or the making of reasonable provision for payment thereof), other than liabilities for which reasonable provision for payment has been made and liabilities for distribution to Members under Section 18-601 or 18-604 of the Act; (b) Second, except as provided in this Agreement, to Members and former Members of the Company in satisfaction of liabilities for distribution under Sections 18-601 or 18-604 of the Act; and (c) The balance, if any, to the Members in accordance with the positive balance in their Capital Accounts, after giving effect to all contributions, distributions, and allocations for all periods. No Member or Manager shall receive additional compensation for any services performed pursuant to this Section 13. 13.3 COMPLIANCE WITH CERTAIN REQUIREMENTS OF REGULATIONS; DEFICIT CAPITAL ACCOUNTS. In the event the Company is "liquidated" within the meaning of Regulations Section 1.704-1(b)(2)(ii)(g), distributions shall be made pursuant to this Article 13 to the Members who have positive Capital Accounts, in proportion to each Members Capital Account balance, in compliance with Regulations Section 1.704-1(b)(2)(ii)(b)(2). If any Member has a deficit balance in his Capital Account (after giving effect to all contributions, distributions, and allocations for all Calendar Years, including the Calendar Year during which such liquidation occurs), such Member shall have no obligation to make any contribution to the capital of the Company with respect to such deficit, and such deficit shall not be considered a debt owed to the Company or to any other Person for any purpose whatsoever. In the discretion of the Liquidator, a pro rata portion of the distributions that would otherwise be made to the Members pursuant to this Article 13 may be: (a) Distributed to a trust established for the benefit of the Members for the purposes of liquidating Company assets, collecting amounts owed to the Company, and paying any contingent or unforeseen liabilities or obligations of the Company. The assets of any such trust shall be distributed to the Members from time to time, in the reasonable discretion of the Liquidator, in the same proportions as the amount distributed to such trust by the Company would otherwise have been distributed to the Members pursuant to Section 13.2 hereof; or (b) Withheld to provide a reasonable reserve for Company liabilities (contingent or otherwise) and to reflect the unrealized portion of any installment obligations owed to the Company, PROVIDED that such withheld amounts shall be distributed to the Members as soon as practicable. 46 13.4 RIGHTS OF MEMBERS. Except as otherwise provided in this Agreement, each Member shall look solely to the Property of the Company for the return of its Capital Contribution and has no right or power to demand or receive Property other than cash from the Company. If the assets of the Company remaining after payment or discharge of the debts or liabilities of the Company are insufficient to return such Capital Contribution, the Members shall have no recourse against the Company or any other Member or Manager for the deficiency. 13.5 NOTICE OF DISSOLUTION/TERMINATION. (a) In the event a Dissolution Event occurs or an event occurs that would, but for provisions of Section 13.1, result in a dissolution of the Company, the Managers shall, within thirty (30) days thereafter, provide written notice thereof to each of the Members and to all other parties with whom the Company regularly conducts business (as determined in the discretion of the Managers) and shall publish notice thereof in a newspaper of general circulation in each place in which the Company regularly conducts business (as determined in the discretion of the Managers). (b) Upon completion of the distribution of the Company's Property as provided in this Article 13, the Company shall be terminated, and the Liquidator shall cause the filing of the Certificate of Cancellation pursuant to Section 18-203 of the Act and shall take all such other actions as may be necessary to terminate the Company. 13.6 ALLOCATIONS DURING PERIOD OF LIQUIDATION. During the period commencing on the first day of the Calendar Year during which a Dissolution Event occurs and ending on the date on which all of the assets of the Company have been distributed to the Members pursuant to Section 13.2 hereof (the "LIQUIDATION PERIOD"), the Members shall continue to share Profits, Losses, gain, loss and other items of Company income, gain, loss or deduction in the manner provided in Section 4 hereof. 13.7 CHARACTER OF LIQUIDATING DISTRIBUTIONS. All payments made in liquidation of the interest of a Member in the Company shall be made in exchange for the interest of such Member in Property pursuant to Section 736(b)(1) of the Code, including the interest of such Member in Company goodwill. 13.8 THE LIQUIDATOR. (a) DEFINITION. The "LIQUIDATOR" shall mean a Person appointed by the Board of Managers to oversee the liquidation of the Company. (b) FEES. The Company is authorized to pay a reasonable fee to the Liquidator for its services performed pursuant to this Article 13 and to reimburse the Liquidator for its reasonable costs and expenses incurred in performing those services unless the liquidator is a Manager or a Member, in which case such Manager or Member shall receive no fee. (c) INDEMNIFICATION. The Company shall indemnify, save harmless, and pay all judgments and claims against such Liquidator or any officers, directors, agents or employees of 47 the Liquidator relating to any liability or damage incurred by reason of any act performed or omitted to be performed by the Liquidator, or any officers, directors, agents or employees of the Liquidator in connection with the liquidation of the Company, including reasonable attorneys' fees incurred by the Liquidator, officer, director, agent or employee in connection with the defense of any action based on any such act or omission, which attorneys' fees may be paid as incurred, except to the extent such liability or damage is caused by the fraud, intentional misconduct of, or a knowing violation by the Liquidator of the applicable laws or regulations or terms of the Liquidation's engagement which violation was material to the cause of action. 13.9 FORM OF LIQUIDATING DISTRIBUTIONS. For purposes of making distributions required by Section 13.2 hereof, the Liquidator shall sell all of the Property and distribute the proceeds therefrom unless the Liquidator and the Managers agree on the distribution of any Property in-kind, in which case the Liquidator shall proceed as agreed with the Managers in such regard. 48 ARTICLE 14 POWER OF ATTORNEY 14.1 MANAGERS AS ATTORNEYS-IN-FACT. Each Member hereby makes, constitutes, and appoints Bradley K. Serwin and R. Steven Clark, either of whom may act alone, with full power of substitution and resubstitution, such Member's true and lawful attorneys-in-fact for it and in its name, place, and stead and for its use and benefit, to sign, execute, certify, acknowledge, swear to, file, publish and record (i) all certificates of formation, amended name or similar certificates, and other certificates and instruments (including counterparts of this Agreement) which the Board Managers may deem necessary to be filed by the Company under the laws of the State of Delaware or any other jurisdiction in which the Company is doing or intends to do business; (ii) any and all amendments, restatements or changes to this Agreement and the instruments described in clause (i), as now or hereafter amended, which the Board Managers may deem necessary to effect a change or modification of the Company in accordance with the terms of this Agreement, including, without limitation, amendments, restatements or changes to reflect (A) any amendments adopted by the Members in accordance with the terms of this Agreement, (B) the admission of any substituted Member and (C) the disposition by any Member of his interest in the Company; (iii) all certificates of cancellation and other instruments which the Board Managers deem necessary or appropriate to effect the dissolution and termination of the Company pursuant to the terms of this Agreement and (iv) any other instrument which is now or may hereafter be required by law to be filed on behalf of the Company or is deemed necessary by the Board Managers to carry out fully the provisions of this Agreement in accordance with its terms. Each Member authorizes each such attorneys-in-fact to take any further action which such attorneys-in-fact shall consider necessary in connection with any of the foregoing, hereby giving such attorneys-in-fact full power and authority to do and perform each and every act or thing whatsoever requisite to be done in connection with the foregoing as fully as such Member might or could do personally, and hereby ratify and confirm all that any such attorneys-in-fact shall lawfully do, or cause to be done, by virtue thereof or hereof. 14.2 NATURE OF SPECIAL POWER. The power of attorney granted to Bradley K. Serwin and R. Steven Clark pursuant to this Article 14: (a) Is a special power of attorney coupled with an interest and is irrevocable; (b) May be exercised by any such attorneys-in-fact by listing the Members executing any agreement, certificate, instrument, or other document with the single signature of any such attorney-in-fact acting as attorney-in-fact for such Members; and (c) Shall survive and not be affected by the subsequent Bankruptcy, insolvency, dissolution, or cessation of existence of a Member and shall survive the delivery of an assignment by a Member of the whole or a portion of its interest in the Company (except that where the assignment is of such Member's entire interest in the Company and the assignee, with the consent of the other Members as provided herein, is admitted as a substituted Member, the power of attorney shall survive the delivery of such assignment for the sole purpose of enabling 49 any such attorney-in-fact to effect such substitution) and shall extend to such Member's, or assignee's successors and assigns. ARTICLE 15 MISCELLANEOUS 15.1 NOTICES. Any notice, payment, demand, or communication required or permitted to be given by any provision of this Agreement shall be in writing and shall be deemed to have been delivered, given, and received for all purposes (i) if delivered personally to the Person or to an officer of the Person to whom the same is directed, or (ii) when the same is actually received, if sent either by registered or certified mail, postage and charges prepaid, or by facsimile, if such facsimile is followed by a hard copy of the facsimile communication sent promptly thereafter by registered or certified mail, postage and charges prepaid, addressed as follows, or to such other address as such Person may from time to time specify by notice to the Members and Managers: (a) If to the Company, to the address determined pursuant to Section 2.4 hereof; (b) If to the Managers, to the address set forth in EXHIBIT D hereto; (c) If to a Member, to the address set forth in EXHIBIT B hereto. 15.2 BINDING EFFECT. Except as otherwise provided in this Agreement, every covenant, term, and provision of this Agreement shall be binding upon and inure to the benefit of the Members and their respective successors, transferees, and assigns. 15.3 CONSTRUCTION. Every covenant, term, and provision of this Agreement shall be construed simply according to its fair meaning and not strictly for or against any Member. 15.4 TIME. In computing any period of time pursuant to this Agreement, the day of the act, event or default from which the designated period of time begins to run shall not be included, but the time shall begin to run on the next succeeding day. The last day of the period so computed shall be included, unless it is a Saturday, Sunday or legal holiday, in which event the period shall run until the end of the next day which is not a Saturday, Sunday or legal holiday. 15.5 HEADINGS. Section and other headings contained in this Agreement are for reference purposes only and are not intended to describe, interpret, define, or limit the scope, extent, or intent of this Agreement or any provision hereof. 15.6 SEVERABILITY. Except as otherwise provided in the succeeding sentence, every provision of this Agreement is intended to be severable, and, if any term or provision of this Agreement is illegal or invalid for any reason whatsoever, such illegality or invalidity shall not affect the validity or legality of the remainder of this Agreement. The preceding sentence of this Section 15.6 shall be of no force or effect if the consequence of enforcing the remainder of this Agreement without such illegal or invalid term or provision would be to cause any Member to lose the material benefit of its economic bargain. 50 15.7 INCORPORATION BY REFERENCE. Every exhibit, schedule, and other appendix attached to this Agreement and referred to herein is not incorporated in this Agreement by reference unless this Agreement expressly otherwise provides. 15.8 VARIATION OF TERMS. All terms and any variations thereof shall be deemed to refer to masculine, feminine, or neuter, singular or plural, as the identity of the Person or Persons may require. 15.9 GOVERNING LAW. The laws of the State of Delaware shall govern the validity of this Agreement, the construction of its terms, and the interpretation of the rights and duties arising hereunder. 15.10 PAYMENT OF FEES AND EXPENSES. The Company shall pay all expenses incurred with respect to this Agreement. If any remedy at law or in equity is necessary to enforce the terms of this Agreement, the prevailing party shall be entitled to reasonable attorney's fees, costs and necessary disbursements in addition to any other relief to which such party may be entitled. 15.11 WAIVER OF JURY TRIAL. Each of the Members irrevocably waives to the extent permitted by law, all rights to trial by jury and all rights to immunity by sovereignty or otherwise in any action, proceeding or counterclaim arising out of or relating to this Agreement. 15.12 COUNTERPART EXECUTION. This Agreement may be executed in any number of counterparts with the same effect as if all of the Members had signed the same document. All counterparts shall be construed together and shall constitute one agreement. 15.13 SPECIFIC PERFORMANCE. Each Member agrees with the other Members that the other Members would be irreparably damaged if any of the provisions of this Agreement are not performed in accordance with their specific terms and that monetary damages would not provide an adequate remedy in such event. Accordingly, it is agreed that, in addition to any other remedy to which the nonbreaching Members may be entitled, at law or in equity, the nonbreaching Members shall be entitled to injunctive relief to prevent breaches of the provisions of this Agreement and specifically to enforce the terms and provisions hereof in any action instituted in any court of the United States or any state thereof having subject matter jurisdiction thereof. 51 IN WITNESS WHEREOF, the parties have executed and entered into this Operating Agreement as of the day first above set forth. /s/ R. Steven Clark ---------------------------------------- R. STEVEN CLARK /s/ Edward A. Lopit ---------------------------------------- EDWARD A. LOPIT /s/ Lawrence A.Riggs ---------------------------------------- LAWRENCE A. RIGGS /s/ John R. Snyder ---------------------------------------- JOHN R. SNYDER PAULA FINANCIAL, a Delaware corporation By: /s/ Bradley K. Serwin ---------------------------------------- Name: Bradley K. Serwin Title: Sr. V.P. 52 EX-10.32 4 WORKERS COMPENSATION QUOTA SHARE REINSUREMENT AGMT PAULA INSURANCE COMPANY WORKERS COMPENSATION QUOTA SHARE REINSURANCE AGREEMENT FINAL PLACEMENT SLIP COMPANY: PAULA Insurance Company a California corporation and/or any Company hereafter affiliated with PAULA Insurance Company EFFECTIVE: Losses occurring during the period beginning 12:01 a.m., Pacific Standard Time, October 1, 1998, and ending 12:01 a.m., Pacific Standard Time, October 1, 2000, under policies in force at 12:01 a.m., Pacific Standard Time, October 1, 1998, and written and renewed with effective dates during the term of this Agreement. If, at any time, the Reinsurer ceases underwriting operations or loses the whole or part of its paid up capital, becomes insolvent, or is placed in conservation, rehabilitation, or liquidation, has a receiver appointed, or is acquired, controlled by, merged with, or reinsures its entire business with any other company or corporation, the Company will have the right to cancel this Agreement by giving 15 days notice by certified or registered mail. BUSINESS COVERED: All business classified by the Company as Workers Compensation and Employers Liability. EXCLUSIONS: Per attached. TERRITORY: Worldwide. LIMIT: 25% Quota Share of the first $10,000 of ultimate net loss, each and every occurrence, regardless of the number of policies involved. -1 of 8- "Occurrence" (except for losses arising from Occupational Disease or Cumulative Trauma as defined below) will mean any one accident, disaster, casualty, or loss or series of accidents, disasters, casualties, or losses arising out of or caused by one event. With respect to Occupational Disease or Cumulative Trauma, all losses arising from each employee will be deemed a separate "occurrence". The date of loss for each occurrence will be the date when the compensable disability of the employee commences, or if there is no such disability, when the medical treatment commences. The terms "Occupation Disease" and "Cumulative Trauma" as used in this Agreement will be as defined by applicable state statutes, regulations, or Federal Law. LOSS EXPENSES: Loss expense included within the ultimate net loss in satisfying Retention and Limit hereon. "Loss expense" will mean expense assignable to the investigation, defense, and settlement of specific claims, including litigation expense, interest on judgments, staff counsel expense, and declaratory judgment expense, but not including salaries and benefits of the Company's directors, officers, and employees, nor the Company's office expenses, overhead, and other fixed expenses of the Company. Any expenses paid to a company that is part of or affiliated with the Company, or to an economically-related enterprise, or to any enterprise which has common ownership with a company or affiliate of the Company, will not be included in loss expense. Any commission or other compensation paid to the Company by a company providing service on the business subject to this Agreement will be deducted from the allowable loss expense hereunder. PREMIUM: Pro-Rata of GNEP, payable monthly as earned. Gross Net Earned Premium is defined as the Company's Premium for the business covered hereunder less 28.7%. -2 of 8- Monthly bordereaux within 45 days of the end of each month of premiums and losses; loss bordereaux to delineate claims for occupational disease, cumulative trauma, employers liability, extra contractual obligations, and excess limits liability claims. Bordeaux to include GNEP associated with class codes with a "D" or "E" modifier. Settlement with bordereaux if balance is due the Reinsurer; if balance is due the Company, settlement due from the Reinsurer within 15 days after receipt of bordereaux. CEDING COMMISSION: Company allowed a ceding commission of [redacted]% on GNEP ceded. ESTIMATED SUBJECT PREMIUM: $162,500,000 - First twelve-months $162,500,000 - Second twelve-months ORIGINAL The liability of the Reinsurer will be subject in all CONDITIONS: respects to the same interpretations, terms, rates, conditions, waivers, modifications, and alterations as the respective policies of the Company to which this Agreement relates. However, in no event will this be construed in any way to provide coverage outside the terms and conditions set forth in this Agreement. The Company will be the sole judge as to what will constitute a claim or loss covered under the Company's policy and as to the Company's liability thereunder and will, at its sole discretion, adjust, settle, or compromise all claims and losses. All such adjustments, settlements, or compromises will be unconditionally binding on the Reinsurer in proportion to its participation, provided they are within the terms and conditions of this Agreement. The Company will, likewise, at its sole discretion, commence, continue, defend, or withdraw from actions, suits, or proceedings and generally handle all matters related to all claims and losses, and all payments made and costs and expenses incurred in connection therewith or taking legal advice therefor will be shared by the Reinsurer. -3 of 8- When so requested, however, the Company will afford the Reinsurer, at the Reinsurer's own expense, an opportunity to be associated with the Company in the defense of any claim, suit, or proceeding involving this Agreement, and the Company and the Reinsurer will cooperate in every respect in such defense. OTHER Access to Records Clause PROVISIONS: Aon Re Inc. Intermediary Clause Arbitration Clause Currency (U.S. Dollars) Clause Delays, Errors, or Omissions Clause 90%ECO/90% ELL (counsel and concur) - included within ultimate net loss Entire Agreement and Amendments Clause Insolvency Clause Settlements Clause Salvage & Subrogation Clause Net Retained Liability Clause Offset Clause Tax Clause Ultimate Net Loss Clause -- UNL to include any deductible under the insured's policy * * * * * -4 of 8- We ask that you review the terms and conditions set forth hereon. Assuming that you find everything in order, please indicate your acceptance and approval by signing and returning one (1) copy of this Placement Slip to Aon Re Inc., 201 California Street, Suite 900, San Francisco, California 94111. REINSURER: RELIANCE INSURANCE COMPANY_________________________________________ SIGNED LINE: 100% BEING $2,500________________________________________________ REFERENCE NO.:_________________________________________________________________ ACCEPTED AND APPROVED BY: /s/ JAMES A. FOWLER__________________ DATED: January 11,1999____ -5 of 8- EXCLUSIONS No reinsurance indemnity will be afforded under this Agreement for: A. Loss arising out of operations employing the process of nuclear fission or fusion or handling radioactive material, which operations include but are not limited to: 1. The use of nuclear reactors such as atomic piles, particle accelerators, or generators, or 2. The use, handling, or transportation of radioactive materials, or 3. The use, handling, or transportation of any weapon of war or explosive device employing nuclear fission or fusion. Subsections 1., 2., and 3. above do not apply to: a. The exclusive use of particle accelerators incidental to ordinary industrial or educational research pursuits, or b. The exclusive use, handling, or transportation of radioisotopes for medical or industrial use, or c. Radium or radium compounds. The term "any weapon of war or explosive device employing nuclear fission or fusion" will not apply to a device not equipped for intended explosive purposes, which employs nuclear fission or fusion for propulsion only. B. Class code with a "D" or "E" modifier (except on an incidental basis, i.e., less than 20% of total book). C. Class code nos. 1164 and 1165. -6 of 8- D. Second Injury Funds or Residual Market Assessments. E. Jones Act. F. Loss Portfolio Transfers. G. Insolvency Funds. H. Aggregate Workers' Compensation Policies. I. Liability assumed by the Company under any form of treaty or facultative reinsurance; however, this exclusion does not apply to policies written by another carrier at the Company's request and reinsured 100% by the Company. The above Exclusions (other than Exclusion A, C, D, E, F, G, and H) will not apply when they are merely incidental to the main operations of the insured provided such main operations are covered by the Company and are not themselves excluded from the scope of this Agreement. The Company will be the sole judge (except as respects exclusion B) as to what constitutes "incidental." Furthermore, should any judicial, regulatory, or legislative entity having jurisdiction invalidate any exclusion of the Company's policy, any amount of loss for which the Company would not be liable except for such invalidation will not be subject to the Exclusions hereunder. Should the Company, by reason of an inadvertent act, error, or omission, be bound to afford coverage excluded hereunder or should an existing insured extend its operations to include coverage excluded hereunder, the Reinsurer will waive the exclusion(s) with the exception of Exclusion A, C, D, E, F, G, and H. The duration of said waiver will not extend beyond the time that notice of such coverage has been received by the responsible underwriting authority of the Company plus the minimum time period required thereafter for the Company to terminate such coverage. The Company may submit in writing to the Reinsurer, for special acceptance hereunder, business not covered by this Agreement. If said business is accepted in writing by the Reinsurer, it will be subject to the terms of this Agreement, except as such terms are modified by such acceptance. Any special acceptance business covered under the reinsurance Agreement being replaced by this Agreement will be automatically covered hereunder. Further, should Reinsurers become a party to this Agreement subsequent to the acceptance of any business not normally covered hereunder, they will automatically accept same as being a part of this Agreement. -7 of 8- ACCESS TO RECORDS The Reinsurer or its duly-accredited representatives will have the right, upon prior notice to the Company, to inspect the books and records of the Company relating to the subject matter of this Agreement at all reasonable times while this Agreement is in force and subsequent to its termination so long as any claim or premium matters remain outstanding. The inspecting party will have the right, at its own expense, to make copies of any relevant information in the Company's files. At the conclusion of the inspection the inspecting party will meet with and discuss the review with the Company and will provide a written report of its findings. All non-public information provided in the course of the inspection will be kept confidential by the Reinsurer as against third parties, except as respects any obligation to do so by law or contract to retrocessionaires of the Reinsurer, to counsel retained by the Reinsurer, or to external accounting or compliance auditors. DEFINITIONS "Ultimate net loss" will mean the actual loss or losses paid or payable by the Company under its policies, after deduction of all salvages and recoveries that are actually received, and inuring reinsurance whether recoverable or not. Ultimate net loss will be inclusive of loss expense, any deductible under the insureds' policies, and 90% of any claims-related extra contractual obligations and excess limits liability. All salvages, recoveries, or reinsurance received subsequent to any loss settlement hereunder will be applied as if received prior to the settlement, and all necessary adjustments will be made by the parties hereto. Nothing in this definition, however, should be construed to mean that losses under this Agreement are not recoverable until the Company's ultimate net loss has been ascertained. In the event a verdict or judgment is reduced by an appeal or a settlement, subsequent to the entry of the judgment, however, resulting in an ultimate saving on such verdict or judgment, or a judgment is reversed outright, the loss expense incurred in securing such final reduction or reversal will be prorated between the Reinsurer and the Company in the proportion that each benefits from such reduction or reversal. "Declaratory judgment expense" will mean all expenses incurred by the Company in connection with declaratory judgment actions brought to determine the Company's defense and indemnification obligations that are allocable to specific policies and claims subject to this Agreement. Declaratory judgment expense will be deemed to have been fully incurred by the Company on the date of the actual or alleged loss giving rise to the action under the Company's policy. OFFSET The Company and each Reinsurer hereunder may offset any paid claims against ceded premiums due from one party to the other under this Agreement or any other agreement entered into between them. -8 of 8- EX-10.33 5 WORKERS COMPENSATION 1ST AND 2ND REINSUREMENT AGMT PAULA INSURANCE COMPANY WORKERS COMPENSATION FIRST AND SECOND EXCESS OF LOSS REINSURANCE AGREEMENT FINAL PLACEMENT SLIP COMPANY: PAULA Insurance Company a California corporation and/or any Company hereafter affiliated with PAULA Insurance Company. EFFECTIVE: Losses occurring during the period beginning 12:01 a.m., Pacific Standard Time, October 1, 1998, and ending 12:01 a.m., Pacific Standard Time, October 1, 2000, under policies in force at 12:01 a.m., Pacific Standard Time, October 1, 1998, and written and renewed with effective dates during the term of this Agreement. If, at any time, the Reinsurer ceases underwriting operations or loses the whole or part of its paid up capital, becomes insolvent, or is placed in conservation, rehabilitation, or liquidation, has a receiver appointed, or is acquired, controlled by, merged with, or reinsures its entire business with any other company or corporation, the Company will have the right to cancel this Agreement by giving 15 days notice by certified or registered mail. BUSINESS COVERED: All business classified by the Company as Workers Compensation and Employers Liability. EXCLUSIONS: Per attached. TERRITORY: Worldwide. RETENTION FIRST EXCESS AND LIMIT: $40,000 ultimate net loss each and every occurrence, excess of $10,000 ultimate net loss each and every occurrence, regardless of the number of policies involved. -1 of 9- SECOND EXCESS $200,000 ultimate net loss each and every occurrence, excess of $50,000 ultimate net loss each and every occurrence, regardless of the number of policies involved. "Occurrence" (except for losses arising from Occupational Disease or Cumulative Trauma as defined below) will mean any one accident, disaster, casualty, or loss or series of accidents, disasters, casualties, or losses arising out of or caused by one event. With respect to Occupational Disease or Cumulative Trauma, all losses arising from each employee will be deemed a separate "occurrence". The date of loss for each occurrence will be the date when the compensable disability of the employee commences, or if there is no such disability, when the medical treatment commences. The terms "Occupation Disease" and "Cumulative Trauma" as used in this Agreement will be as defined by applicable state statutes, regulations, or Federal Law. LOSS Loss expense included within the ultimate net loss in EXPENSES: satisfying Retention and Limit hereon. "Loss expense" will mean expense assignable to the investigation, defense, and settlement of specific claims, including litigation expense, interest on judgments, staff counsel expense, and declaratory judgment expense, but not including salaries and benefits of the Company's directors, officers, and employees, nor the Company's office expenses, overhead, and other fixed expenses of the Company. Any expenses paid to a company that is part of or affiliated with the Company, or to an economically-related enterprise, or to any enterprise which has common ownership with a company or affiliate of the Company, will not be included in loss expense. Any commission or other compensation paid to the Company by a company providing service on the business subject to this Agreement will be deducted from the allowable loss expense hereunder. PREMIUM FIRST EXCESS AND REMITTANCES: Rate: [Redacted]% GNEP, payable monthly as earned. -2 of 9- SECOND EXCESS Rate: [Redacted]% GNEP, payable monthly as earned. Monthly bordereaux within 45 days of the end of each month of premiums and losses; loss bordereaux to delineate claims for occupational disease, cumulative trauma, employers liability, extra contractual obligations, and excess limits liability claims. Bordeaux to include GNEP associated with class codes with a "D" or "E" modifier. Settlement with bordereaux if balance is due the Reinsurer; if balance is due the Company, settlement due from the Reinsurer within 15 days after receipt of bordereaux. ESTIMATED SUBJECT PREMIUM: $162,500,000 - First twelve-months $162,500,000 - Second twelve-months ORIGINAL The liability of the Reinsurer will be subject in all CONDITIONS: respects to the same interpretations, terms, conditions, waivers, modifications, and alterations, as the respective policies of the Company to which this Agreement relates. However, in no event will this be construed in any way to provide coverage outside the terms and conditions set forth in this Agreement. The Company will be the sole judge as to what will constitute a claim or loss covered under the Company's policy and as to the Company's liability thereunder and will, at its sole discretion, adjust, settle, or compromise all claims and losses. All such adjustments, settlements, or compromises will be unconditionally binding on the Reinsurer in proportion to its participation, provided they are within the terms and conditions of this Agreement. The Company will, likewise, at its sole discretion, commence, continue, defend, or withdraw from actions, suits, or proceedings and generally handle all matters related to all claims and losses, and all payments made and costs and expenses incurred in connection therewith or taking legal advice therefor will be shared by the Reinsurer. When so requested, however, the Company will afford the Reinsurer, at the Reinsurer's own expense, an opportunity to be associated with the Company in the defense of any claim, suit, or -3 of 9- proceeding involving this Agreement, and the Company and the Reinsurer will cooperate in every respect in such defense. OTHER Access to Records Clause PROVISIONS: Aon Re Inc. Intermediary Clause Arbitration Clause Currency (U.S. Dollars) Clause Delays, Errors, or Omissions Clause 90% ECO/90% ELL (counsel and concur) - included within ultimate net loss Entire Agreement and Amendments Clause Insolvency Clause Loss Notices and Settlements Clause Net Retained Liability Clause Salvage and Subrogation Clause Offset Clause Tax Clause Ultimate Net Loss Clause -- UNL to include any deductible under the insured's policy * * * * * -4 of 9- We ask that you review the terms and conditions set forth hereon. Assuming that you find everything in order, please indicate your acceptance and approval by signing and returning one (1) copy of this Placement Slip to Aon Re Inc., 201 California Street, Suite 900, San Francisco, California 94111. REINSURER: RELIANCE INSURANCE COMPANY_________________________________________ FIRST LAYER SIGNED LINE: 75% BEING $30,000_______________________________________________ SECOND LAYER SIGNED LINE: 100% BEING $200,000______________________________________________ ACCEPTED AND APPROVED BY: /s/ JAMES A. FOWLER________________ DATED: January 11,1999 _____ -5 of 9- EXCLUSIONS No reinsurance indemnity will be afforded under this Agreement for: A. Loss arising out of operations employing the process of nuclear fission or fusion or handling radioactive material, which operations include but are not limited to: 1. The use of nuclear reactors such as atomic piles, particle accelerators, or generators, or 2. The use, handling, or transportation of radioactive materials, or 3. The use, handling, or transportation of any weapon of war or explosive device employing nuclear fission or fusion. Subsections 1., 2., and 3. above do not apply to: a. The exclusive use of particle accelerators incidental to ordinary industrial or educational research pursuits, or b. The exclusive use, handling, or transportation of radioisotopes for medical or industrial use, or c. Radium or radium compounds. The term "any weapon of war or explosive device employing nuclear fission or fusion" will not apply to a device not equipped for intended explosive purposes, which employs nuclear fission or fusion for propulsion only. B. Class code with a "D" or "E" modifier (except on an incidental basis, i.e., less than 20% of total book). C. Class code nos. 1164 and 1165. D. Second Injury Funds or Residual Market Assessments. E. Jones Act. F. Loss Portfolio Transfers. G. Insolvency Funds. H. Aggregate Excess Workers' Compensation Policies. -6 of 9- I. Liability assumed by the Company under any form of treaty or facultative reinsurance, however, this exclusion does not apply to policies written by another carrier at the Company's request and reinsured 100% by the Company. The above Exclusions (other than Exclusion A, C, D, E, F, G, and H) will not apply when they are merely incidental to the main operations of the insured provided such main operations are covered by the Company and are not themselves excluded from the scope of this Agreement. The Company will be the sole judge (except as respects exclusion B) as to what constitutes "incidental." Furthermore, should any judicial, regulatory, or legislative entity having jurisdiction invalidate any exclusion of the Company's policy, any amount of loss for which the Company would not be liable except for such invalidation will not be subject to the Exclusions hereunder. Should the Company, by reason of an inadvertent act, error, or omission, be bound to afford coverage excluded hereunder or should an existing insured extend its operations to include coverage excluded hereunder, the Reinsurer will waive the exclusion(s) with the exception of Exclusion A, C, D, E, F, G, and H. The duration of said waiver will not extend beyond the time that notice of such coverage has been received by the responsible underwriting authority of the Company plus the minimum time period required thereafter for the Company to terminate such coverage. The Company may submit in writing to the Reinsurer, for special acceptance hereunder, business not covered by this Agreement. If said business is accepted in writing by the Reinsurer, it will be subject to the terms of this Agreement, except as such terms are modified by such acceptance. Any special acceptance business covered under the reinsurance Agreement being replaced by this Agreement will be automatically covered hereunder. Further, should Reinsurers become a party to this Agreement subsequent to the acceptance of any business not normally covered hereunder, they will automatically accept same as being a part of this Agreement. -7 of 9- ACCESS TO RECORDS The Reinsurer or its duly-accredited representatives will have the right, upon prior notice to the Company, to inspect the books and records of the Company relating to the subject matter of this Agreement at all reasonable times while this Agreement is in force and subsequent to its termination so long as any claim or premium matters remain outstanding. The inspecting party will have the right, at its own expense, to make copies of any relevant information in the Company's files. At the conclusion of the inspection the inspecting party will meet with and discuss the review with the Company and will provide a written report of its findings. All non-public information provided in the course of the inspection will be kept confidential by the Reinsurer as against third parties, except as respects any obligation to do so by law or contract to retrocessionaires of the Reinsurer, to counsel retained by the Reinsurer, or to external accounting or compliance auditors. DEFINITIONS "Ultimate net loss" will mean the actual loss or losses paid or payable by the Company under its policies, after deduction of all salvages and recoveries that are actually received, and inuring reinsurance whether recoverable or not. Ultimate net loss will be inclusive of loss expense, any deductible under the insureds' policies, and 90% of any claims-related extra contractual obligations and excess limits liability. All salvages, recoveries, or reinsurance received subsequent to any loss settlement hereunder will be applied as if received prior to the settlement, and all necessary adjustments will be made by the parties hereto. Nothing in this definition, however, should be construed to mean that losses under this Agreement are not recoverable until the Company's ultimate net loss has been ascertained. In the event a verdict or judgment is reduced by an appeal or a settlement, subsequent to the entry of the judgment, however, resulting in an ultimate saving on such verdict or judgment, or a judgment is reversed outright, the loss expense incurred in securing such final reduction or reversal will be prorated between the Reinsurer and the Company in the proportion that each benefits from such reduction or reversal. "Declaratory judgment expense" will mean all expenses incurred by the Company in connection with declaratory judgment actions brought to determine the Company's defense and indemnification obligations that are allocable to specific policies and claims subject to this Agreement. Declaratory judgment expense will be deemed to have been fully incurred by the Company on the date of the actual or alleged loss giving rise to the action under the Company's policy. -8 of 9- OFFSET The Company and each Reinsurer hereunder may offset any paid claims against ceded premiums due from one party to the other under this Agreement or any other agreement entered into between them. -9 of 9- EX-10.34 6 EXHIBIT 10.34 CHANGE OF CONTROL AGREEMENT This change of control agreement (the "Agreement") is made effective as of November 1, 1998 by and between PAULA FINANCIAL, a Delaware corporation (the "Company"), and Jeffrey A. Snider ("Employee"). WITNESSETH WHEREAS, if certain corporate transactions were proposed or pending, such potential transactions could result in distractions to Employee's performance at a critical period; and WHEREAS, Employee and Company wish to enter into this Agreement in order to provide security to Employee as a means of maintaining performance under such circumstances; NOW, THEREFORE, in consideration of the mutual promises and agreements set forth herein, the Company and Employee agree as follows: 1. TERM. 1.1 The term of this Agreement (the "Term") shall commence on November 1, 1998 and shall be for three years, subject to earlier termination in accordance with the provisions of Section 4 hereinbelow. Beginning on November 1, 1998 and on each day thereafter, the Term shall automatically be extended for an additional day, unless the Company notifies Employee in writing that it does not wish to further extend the Term. 2. POSITION AND TITLE. 2.1 The Company on behalf of itself and its affiliates and subsidiaries currently employs Employee as Chairman of the Board of Directors, President and Chief Executive Officer. 2.2 Employee shall devote substantially all of his efforts on a full-time basis to the business and affairs of the Company and shall not engage in any business or perform any services in any capacity whatsoever adverse to the interests of the Company. 2.3 Employee shall at all times faithfully, industriously, and to the best of his ability, experience, and talents, perform all of the duties of his position. 1 3. COMPENSATION. 3.1 As of the date of this Agreement, Employee's annual base salary is $360,000. Employee's base salary and performance shall be reviewed periodically at intervals approved by the Executive Compensation Committee of the Board of Directors of the Company (the "Committee"), and Employee's base salary may be increased from time to time based on merit or such other considerations as the Committee may deem appropriate. 4. TERMINATION OF EMPLOYMENT. For purposes of this Agreement, a Termination Without Cause shall exist if Employee is terminated by the Company for any reason except: (1) Intentional conduct or action by Employee which, in the opinion of a majority of the Board of Directors (the "Board"), is materially harmful to the Company; (2) Willful failure by Employee to follow an order of the Board, except in a case where the Employee reasonably believes in good faith that following such order would be materially detrimental to the interests of the Company; or (3) Employee's conviction of a felony. Additionally, if (a) Employee's annual base salary is reduced below the amount stated in Paragraph 3.1 hereinabove (unless such reduction is part of an across the board reduction affecting all executive officers of the Company), (b) Employee is removed from or denied participation in incentive plans, benefit plans, or perquisites generally provided by the Company to other executive officers, (c) Employee's target incentive opportunity, benefits or perquisites are reduced relative to other executive officers, (d) Employee is assigned duties or obligations inconsistent with his position with the Company, (e) Employee is required to relocate to an area outside the Metropolitan Los Angeles area, or (f) there is a material reduction in Employee's position (status, offices, titles, or reporting requirements), duties or responsibilities or a significant change in the nature and scope of Employee's authority or his overall working environment, such event shall be considered a Termination Without Cause. 5. CHANGE OF CONTROL. 5.1 Employee shall be entitled to the benefits set forth in this Section 5 in the event: (i) a Change of Control of the Company occurs at any time during the Term of this Agreement; AND (ii) Employee is Terminated Without Cause within a period of twenty-four (24) months following the date of such Change of Control: 2 (1) The Company shall pay Employee a lump-sum severance amount within thirty (30) days following his Termination Without Cause equal to the sum of (a) three (3) times the higher of the Employee's annual base salary at the time of Termination Without Cause or the annual base salary stated in Paragraph 3.1 hereinabove, and (b) one (1) times the target annual bonus of Employee for the fiscal year in which such Termination Without Cause occurs. (2) The Company shall provide for Employee to receive medical, dental, life, and disability insurance coverage for three (3) years following his Termination Without Cause at levels and a net cost to Employee comparable to that provided to Employee immediately prior to Employee's Termination Without Cause. The Company shall also provide Employee with the use of the automobile then provided to him under the same terms as then in force for three (3) years following his Termination Without Cause. (3) The Company shall pay for Employee's use of an executive office with secretarial support in premises outside of Company facilities for a period of six (6) months following his Termination Without Cause. 5.2 All stock options, restricted stock and other stock based awards held by Employee which are not then fully vested shall become 100% vested upon his Termination Without Cause if the Termination Without Cause occurs within a period of twenty-four (24) months following the date of a Change of Control. 5.3 If it is determined that any payment, distribution or benefit made or provided by the Company to Employee pursuant to this Agreement (determined without regard to any additional payments required pursuant to this sentence) (a "Payment") would be subject to the excise tax imposed by Section 4999 of the Internal Revenue Code of 1986, as amended (the "Code"), or any interest or penalties are incurred by the Employee with respect to such excise tax (such excise tax, together with any such interest and penalties, are hereinafter collectively referred to as the "Excise Tax"), then upon such determination the Employee shall be entitled to receive with respect to each Payment an additional payment (a "Gross-Up Payment") in an amount such that after payment by the Employee of all taxes (including any interest or penalties imposed with respect to such taxes), including, without limitation, any income and employment taxes (and any interest and penalties imposed with respect thereto) and Excise Tax imposed upon the Gross-Up Payment, the Employee retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments. 5.4 As used herein, the term "Change of Control" shall mean any of the following events: (W) any date upon which the directors of the Company who were nominated by the Board for election as directors cease to constitute a majority of the directors of the Company; (X) the date of the first public announcement that any person or entity, together with all Affiliates and Associates (as such capitalized terms are defined 3 in Rule 12b-2 promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) of such person or entity, shall have become the Beneficial Owner (as defined in Rule 13d-3 promulgated under the Exchange Act) of voting securities of the Company representing 50% or more of the voting power of the Company (a "50% Stockholder"), provided, however, that the terms "person" and "entity," as used in this clause (Y), shall not include (1) the Company or any of its subsidiaries, (2) any employee benefit plan of the Company or any of its subsidiaries, including the Company s Employee Stock Ownership Plan, or (3) any entity holding voting securities of the Company for or pursuant to the terms of any such plan; (Y) a reorganization, merger or consolidation of the Company in which the holders of voting stock of the Company immediately before the reorganization, merger or consolidation will not own more than fifty percent (50%) of the outstanding voting shares of the continuing or surviving entity immediately after such reorganization, merger or consolidation; or (Z) a sale of all or substantially all of the assets of the Company to an entity the voting securities of which are not then owned at least fifty percent (50%) by the holders of the voting securities of the Company immediately prior to the closing of the transaction. 5.5 Employee shall not be obligated to seek other employment or take any other action by way of mitigation of the amounts and benefits payable to Employee under any provisions of this Agreement, and the amounts and benefits payable under this Agreement shall not be offset by any amounts or benefits which Employee earns from any other employment or services. Notwithstanding the foregoing, in the event that Employee actually receives group medical, dental, disability and/or life insurance benefits from a subsequent employer, the Company shall not be required to provide such benefits to Employee to the extent that the benefits which would be provided by the Company would be redundant. 6. COVENANTS. 6.1 Employee agrees that any and all confidential knowledge or information, including but not limited to customer lists, books, records, data, formulae, inventions, processes and methods, which have been or may be obtained or learned by Employee in the course of his employment with the Company, will be held confidential by Employee, and that Employee shall not disclose the same to any person outside of the Company either during his employment with the Company or after his employment by the Company has terminated. 6.2 Employee agrees that, upon termination of his employment with the Company, he will immediately surrender and turn over to the Company all books, records, forms, and all other property belonging to the Company. 4 7. MISCELLANEOUS PROVISIONS. 7.1 All terms and conditions of this Agreement are set forth herein, and there are no warranties, agreements or understandings, express or implied, except those expressly set forth herein. 7.2 Any modifications to this Agreement shall be binding only if evidenced in writing signed by all parties hereto. 7.3 Any notice or other communication required or permitted to be given hereunder shall be deemed properly given if personally delivered or deposited in the United States Mail, registered or certified and postage prepaid, addressed to the Company at 300 North Lake Avenue, Suite 300, Pasadena, CA 91101 or to Employee at his most recent home address on file with the Company, or at other such addresses as may from time to time be designated in writing by the respective parties. 7.4 The laws of the State of California shall govern the validity of this Agreement, the construction of its terms, and the interpretation of the rights and duties of the parties involved. 7.5 In the event that any one or more of the provisions contained in this Agreement shall for any reason be held to be invalid, illegal or unenforceable, the same shall not affect any other provision of this Agreement, but this Agreement shall be construed as if such invalid, illegal or unenforceable provisions had never been contained herein. 7.6 This Agreement shall be binding upon, and inure to the benefit of, the successors and assigns of the Company and the personal representatives, heirs and legatees of Employee. 5 7.7 The term "Company" shall include, with respect to employment hereunder, any subsidiary or affiliate of the Company, as well as any successor employer following a Change of Control. IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the date first above written. PAULA FINANCIAL BY: /s/ John B. Clinton ------------------- Chairman of the Executive Compensation Committee of the Board of Directors EMPLOYEE BY: /s/ Jeffrey A. Snider --------------------- Jeffrey A. Snider 6 EX-11 7 EXHIBIT 11 EXHIBIT 11 PAULA FINANCIAL AND SUBSIDIARIES COMPUTATION OF BASIC AND DILUTED EARNINGS PER SHARE (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED DECEMBER 31, -------------------------------------------------- 1998 1997 1996 -------------- ------------- ------------- Net income (loss) $ (4,877) $ 5,159 $ 3,923 -------------- ------------- ------------- -------------- ------------- ------------- Weighted average shares outstanding for calculating basic earnings per share 6,228 2,737 1,897 Convertible preferred stock - 1,527 1,882 Warrants - 49 40 Options - 352 92 -------------- ------------- ------------- Total shares for calculating diluted earnings per share 6,228 4,665 3,911 -------------- ------------- ------------- -------------- ------------- ------------- Basic earnings (loss) per share $ (0.78) $ 1.88 $ 2.07 -------------- ------------- ------------- -------------- ------------- ------------- Diluted earnings (loss) per share $ (0.78) $ 1.11 $ 1.00 -------------- ------------- ------------- -------------- ------------- -------------
Options are excluded from the calculation of diluted loss per share as the inclusion of such options would have an anti-dilutive effect. EX-23 8 EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS The Board of Directors PAULA Financial: We consent to the incorporation by reference in the registration statements (No. 333-42627 and No. 333-45517) on Form S-8 of PAULA Financial and subsidiaries of our report dated March 2, 1999, relating to the consolidated balance sheets of PAULA Financial and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998, and all related schedules, which report appears in the December 31, 1998, annual report on Form 10-K of PAULA Financial. /s/ KPMG LLP Los Angeles, California March 30, 1999 EX-27 9 EXHIBIT 27
7 1,000 YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 170,792 0 0 4,259 0 0 177,623 4,145 715 2,533 254,948 136,316 20,234 0 335 2,667 0 0 63 73,973 254,948 128,770 9,540 1,706 4,076 114,483 37,636 677 (8,704) (3,827) (4,877) 0 0 0 (4,877) (0.78) (0.78) 71,390 108,454 6,029 34,674 40,020 111,179 0
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