**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C.  20549**

**FORM 10-QSB**

**(Mark One)**

**x****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the Quarterly Period EndedJune 30, 2006**

**OR**

**o****        TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the Transition Period from                   to                   **

**Commission filenumber 0-23181**

**PAULA FINANCIAL**

(Exactname of small business issuer as specified in its charter)

 

| **Delaware**                     |   | **95-4640638**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (IRS Employer        |
| incorporation or  organization)  |   | Identification  No.) |

**PAULA FINANCIAL**

**87 East Green Street, Suite 206**

**Pasadena, CA 91105**

(Address of principalexecutive offices)

**(626) 844-7100**

(Issuer’stelephone number)

 

Check whether the Issuer(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.    oYes   x  No

Indicate by check mark if the registrant is ashell company (as defined by Rule 12b-2 of the Exchange Act). o Yes   x No

**APPLICABLEONLY TO CORPORATE ISSUERS**

State the number of shares outstanding of each of the issuer’s classesof common equity as of the latest practicable date:

There were approximately6,487,045 shares of the registrant’s common stock, $0.01 par value, issued andoutstanding as of September 15, 2006.

Transitional Small Business Disclosure Format (Check one)  xYes   oNo

 

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PAULAFINANCIAL

INDEX TO FORM 10-QSB
| PART I.   |   | FINANCIAL INFORMATION                                                                                                                               |   |
|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|      |   |                                                                                                                                                |   |
| Item 1.   |   | Financial Statements                                                                                                                                |   |
|      |   |                                                                                                                                                |   |
|      |   | Condensed consolidated  balance sheets as of June 30, 2006 (unaudited) and  December 31, 2005                                                       |   |
|      |   |                                                                                                                                                |   |
|      |   | Condensed  consolidated statements of income and comprehensive income for the three  months and six months ended June 30, 2006 and 2005 (unaudited) |   |
|      |   |                                                                                                                                                |   |
|      |   | Condensed  consolidated statements of cash flows for the six months ended June 30, 2006  and 2005 (unaudited)                                       |   |
|      |   |                                                                                                                                                |   |
|      |   | Notes to  condensed consolidated financial statements for the three months and six  months ended June 30, 2006 (unaudited)                          |   |
|      |   |                                                                                                                                                |   |
| Item 2.   |   | Management’s  Discussion and Analysis or Plan of Operations                                                                                    |   |
|      |   |                                                                                                                                                |   |
| Item 3.   |   | Controls and  procedures                                                                                                                            |   |
|      |   |                                                                                                                                                |   |
| PART II.  |   | OTHER INFORMATION                                                                                                                                   |   |
|      |   |                                                                                                                                                |   |
| Item 2.   |   | Unregistered  Sale of Equity Securities and Use of Proceeds                                                                                         |   |
|      |   |                                                                                                                                                |   |
| Item 4.   |   | Submission of  Matters to a Vote of Security Holders                                                                                                |   |
|      |   |                                                                                                                                                |   |
| Item  6.  |   | Exhibits                                                                                                                                            |   |
|      |   |                                                                                                                                                |   |
| SIGNATURE |   |

 

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| **PART I.** | ** ** | **FINANCIAL INFORMATION** |
|-------------|------------|---------------------------|
| **Item 1.** | ** ** | **Financial Statements**  |

 

**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

(In thousands, exceptshare data)

 
| ** **                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                             | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                             | ** ** | **(Unaudited)**   | ** ** | **(*)**               | ** ** |
| ***Assets***                                                                                                           |       |              |       |                  |       |
|                                                                                                                   |       |              |       |                  |       |
| *Current Assets:*                                                                                                      | * *   | * *          | * *   | * *              | * *   |
| Cash and cash  equivalents (restricted: 2006, $1,513; 2005, $928)                                                      |       | $                 | 3,119      |                  | $          | 3,492 |   |
| Marketable  securities (Note B)                                                                                        |       | 1,303             |       | 1,226                 |       |
| Accounts  receivable, net of allowance for uncollectible accounts (2006 and 2005, $80)                                 |       | 2,738             |       | 4,236                 |       |
| Commissions  receivable                                                                                                |       | 2,610             |       | 1,986                 |       |
| Other  receivables                                                                                                     |       | 69                |       | 60                    |       |
| Deferred income  taxes (Note C)                                                                                        |       | 883               |       | 1,010                 |       |
| Other assets                                                                                                           |       | 201               |       | 154                   |       |
| *Total Current Assets*                                                                                                 |       | 10,923            |       | 12,164                |       |
| * *                                                                                                               | * *   | * *          | * *   | * *              | * *   |
| Restricted cash  related to deferred compensation plan                                                                 |       | 249               |       | —                |       |
| Property and  equipment, net                                                                                           |       | 476               |       | 536                   |       |
| Investment in  related party, at cost                                                                                  |       | 703               |       | 703                   |       |
| Goodwill, net                                                                                                          |       | 2,520             |       | 2,124                 |       |
| Other intangible  assets, net                                                                                          |       | 1,813             |       | 1,582                 |       |
| Deferred income  taxes (Note C)                                                                                        |       | 3,130             |       | 3,586                 |       |
| Other assets                                                                                                           |       | 172               |       | 191                   |       |
| *Total Assets*                                                                                                         |       | $                 | 19,986     |                  | $          | 20,886 |   |
| ***Liabilities  and Stockholders’ Equity***                                                                       |       |              |       |                  |       |
| *Current Liabilities:*                                                                                                 |       |              |       |                  |       |
| Due to  underwriters and assureds                                                                                      |       | $                 | 4,201      |                  | $          | 5,782 |   |
| Accounts payable  and accrued expenses                                                                                 |       | 607               |       | 583                   |       |
| Capital lease                                                                                                          |       | 40                |       | 41                    |       |
| Employment  related accruals                                                                                           |       | 734               |       | 886                   |       |
| Acquisition  related accruals                                                                                          |       | 588               |       | 987                   |       |
| Income taxes  payable                                                                                                  |       | 110               |       | 62                    |       |
| Notes payable to  bank                                                                                                 |       | 300               |       | 876                   |       |
| *Total Current Liabilities*                                                                                            |       | 6,580             |       | 9,217                 |       |
| * *                                                                                                               | * *   | * *          | * *   | * *              | * *   |
| Capital lease                                                                                                          |       | 175               |       | 178                   |       |
| Deferred  compensation plan                                                                                            |       | 249               |       | —                |       |
| Acquisition  related accruals                                                                                          |       | 889               |       | 427                   |       |
| *Total Liabilities*                                                                                                    |       | $                 | 7,893      |                  | $          | 9,822 |   |
| * *                                                                                                               | * *   | * *          | * *   | * *              | * *   |
| *Commitments and contingencies  (Note H)*                                                                              | * *   | * *          | * *   | * *              | * *   |
| * *                                                                                                               | * *   | * *          | * *   | * *              | * *   |
| *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 7,858,379 and 7,455,879  shares in 2006 and 2005) |       | 79                |       | 75                    |       |
| Additional  paid-in-capital                                                                                            |       | 14,642            |       | 14,353                |       |
| Accumulated  earnings, after January 1, 2003                                                                           |       | 3,796             |       | 2,922                 |       |
| Accumulated  other comprehensive loss                                                                                  |       | (24               | )          | (69                   | )          |
| Employee loans  for stock purchase                                                                                     |       | (23               | )          | (23                   | )          |
| Treasury stock,  at cost (1,144,534 and 1,052,034 shares in 2006 and 2005, respectively)                               |       | (6,377            | )          | (6,194                | )          |
| *Net Stockholders’ Equity*                                                                                        |       | $                 | 12,093     |                  | $          | 11,064 |   |
| *Total Liabilities and Stockholders’ Equity*                                                                      |       | $                 | 19,986     |                  | $          | 20,886 |   |

 

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* Derived fromaudited financial statements.

 

See notes tocondensed consolidated financial statements.

2

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**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Income and Comprehensive Income**

(In thousands,except share and per share data)
| ** **                                                                                                     | ** **   | **Three Months Ended** | ** **   | **Six Months Ended** | ** **   |
|----------------------------------------------------------------------------------------------------------------|--------------|----------------------------------|--------------|--------------------------------|--------------|
| ** **                                                                                                     | ** **   | **June 30,**                | ** **   | **June 30,**              | ** **   |
| ** **                                                                                                     | ** **   | **2006**                         | ** **   | **2005**                       | ** **   | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                     | ** **   | **(Unaudited)**                  | ** **   | **(Unaudited)**                | ** **   |
| ***Income:***                                                                                                  |         |                             |         |                           |         |   |   |   |   |
| Commissions and placement fees                                                                                 |         | $                                | 3,987        |                           | $            | 3,818 |   | $ | 7,768 |   | $ | 7,272 |   |
| Profit sharing                                                                                                 |         | 520                              |         | 23                             |         | 2,045 |   | 2,014 |   |
| Investment income                                                                                              |         | 57                               |         | 7                              |         | 109 |   | 25 |   |
| Service fees                                                                                                   |         | 120                              |         | 203                            |         | 231 |   | 364 |   |
| TPA fees                                                                                                       |         | —                           |         | 41                             |         | — |   | 71 |   |
| Other income                                                                                                   |         | —                           |         | 22                             |         | 1 |   | 19 |   |
|                                                                                                           |         | 4,684                            |         | 4,114                          |         | 10,154 |   | 9,765 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| ***Operating  Expenses:***                                                                                     |         |                             |         |                           |         |   |   |   |   |
| Salaries and related expenses                                                                                  |         | 2,708                            |         | 2,028                          |         | 5,223 |   | 5,006 |   |
| Interest expense                                                                                               |         | 20                               |         | 21                             |         | 38 |   | 41 |   |
| Amortization expense                                                                                           |         | 195                              |         | 181                            |         | 376 |   | 328 |   |
| Other expenses                                                                                                 |         | 1,282                            |         | 1,410                          |         | 2,688 |   | 2,797 |   |
|                                                                                                           |         | 4,205                            |         | 3,640                          |         | 8,325 |   | 8,172 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| Income from operations before income taxes                                                                     |         | 479                              |         | 474                            |         | 1,829 |   | 1,593 |   |
| Income tax expense                                                                                             |         | 204                              |         | 201                            |         | 753 |   | 659 |   |
| ***Net income***                                                                                               |         | $                                | 275          |                           | $            | 273 |   | $ | 1,076 |   | $ | 934 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| ***Other  comprehensive gain (loss), net of tax:***                                                            | *** *** | *** ***                     | *** *** | *** ***                   | *** *** | *** *** | *** *** | *** *** | *** *** |
| Unrealized holding gains (losses) arising during  period (tax impact: 2006 ($3) and ($17); 2005 $23 and ($17)) |         | (5                               | )            | (32                            | )            | 45 |   | (32 | ) |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| ***Comprehensive income***                                                                                     |         | $                                | 270          |                           | $            | 241 |   | $ | 1,121 |   | $ | 902 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| Earnings per  share                                                                                            |         | $                                | 0.04         |                           | $            | 0.04 |   | $ | 0.17 |   | $ | 0.14 |   |
| Weighted average  shares outstanding                                                                           |         | 6,481,367                        |         | 6,581,618                      |         | 6,493,036 |   | 6,587,050 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| Earnings per  share - assuming dilution                                                                        |         | $                                | 0.04         |                           | $            | 0.04 |   | $ | 0.16 |   | $ | 0.14 |   |
| Weighted average  shares outstanding – assuming dilution                                                  |         | 6,744,544                        |         | 6,794,585                      |         | 6,726,897 |   | 6,805,335 |   |
|                                                                                                           |         |                             |         |                           |         |   |   |   |   |
| Dividends declared per  common share                                                                           |         | $                                | 0.015        |                           | $            | 0.015 |   | $ | 0.030 |   | $ | 0.030 |   |

 

See notes to condensedconsolidated financial statements.

3

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**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)
| ** **                                                                           | ** **   | **Six Months Ended  June 30,** | ** **   |
|--------------------------------------------------------------------------------------|--------------|-----------------------------------------------|--------------|
| ** **                                                                           | ** **   | **2006**                                      | ** **   | **2005** | ** ** |
| ** **                                                                           | ** **   | **(Unaudited)**                               | ** **   |
| ***Cash  flows from operating activities:***                                         |         |                                          |         |   |   |
| Net income                                                                           |         | $                                             | 1,076        |   | $ | 934 |   |
| * *                                                                             | * *     | * *                                      | * *     | * * | * * |
| *Adjustments  to reconcile net income to net cash provided by operating activities:* |         |                                          |         |   |   |
| Depreciation                                                                         |         | 99                                            |         | 83 |   |
| Amortization                                                                         |         | 376                                           |         | 328 |   |
| Changes in operating assets and liabilities:                                         |         |                                          |         |   |   |
| (Increase) decrease  in receivables                                                  |         | 865                                           |         | (246 | ) |
| Decrease in deferred income taxes                                                    |         | 560                                           |         | 480 |   |
| Increase (decrease) in accounts payable and accrued  expenses                        |         | (1,370                                        | )            | 355 |   |
| Other, net                                                                           |         | (26                                           | )            | 46 |   |
| ***Net  cash provided by operating activities***                                     |         | 1,580                                         |         | 1,980 |   |
|                                                                                 |         |                                          |         |   |   |
| ***Cash  flows used in investing activities:***                                      | ** **   | ** **                                    | ** **   | ** ** | ** ** |
| Purchase of property and equipment                                                   |         | (39                                           | )            | (84 | ) |
| Purchase of investments                                                              |         | (9                                            | )            | (1,110 | ) |
| Purchase of book of business                                                         |         | (944                                          | )            | (531 | ) |
| ***Net  cash used in investing activities***                                         |         | (992                                          | )            | (1,725 | ) |
|                                                                                 |         |                                          |         |   |   |
| ***Cash  flows used in financing activities:***                                      | ** **   | ** **                                    | ** **   | ** ** | ** ** |
| Payments on line of credit                                                           |         | (576                                          | )            | (100 | ) |
| Dividends paid                                                                       |         | (202                                          | )            | (190 | ) |
| Repurchase of common stock                                                           |         | (183                                          | )            | (36 | ) |
| ***Net  cash used in financing activities***                                         |         | (961                                          | )            | (326 | ) |
|                                                                                 |         |                                          |         |   |   |
| ***Net  decrease in cash and cash equivalents***                                     |         | (373                                          | )            | (71 | ) |
| Cash and  invested cash at beginning of period                                       |         | 3,492                                         |         | 3,241 |   |
| ***Cash  and cash equivalents at end of period***                                    |         | $                                             | 3,119        |   | $ | 3,170 |   |
| *** ***                                                                         | *** *** | *** ***                                  | *** *** | *** *** | *** *** |
| ***Supplemental  disclosure of non-cash investing and financing activities:***       | *** *** | *** ***                                  | *** *** | *** *** | *** *** |
| Furniture and equipment acquired under a capital  lease                              |         | $                                             | —       |   | $ | 277 |   |
| Issuance of  restricted stock                                                        |         | 435                                           |         | — |   |

 

See notes to condensedconsolidated financial statements.

4

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**PAULA FINANCIAL AND SUBSIDIARIES**

**Notes toCondensed Consolidated Financial Statements**

**For theThree Months and Six Months Ended June 30, 2006 (Unaudited)**

**Note A - Basis of Presentation**

PAULA Financialand subsidiaries (collectively, the “Company”) is a California-basedspecialty distributor of commercial insurance products. The Company’s agencyoperations place a full array of commercial, employee benefits, personal andlife insurance products for its customers. The Company’s primary operations are in the state of California.

The accompanyingunaudited condensed consolidated financial statements of the Company have beenprepared in accordance with accounting principles generally accepted in theUnited States (“GAAP”) for interim financial information and with theinstructions to Form 10-QSB and Regulation S-B. Accordingly, they do not include all of the information and footnotesrequired by GAAP for complete financial statements.  In the opinion of management, alladjustments, including normally occurring accruals, considered necessary for afair presentation have been included.

Where necessary,prior years’ information has been reclassified to conform to the presentationfor the period covered by this report.

The Company’soperating results tend to be cyclical. Consequently, operating results for thesix months ended June 30, 2006 are not necessarily indicative of the results tobe expected for the year ending December 31, 2006.  For further information regarding the Company’sbusiness cycle, refer to the consolidated financial statements and footnotesthereto included in the Company’s Annual Report on Form 10-KSB for the yearended December 31, 2005.

*EarningsPer Share*

Stock options topurchase 300,000 shares that were outstanding as of June 30, 2006 were notincluded in the computation of earnings per share for the three months and sixmonths ended June 30, 2006 as inclusion of such shares would be antidilutive.

*DeferredCompensation Plan*

The Company hasadopted the PAULA Financial & Subsidiaries Deferred Compensation Plan (the “Plan”).  Eligibility under the Plan isdiscretionary.  Under the Plan,participants may defer a specified dollar amount of their base compensationranging from $5,000 to amounts allowed under the Internal Revenue Code and/or apercentage of any incentive compensation ranging from 50% to 100% of anyincentive amount for an annual period. The Plan was effective January 1, 2006 for base compensation and thefirst incentive compensation determination period ended May 31, 2006.  Commencement of payments under the Plan areat the election of the participant either payable at the beginning of the followingyear upon (a) attaining age 55 or (b) termination of employment.

5

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During the firstsix months of 2006, $121,000 in base compensation and $127,000 in incentivecompensation was deferred by the participants under the Plan.   Amounts deferred are reflected ascompensation expense in the period earned. Funds equivalent to amounts deferred are deposited into a Rabbi Trustand invested in money market funds, and a corresponding liability is recorded.The Rabbi Trust is administered by the Company.   The Company retains the right to amend orterminate the Plan at its discretion.

*Accountingand Disclosure Changes*

In February 2006,the Financial Accounting Standards Board (“FASB”) issued Statement No. 155, “Accountingfor Certain Hybrid Financial Instruments – an amendment of FASB Statements No.133 and 140.” Statement No. 155 simplifies the accounting for certain hybridfinancial instruments, eliminates the FASB’s interim guidance which providesthat beneficial interests in securitized financial assets are not subject tothe provisions of Statement No. 133, “Accounting for Derivative Instruments andHedging Activities, “ and eliminates the restriction on the passive derivativeinstruments that a qualifying special-purpose entity may hold. Statement No.155 is effective for all financial instruments acquired or issued after thebeginning of an entity’s first fiscal year that begins after September 15,2006.  The Company does not believe that the adoption of thispronouncement will have any material impact to the financial position andresults of operations because the Company has not entered into suchtransactions.

In March 2006, theFASB issued Statement No. 156, “Accountingfor Servicing of Financial Assets–an amendment of Statement No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities”*,* with respect to the accounting forseparately recognized servicing assets and liabilities. Statement No. 156requires an entity to recognize a servicing asset or liability each time itundertakes an obligation to service a financial asset by entering into aservicing contract in certain situations, including a transfer of the servicer’sfinancial assets that meets the requirements for sale accounting. Statement No.156 is effective for the first fiscal year beginning after September 30, 2006.The Company does not believe that the adoption of this pronouncement will haveany material impact to the financial position and results of operations becausethe Company has not entered into such transactions.

In July 2006, theFASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an Interpretation of FASBStatement No. 109.”  FIN 48clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with Statement No. 109, Accounting for Income Taxes. FIN 48prescribes a recognition threshold and measurement of a tax position taken orexpected to be taken in a company’s tax return. FIN 48 is effective for fiscalyears beginning after December 15, 2006. Accordingly, the Company will berequired to adopt FIN 48 in first quarter 2007. The Company is currentlyevaluating the impact that the adoption of FIN 48 will have, if any, on itsconsolidated financial statements and notes thereto.

On September 13,2006, the Securities and Exchange Commission issued Staff Accounting Bulletin108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements WhenQuantifying Misstatements in Current Year Financial Statements.”  SAB 108 clarifies the staff’s views regardingthe process of quantifying financial statement misstatements.  More specifically, the staff noted thatcertain registrants do not consider the effects of prior year errors on currentyear financial statements, thereby allowing improper assets or liabilities toremain unadjusted.    The staff believesthis approach is not in the best interests of the users of the financialstatements.

6

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SAB 108 iseffective for fiscal years ending on or after November 15, 2006 with earlieradoption encouraged.  The Company hashistorically applied the Iron Curtain method. The Company is currently evaluating the impact that the adoption of SAB108 will have, if any, on its consolidated financial statements and notesthereto.

##### **NoteB – Marketable Securities**

Held to maturityfixed income securities are those securities which the Company has the abilityand intent to hold until maturity. Held-to-maturity securities are carried at amortized cost withcorresponding premiums or discounts amortized to interest income over the lifeof the investment using the effective interest method.

Securities notclassified as trading securities or held-to-maturity are classified asavailable-for-sale and are reported at estimated fair value. Unrealized gainsor losses on available-for-sale securities are included as a separate componentof stockholders’ equity, net of related income taxes.

Common andpreferred stock, treated as available for sale securities, are recorded atestimated fair value with unrealized gains or losses recorded as a separatecomponent of stockholders’ equity, net of related income taxes.

The cost ofsecurities sold is based on the specific identification method.

Investments in which adecline in market value is deemed other than temporary are reduced to theestimated realizable value through a charge to income.

Marketable securities,primarily held in mutual funds, are comprised of the following ($’s in 000’s):
| ** **                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                          | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
|                                                                |       |              |       |                  |       |
| Common stock, at  fair value (cost: 2006 $1,086; 2005 $1,077)       |       | $                 | 1,049      |                  | $          | 971 |   |
| Preferred stock,  at fair value (cost: 2006 $203; 2005 $203)        |       | 204               |       | 205                   |       |
| Fixed  maturities, held-to-maturity (fair value: 2006 and 2005 $50) |       | 50                |       | 50                    |       |
| Total                                                               |       | $                 | 1,303      |                  | $          | 1,226 |   |

 

7

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##### **Note C – Deferred Income Taxes**

As ofJune 30, 2006 and December 31, 2005, the Company’s net deferred tax asset wascomprised of the following ($’s in 000’s):
| ** **                       | ** ** | **June 30** | ** ** | **December 31** | ** ** |
|----------------------------------|------------|------------------|------------|----------------------|------------|
| ** **                       | ** ** | **2006**         | ** ** | **2005**             | ** ** |
| ** **                       | ** ** | **(unaudited)**  | ** ** | ** **           | ** ** |
| Deferred tax assets:             |       |             |       |                 |       |
| Net operating  loss carryforward |       | $                | 23,714     |                 | $          | 24,246 |   |
| Net capital loss  carryforward   |       | 430              |       | 431                  |       |
| Goodwill and  other intangibles  |       | 584              |       | 572                  |       |
| Other                            |       | 685              |       | 747                  |       |
| Gross deferred  tax assets       |       | 25,413           |       | 25,996               |       |
| Less valuation  allowance        |       | (21,400          | )          | (21,400              | )          |
| Deferred tax  assets             |       | $                | 4,013      |                 | $          | 4,596 |   |
| Gross deferred  tax liabilities  |       | $                | —     |                 | $          | — |   |
| Net deferred tax asset           |       | $                | 4,013      |                 | $          | 4,596 |   |

 

Thenet operating loss carryforward includes losses generated by PAULA InsuranceCompany which are available to offset future taxable income of the Company.

Managementbelieves that it is more likely than not that the results of future operationswill generate sufficient taxable income in the periods necessary to realize thenet deferred tax asset.

##### **Note D – Acquisitions**

##### Since 2002, the Company hasactively pursued transactions as a means of revenue diversification.  In the second quarter of 2006, the Companycompleted two transactions with companies having business specializations thatboth expand the Company’s areas of expertise and provide further revenuediversification.

*SunlandInsurance Services*

##### Effective May 1, 2006, theCompany entered into an agreement to acquire the assets of Sunland InsuranceServices (“Sunland”).  The financialresults of Sunland have been included in the Company’s consolidated financialstatements since the effective date of the transaction.  Sunland specializes in the placement ofpersonal lines insurance and operates out of five offices in California’sCentral Valley.  The estimatedundiscounted purchase price is $1.0 million and the estimated discountedpurchase price is $852,000.  For purposesof discounting, the Company used an implied interest rate of 7.0% andcontractual payout terms over five years.

##### The purchase price forSunland is subject to adjustment based on actual revenue earned over the nextfive years.  Consequently, the purchaseprice will not be finalized until 2011. As of June 30, 2006, $200,000 had been paid related to this acquisition.  The remaining estimated obligation of$652,000 will be paid over the next five years, subject to adjustment asdescribed above.

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Estimated futurepayments under the Sunland asset purchase agreement at June 30, 2006 are asfollows ($’s in 000’s):

| 2007 |   | $   | 124    |   |
|------|--------|-----|--------|--------|
| 2008 |   | 145 |   |
| 2009 |   | 136 |   |
| 2010 |   | 127 |   |
| 2011 |   | 120 |   |

 

##### The following tablesummarizes the allocation of the estimated discounted purchase price as of June30, 2006 ($’s in 000’s):

| Other amortizable intangible  assets – expiration lists         |   | $   | 356    |   |
|----------------------------------------------------------------------|--------|-----|--------|--------|
| Other  amortizable intangible assets – covenants not to compete |   | 100 |   |
| Goodwill                                                             |   | 396 |   |
| Total                                                                |   | $   | 852    |   |

 

##### Expiration lists are beingamortized over a period of five years and covenants not to compete are beingamortized over their non-compete period of six years.  The following table summarizes the expectedfuture amortization of intangibles related to this transaction ($’s in 000’s):

| 2006       |   | $  | 58     |   |
|------------|--------|----|--------|--------|
| 2007       |   | 88 |   |
| 2008       |   | 88 |   |
| 2009       |   | 88 |   |
| 2010       |   | 88 |   |
| Thereafter |   | 46 |   |

 

##### *LongInsurance Services*

EffectiveJune 1, 2006, the Company entered into an asset purchase agreement withLawrence B. Long Insurance Services (“Long”). The financial results of Long have been included in the Company’sconsolidated financial statements since the effective date of the transaction.** **Long is a wholesale lifeinsurance operation based in Sacramento, California.  The total purchase price of $260,000 was paidin full at the close of the transaction. The entire purchase price has been allocated to another amortizableintangible asset associated with contract rights and is being amortized over afive year period.

##### The following tablesummarizes the expected future amortization of intangibles related to thistransaction ($’s in 000’s):

| 2006       |   | $  | 30     |   |
|------------|--------|----|--------|--------|
| 2007       |   | 52 |   |
| 2008       |   | 52 |   |
| 2009       |   | 52 |   |
| 2010       |   | 52 |   |
| Thereafter |   | 22 |   |

 

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*Integrated Financial*

EffectiveApril 1, 2005, the Company entered into an agreement to purchase the existingbook of business of Integrated Financial (“Integrated”).  Integrated is based in Sacramento, Californiaand specializes in accident and health and financial products.  While the purchase price will not befinalized until the second quarter of 2008, a true up was performed in thesecond quarter of 2006.  As a result ofthe true-up performed in the second quarter of 2006, the estimated purchaseprice was reduced by $109,000 with a corresponding reduction in otheramortizable intangible assets.  As ofJune 30, 2006, the estimated purchase price was $695,000.

##### The following tablesummarizes the allocation of the estimated purchase price as of June 30, 2006($’s in 000’s):

| Other amortizable intangible  assets – expiration lists         |   | $   | 468    |   |
|----------------------------------------------------------------------|--------|-----|--------|--------|
| Other  amortizable intangible assets – covenants not to compete |   | 120 |   |
| Goodwill                                                             |   | 107 |   |
| Total                                                                |   | $   | 695    |   |

 

Expirationlists are being amortized over a period of five years and covenants not tocompete are being amortized over their non-compete period of five years.

##### The following tablesummarizes the expected future amortization of intangibles related to thistransaction ($’s in 000’s):

| 2006 |   | $   | 120    |   |
|------|--------|-----|--------|--------|
| 2007 |   | 112 |   |
| 2008 |   | 112 |   |
| 2009 |   | 112 |   |
| 2010 |   | 27  |   |

 

Asof June 30, 2006, $403,000 had been paid related to this acquisition.  The remaining obligation of $292,000 will bepaid over the next four years.

*Summary*

Inaddition to the transactions discussed above, in 2003 the Company purchased theexisting book of business of Roudebush & Avina Insurance Agency, Inc. (“R&A”).  The purchase price allocation related to theR&A transaction was finalized in 2004. In 2002, the Company successfully recruited an experienced, largeaccount agribusiness producer, Roberts Underwood (“Underwood”) and acquired hisbook of business.  The purchase priceallocation related to this transaction was finalized in 2003.  Finally, in 1999, the Company acquired theassets of CAPAX Management & Insurance Services (“CAPAX”).  The purchase price allocation related to theCAPAX transaction was finalized in 2001.

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##### The following table summarizes information related to goodwill as ofJune 30, 2006 ($’s in 000’s):

|            | ** ** | **Goodwill** | ** ** | **Accumulated  Amortization (1)** | ** ** | **Net  Goodwill** | ** ** |
|------------|------------|--------------|------------|----------------------------------------|------------|-------------------|------------|
| Sunland    |       | $            | 396        |                                   | $          | —            |       | $ | 396 |   |
| Integrated |       | 107          |       | —                                 |       | 107               |       |
| R&A    |       | 561          |       | —                                 |       | 561               |       |
| Underwood  |       | 786          |       | —                                 |       | 786               |       |
| CAPAX      |       | 750          |       | (80                                    | )          | 670               |       |
| Total      |       | $            | 2,600      |                                   | $          | (80               | )          | $ | 2,520 |   |

 

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(1)          Until the adoption ofStatement of Financial Accounting Standard 141, “Business Combinations” in2002, the Company amortized goodwill. Subsequently, the Company tests for impairment at least annually in thefourth quarter or sooner, if triggering events occur indicating that animpairment may exist.

##### The following table summarizes informationrelated to the Company’s other intangibles as of June 30, 2006 ($’s in 000’s):

|            | ** ** | **Other  Intangibles** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Other  Intangible** | ** ** | **Weighted  Average  Remaining  Life (Yrs.)** | ** ** |
|------------|------------|------------------------|------------|-------------------------------|------------|----------------------------|------------|----------------------------------------------------|------------|
| Long       |       | $                      | 260        |                          | $          | (4                         | )          | $                                                  | 256        |   | 4.9 |   |
| Sunland    |       | 456                    |       | (15                           | )          | 441                        |       | 5.1                                                |       |
| Integrated |       | 588                    |       | (170                          | )          | 418                        |       | 3.8                                                |       |
| R&A    |       | 325                    |       | (193                          | )          | 132                        |       | 2.7                                                |       |
| Underwood  |       | 1,237                  |       | (789                          | )          | 448                        |       | 1.7                                                |       |
| CAPAX      |       | 2,082                  |       | (1,964                        | )          | 118                        |       | 0.4                                                |       |
| Total      |       | $                      | 4,948      |                          | $          | (3,135                     | )          | $                                                  | 1,813      |   | 3.4 |   |

 

##### **Note E – Accounting for Stock-Based Compensation**

Throughthe end of fiscal 2005, the Company measured compensation expense for itsstock-based incentive program utilizing the intrinsic value method prescribedby Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees.”  Under this method,the Company did not record compensation expense when stock options were grantedto eligible participants as long as the exercise price was not less than the fairmarket value of the stock when the option was granted.

InDecember 2004, the FASB issued SFAS No. 123R, “Share Based Payment: AnAmendment of FASB Statements No. 123 and 95” (“SFAS 123R”).  This statement requires that the costresulting from all share-based payment transactions be recognized in theCompany’s consolidated financial statements, including recognition of the fairvalue of options granted.

In thefirst quarter of 2006, the Company adopted the provisions of SFAS 123R usingthe modified prospective transition method. In accordance with the modified prospective transition method, theCompany’s condensed consolidated financial statements for prior periods havenot been restated to reflect, and do not include, the effect of SFAS 123R.  Under the modified prospective method, theCompany is required to expense the grant date fair value of unvested

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outstandingstock options that remain outstanding at December 31, 2005.  The Company will not incur any additionalexpense relating to stock options granted before December 31, 2005 insubsequent years because the final vesting date of stock options previouslygranted had been reached by December 31, 2005. At adoption, there was no impact on the Company’s condensed consolidatedfinancial statements as all outstanding options were fully vested as ofDecember 31, 2005 and there were no share-based payment transactions during thefirst quarter of 2006.

*Stock-Based Incentive Compensation Plans*

In 1994, theCompany adopted a stock incentive plan, reserving 550,000 shares of commonstock, which provides for granting of stock options and restricted stockbonuses to officers, directors and key employees of the Company. AtDecember 31, 2005, no shares of common stock were available for issuanceunder the 1994 plan.

In 1997, theCompany adopted its 1997 Stock Incentive Plan, reserving 200,000 shares ofcommon stock.  In 2001, and again in2004, shares authorized under the 1997 plan were increased to 900,000 and1,500,000 shares, respectively. At December 31, 2005, all shares available forissuance under the 1997 plan had been issued.

In the second quarter of2006, the Company offered Jeffrey A. Snider, the Company’s Chairman and ChiefExecutive Officer, the opportunity to exchange out-of-the-money options forshares of restricted stock.  Pursuant tothe exchange offer, Mr. Snider tendered vested options to purchase 400,000shares of common stock.  Mr. Snideracquired the options subject to the tender by way of an affirmative vote bystockholders to increase the number of shares authorized under the 1997 plan in2004.  The options tendered by Mr. Sniderwere canceled and exchanged for 400,000 shares of common stock, 284,615 sharesof which were restricted and unvested, authorized under the Company’s Amendedand Restated 1997 Stock Incentive Plan. The fair value of the options exchangedon the date of the restricted stock grant were as follows:
| Date of Original Grant | ** ** | **Number  of  Shares** | ** ** | **Exercise  Price** | ** ** | **Fair Value  Per  Share at  Cancellation  Date** | ** ** | **Estimated  Fair  Value** | ** ** |
|---------------------------------------|------------|------------------------|------------|---------------------|------------|-------------------------------------------------------------|------------|----------------------------|------------|
|                                  |       |                   |       |                |       |                                                        |       |                       |       |
| February 24,  2004                    |       | 280,000                |       | $                   | 2.87       |                                                        | $          | 1.42                       |       | $ | 398,000 |   |
| May 26, 2004                          |       | 120,000                |       | $                   | 2.63       |                                                        | $          | 1.46                       |       | 175,000 |   |
| Total                                 |       | 400,000                |       |                |       |                                                        |       | $                          | 573,000    |   |

 

In computing thefair value of the stock options cancelled, the Company used the followingsubjective assumptions: volatility of 70%, risk free rate of return of 4.97%, expectedterm of 7.75 years and expected annual dividend yield of 2.38%.

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The value of therestricted stock grant was $2.52 per share based on the closing price of theCompany’s common stock on June 5, 2006, the date of the restricted stockgrant.  At grant, 115,385 shares vestedimmediately.  The value of the unvestedportion of the restricted stock grant, 284,615 shares, vests in equal-sizedtranches over the next three years, subject to Mr. Snider’s continuedemployment with the Company.  Inaccordance with SFAS 123R, the Company calculated the compensation cost relatedto the restricted stock and will record incremental compensation costs, fromthe date of the transaction, for the restricted stock grant based on the fairvalue of the restricted shares awarded in excess of the fair value of thecancelled options immediately preceding the exchange transaction.  The Company’s anticipated compensationexpense related to the vesting of this restricted stock is as follows ($’s in000’s):
| 2006 |   | $  | 232    |   |
|------|--------|----|--------|--------|
| 2007 |   | 48 |   |
| 2008 |   | 48 |   |
| 2009 |   | 16 |   |

 

As of June 30,2006, $209,000 of the anticipated 2006 expense has been expensed in theaccompanying condensed consolidated financial statements.

Asummary of restricted stock activity during the second quarter of 2006 follows:
|                      | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|----------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
|                 |       |                       |       |                                                    |       |
| Beginning of  period |       | —                     |       | —                                                  |       |
| Add (deduct):        |       |                       |       |                                                    |       |
| Granted              |       | 400,000                    |       | $                                                       | 2.52       |   |
| Vested               |       | (115,385                   | )          | 2.52                                                    |       |
| End of period        |       | 284,615                    |       | $                                                       | 2.52       |   |

 

Forthe six months ended June 30, 2006, the pre-tax expense of the Company’sstock-based compensation was $209,000, all of which related to the issuance offully vested restricted stock in excess of amounts issued to settle the unpaidaccrued bonus due Mr. Snider.

Duringthe first six months of 2006, there was no change to options outstanding underthe 1994 plan.  A summary of stock optionactivity related to the 1997 plan during the second quarter of 2006 follows:
|                                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|
|                                   |       |                  |       |                                   |       |
| Beginning of period, December 31, 2005 |       | 1,149,936             |       | $                                      | 2.07       |   |
| Add (deduct):                          |       |                  |       |                                   |       |
| Exercised                              |       | (2,500                | )          | $                                      | 0.46       |   |
| Exchanged                              |       | (400,000              | )          | $                                      | 2.80       |   |
| End of period, June 30, 2006           |       | 747,436               |       | $                                      | 1.69       |   |
| Exercisable, end of period             |       | 747,436               |       | $                                      | 1.69       |   |

 

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Stockoptions vest either immediately or over periods not to exceed five years andcarry an exercise price equal to or in excess of the fair market value of theCompany’s common stock on the date of grant. The stock options are generally exercisable for a ten-year term.

Thefollowing employee stock options were outstanding or exercisable as of June 30,2006:
|                                      | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Strike  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|--------------------------------------|------------|------------------------|------------|------------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
|                                 |       |                   |       |                                           |       |                            |       |                                                |       |
| Options outstanding and  exercisable |       | 747,436                |       | $                                              | 1.69       |                            | $          | 519,000                                             |       | 7.8 years |   |
|                                      |            |                        |            |                                                |            |                                 |            |                                                     |            |  |  |

 

Theaggregate intrinsic value in the preceding table represents the total pretaxintrinsic value, based on the Company’s closing stock price of $2.22 as of June30, 2006, which would have been received by the option holders had all optionholders exercised their options as of that date.  For purposes of the intrinsic valuecalculation, 447,436 shares of in-the-money options were included, which shareshad a weighted average exercise price of $1.06.

##### **Note F– Executive Compensation**

Pursuantto the Company’s restructured performance based executive compensation program,as described in the Company’s 2004 Proxy Statement, the Company’s executiveofficers are eligible for a cash bonus to the extent the Company’s operatingresults exceed certain pre-determined profitability goals.  Beginning in the first quarter of 2005, theCompany established an accrual for bonuses under the program because operatingresults showed that the Company would likely exceed profitability goals.  Based on the Company’s 2005 operatingresults, as of December 31, 2005, the Company had accrued $325,000 for thesebonuses, of which $225,000 had been accrued with respect to Mr. Snider.  In the first quarter of 2006 (and consistentwith the Company’s practices regarding accrued but unpaid bonuses), the Companyallowed Mr. Snider to draw $70,000 of his accrued but unpaid bonus.  This amount, however, was improperlyreflected as a receivable (with no related party disclosure) on the Company’sMarch 31, 2006 condensed consolidated balance sheet included in its Form 10-QSBas filed with the Securities and Exchange Commission on May 11, 2006.  In the second quarter of 2006, Mr. Sniderdrew a net additional $65,000 on his accrued but unpaid bonus.

TheCompany is making this disclosure in order to clarify any misinterpretation ofsuch amounts as a loan which may have resulted from the improper classificationof such amounts as a receivable in the Company’s March 31, 2006 condensedconsolidated balance sheet.  The Company’sAudit Committee engaged independent counsel in connection with its review ofamong other things, the above referenced bonus draws to determine if such drawswere in violation of Section 402 of the Sarbanes Oxley Act of 2002, whichrestricts personal loans to a company’s executive officers.  The Audit Committee determined that the drawsdid not constitute loans in violation of Section 402 of the Sarbanes Oxley Actof 2002.

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In aseparate transaction and as discussed in Note E above, on April 26, 2006, theCompany’s Executive Compensation Committee approved the exchange by Mr. Sniderof out-of-the-money options to purchase 400,000 shares of common stock for400,000 shares of restricted stock.  Mr.Snider accepted the offer to exchange his options on June 5, 2006 and enteredinto a restricted stock agreement with the Company on that date.  Of the 400,000 shares of restricted stock,115,385 shares were immediately vested and the remaining shares vest inequal-sized tranches over the next three years upon completion of eachadditional year of service from the date of the award.  In connection with this exchange, the Companyincurred a compensation charge of $209,000 (representing the value of thevested shares in excess of the remaining $90,000 accrued but unpaid bonus dueto Mr. Snider under the restructured executive compensation program) in thesecond quarter of 2006.  The Company willrecognize an expense for the unearned compensation costs over the estimatedservice period of three years on a straight line basis, but in no event lessthan the vested amounts.

**Note G – Other Matters**

In the second quarter of2006, Mr. Snider began selling shares of common stock on the open market, allof which has been reported in compliance with Form 4 rules.  Mr. Snider first discussed his plans to begina minor diversification of his personal holdings of PAULA Financial commonstock in the Company’s 2004 Proxy Statement. Mr. Snider may choose to sell more shares from time to time but alsointends to hold the majority of his share and option interests in PAULAFinancial for the foreseeable future.

##### **Note H – Legal Matters**

Inearly 1999, PAULA Financial made an investment in a start up specialty workers’compensation insurance company, Montlake Insurance Holdings, LLC (“Montlake”).  This investment was accounted for using theequity method.  During the initial set upof the Montlake operations, PAULA Financial provided assistance in severalareas including license application, insurance placement, human resourcematters and systems support.  As part ofthis support, PAULA Financial executed a guarantee related to certain aspectsof the relationship between Montlake and the issuing company, RelianceInsurance Company (“Reliance”).  At thetime of the guarantee, Reliance did not retain any exposure associated with thepremiums fronted.  Reliance was theissuing carrier for Montlake from March 15, 1999 to July 31, 2000.

InOctober 2001, Reliance was placed in liquidation by the Pennsylvania Departmentof Insurance.  In October 2002, Montlakewas liquidated by the Superior Court of Washington for King County.

InMay 2004, the Company received a demand for payment from Reliance inLiquidation in the amount of $1.9 million related to unpaid deductibles by apolicyholder placed under the Montlake fronting arrangement with Reliance.  The policy in question was effective March2000 and was cancelled in September 2000.

The Companyreplied to the demand in a letter dated August 13, 2004, disputing any amountdue to Reliance in Liquidation.  OnOctober 19, 2005, the Company received a response from Reliance inLiquidation.  The correspondence, datedOctober 17, 2005, reduces the demand related to unpaid deductibles from $1.9million to $40,000.  However, a newdemand contained

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in the October 19,2005 letter in the amount of $3.0 million is asserted related to retrospectivepremium adjustments on the same policy.

The Companybelieves there are good and meritorious arguments that the demand does notrepresent an obligation of the Company.  TheCompany believes, among other defenses, that the obligation subject to theguarantee was previously discharged.

**Note I – Related PartyTransactions**

Since 1999, theCompany’s agency operations have outsourced certain backroom functions to anagency providing service center support. In 2001, a partial owner of this agency, James G. Parker, III, waselected to the Company’s Board of Directors. Fees paid by the Company’s agency to the service center were $443,000and $721,000 for the six months ended June 30, 2006 and 2005,respectively.  These fees primarilyrelate to direct expense reimbursement. As of June 30, 2006, the Company owed $59,000 related to suchservices.  The Company has a workingcapital deposit of $100,000 related to the direct expense reimbursementarrangement.  Additionally, the Companyhas a $703,000 minority investment in the agency which is a long-terminvestment accounted for under the cost basis. As of June 30, 2006, Management estimates that the fair value farexceeds the carrying value of this investment.

On September 1,2006, the Board of Directors authorized the Company to purchase up to 200,000shares of the Company’s common stock from Mr. Snider in a privatetransaction.  The purchase wasaccomplished pursuant to the Company’s previously announced and adopted share repurchaseprogram.  The purchase price was $2.49per share, the average closing price for the prior 20 trading days.  The repurchase authorization included a downwardprice reset provision.  The resetprovision requires Mr. Snider to pay to the Company the amount by which the$2.49 per share purchase price exceeds the 20 trading day closing price averagefollowing the date of the Company’s filing of this Form 10-QSB.

**Note J – Subsequent Event**

Asdiscussed more completely in Note F above and in Item 3 below, in the course ofthe preparation of the Company’s consolidated financial statements for thequarter ended June 30, 2006, the Company identified significant certainsignificant deficiencies in both the Company’s internal controls and in its disclosurecontrols and procedures.  Thedeficiencies in the internal controls collectively constitute a materialweakness.

The Company’s Audit Committee engaged independent counsel in connectionwith its review of the Company’s reserve accrual practices and the executivecompensation matters discussed in Note F above. In conjunction with this review, the Audit Committee determined that thedraws did not violate Section 402 of the Sarbanes-Oxley Act of 2002.  Additionally, the Company identified certain significant deficiencies in the Company’s internal controls related to quarterly reviews of, and adjustments to,certain accruals for Company reserves.  These accruals related to (i) an ongoing legal matterthat had been previously disclosed in the Company’s SEC filings (decreased$30,000), (ii) anticipated costs associated with complying with Section 404 ofthe Sarbanes-Oxley Act of 2002 (decreased $55,000), (iii) “Errors &Omissions” costs relating to the Company’s agency operations (decreased$75,000), (iv) employee bonus (increased $4,000) and vacation costs (increased$123,000), (v) costs associated with certain outsourced services (increased$60,000), and (vi) costs associated with certain

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Company-hosted events (decreased $15,000) and thecommemoration of the Company’s 60th anniversary (decreased $13,000).  Further, the Company initially did notappropriately apply existing accounting literature to the exchange transactiondescribed in Notes E and F above.

The time necessary tocomplete these reviews explain the Company’s failure to timely file this reporton Form 10-QSB.

The Company estimatesthat it has incurred legal and accounting fees in excess of $300,000 related tothese reviews.  These fees and expenseswill be reflected in the Company’s third quarter 2006 operating results.

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**Item 2.**           Management’s Discussion and Analysis or Planof Operations

**Overview**

The Company’srevenues consist primarily of commission and placement fee income, profitsharing income, investment income, and service fees. Commission and placementfee income is earned from the distribution of insurance. Profit sharing incomeis related to profit sharing arrangements with insurance carriers.  Service fees consist primarily of fees forloss control and claims adjudication services. 

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

**Resultsof Operations for the Three Months and Six Months Ended June 30, 2006 Comparedto the Three Months and Six Months Ended June 30, 2005:**

***Commission and placement fee income.***  Commission and placement fee income increased4.4% to $4.0 million for the three months ended June 30, 2006 from $3.8 millionfor the three months ended June 30, 2005 and increased 6.8% to $7.8 million forthe six months ended June 30, 2006 from $7.3 million for the six months endedJune 30, 2005.  The increase incommission and placement fee income in the first half of 2006 is mostmeaningful in the health line of business.

***Profitsharing income.*** Profit sharing income increased to $520,000 for the three months endedJune 30, 2006 from $23,000 for the three months ended June 30, 2005 and wasunchanged at $2.0 million for the six month periods ended June 30, 2006 and2005.  Profit sharing income fluctuatesfrom year to year based on the profitability of the underlying business andexternal market conditions either of which can result in changes to profitsharing programs offered by insurance carriers. The increase in the second quarter of 2006 reflects the impact of a newprofit sharing agreement.

***Investment income.***  Investment income increased to $57,000 forthe three months ended June 30, 2006 from $7,000 for the three months endedJune 30, 2005 and increased to $109,000 for the six months ended June 30, 2006from $25,000 for the six months ended June 30, 2005.   In 2005, the Company began makinginvestments in selected money market funds, common stock mutual funds, fixedincome securities and preferred stocks.

***TPA fees.*** During the third quarter of 2005, the Company completed its exit fromthe third party administration business. Consequently, the Company has no TPA fees in 2006. 

***Salaries and related expenses.*** Salaries andrelated expenses increased 33.5% to $2.7 million for the three months endedJune 30, 2006 from $2.0 million for the three months ended June 30, 2005.  Salaries and related expenses increased 4.3%to $5.2 million for the six months ended June 30, 2006 from $5.0 million forthe comparable 2005 period.  The increasein the second quarter is due primarily to the addition of employees related tothe acquisitions of Sunland and Long, an increase in the Company’s accrual forearned and unused vacation and compensation expense associated with theexchange offer.  

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Asdiscussed in Note D above, the Sunland acquisition was effective May 1, 2006and the Long acquisition was effective June 1, 2006, at which such times theiremployees became employees of the Company.

As ofJune 30, 2006, the Company’s employees have accrued more vacation time thanthey have taken, resulting in an increase to the Company’s vacationaccrual.  The Company expects that thisrelationship will reverse in the second half of 2006 as employees take timeoff.  

As discussed abovein Note E, in the second quarter of 2006, Mr. Snider was granted 400,000 sharesof restricted stock authorized under the Company’s Amended and Restated 1997Stock Incentive Plan. Compensation expense in the second quarter of 2006related to this transaction was $209,000.  The unvested portion of the restricted stock grant will vest conditionedupon Mr. Snider’s continued employment with the Company.  

***Amortizationexpense.*** Amortization expense increased 7.7% to $195,000for the three months ended June 30, 2006 from $181,000 for the three monthsended June 30, 2005 and increased 14.6% to $376,000 for the six months endedJune 30, 2006 from $328,000 for the six months ended June 30, 2005.  The increase is due to an increase inamortizable intangible assets related to the Integrated transaction completedin the second quarter of 2005 and the acquisitions of Sunland and Long, both ofwhich were completed in the second quarter of 2006.

***Incometaxes on operations.*** Income tax expense on operations for the three months ended June 30,2006 was $204,000 compared to $201,000 for the three months ended June 30,2005.  Income tax expense on operationsfor the six months ended June 30, 2006 was $753,000 compared to $659,000 forthe six months ended June 30, 2005.  Theeffective income tax rates for the three months ended June 30, 2006 and thethree months ended June 30, 2005 were 42% each. The effective income tax rates for the six months ended June 30, 2006and the six months ended June 30, 2005 were 41% each. The total tax expense fromoperations is different from the applicable Federal income tax rate of 34% dueto non-deductible expenses and the impact of state income taxes.

***Netincome. ***Net incomewas $275,000 for the three months ended June 30, 2006 compared to $273,000 forthe comparable 2005 period.  Net incomeincreased 15.2% to $1.1 million for the six months ended June 30, 2006 from$934,000 for the comparable 2005 period. The increase in the first six months of 2006 is due to the factorsdiscussed above.

**Liquidityand Capital Resources:**

***TheParent Company***

As a holdingcompany, PAULA Financial’s principal sources of funds are dividends and expensereimbursements from its operating subsidiaries and proceeds from the sale ofits capital stock. PAULA Financial’s principal uses of funds are capitalcontributions to its subsidiaries, payment of operating expenses, payment ofdividends, and repurchase of Company common stock. 

The Company currently has a revolving line of credit (the “Line ofCredit”) with US Bank (the “Lender”) that matures on November 1, 2006.  The Line of Credit has a total available lineof $1.4 million of which $0.3 million was outstanding at June 30, 2006.  While the Company has been making quarterlypayments to pay down the outstanding balance, the terms of the Line of

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Credit do not require any principal payment prior to maturity.  Other than with respect to covenants relatingto the timely filing of this report, PAULA Financial is in compliance with allof the covenants.  Balances outstandingunder the Line of Credit bear interest at the prime rate plus 1.0%.  As of July 31, 2006, the interest rate was9.25%.

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

The Company’s Board of Directors has previously approved a 3,000,000share repurchase program.  In the secondquarter of 2006, the Company acquired 47,392 shares of treasury stock at anaverage price of $1.96 per shares.  Theredemption of shares was done in accordance with the Safe-Harbor provisions ofRule 10b-18.  As of June 30, 2006, theCompany held 1,144,534 shares in treasury stock.  

On September 1,2006, the Board of Directors authorized the Company to purchase up to 200,000shares of the Company’s common stock from Mr. Snider in a privatetransaction.  The purchase price was$2.49 per share, the average closing price for the prior 20 trading days.  The transaction was completed at an aggregatepurchase price of $498,000.  Therepurchase authorization included a downward price reset provision.  The reset provision requires Mr. Snider topay to the Company the amount by which the $2.49 per share purchase priceexceeds the 20 trading day closing price average following the date of theCompany’s filing of this Form 10-QSB. The purchase was accomplished pursuant to the Company’s previouslyannounced and adopted share repurchase program. 

On May 10, 2006, the Board of Directors declared a quarterly dividendof $0.015 per share.  The second quarter2006 dividend was paid to holders of record as of June 7, 2006 and wasdistributed on June 28, 2006.

***ContractualObligations and Commitments***

##### In addition tothe disclosures included in the Company’s Annual Report on Form 10-KSB for theyear ended December 31, 2005, the Company has entered into a contractualobligation related to an asset purchase transaction.  As discussed in Note D above, effective May1, 2006, the Company entered into an agreement to acquire the assets ofSunland.  Estimated future payments under the Sunlandasset purchase agreement at June 30, 2006 are as follows ($’s in 000’s):

| 2007 |   | $   | 124    |   |
|------|--------|-----|--------|--------|
| 2008 |   | 145 |   |
| 2009 |   | 136 |   |
| 2010 |   | 127 |   |
| 2011 |   | 120 |   |

 

**Off-BalanceSheet Arrangements**

The Company doesnot have any off-balance sheet arrangements.

**Forward-LookingStatements**

In connectionwith, and because it desires to take advantage of the “safe harbor” provisionsof the Private Securities Litigation Reform Act of 1995, the Company cautionsreaders to recognize the existence of certain forward-looking statements inthis Form 10-QSB and in any other statement made by, or on behalf of, theCompany, whether or not in future filings with the Securities and ExchangeCommission.  The Company’s actual resultsmay differ materially from those included in the forward-lookingstatements.   Forward-looking statementsare statements not based on historical information and which relate to futureoperations, strategies, financial results or other developments.  Some forward-looking statements may beidentified by the use of terms such as “expects,” “believes,” “anticipates,” “intends,”“estimates,” “may increase,” “may fluctuate,” “judgment” and similarexpressions or future or conditional verbs such as “will,” “should,” “would,”and “could.”  Forward-looking statementsare necessarily based upon estimates and

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assumptions thatare inherently subject to significant business, economic and competitiveuncertainties, many of which are beyond the Company’s control and many ofwhich, with respect to future business decisions, are subject to change.  Examples of such uncertainties andcontingencies include, among other important factors, those affecting theinsurance industry in general, such as the economic and interest rate environment,geo political risks, the continued threat of terrorism, legislative andregulatory developments and market pricing and competitive trends, and thoserelating specifically to the Company and its businesses, such as the level ofcommission revenue and fee income, acquisitions of companies or blocks ofbusiness and future compliance with Nasdaq listing requirements.  These uncertainties and contingencies canaffect actual results and could cause actual results to differ materially fromthose expressed in any forward-looking statements made by, or on behalf of, theCompany. The Company disclaims any obligation to update forward-lookingstatements.

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**Item3.  Controls and Procedures**

**DisclosureControls and Procedures**

In thecourse of the preparation of the Company’s consolidated financial statementsfor the quarter ended June 30, 2006, the Company’s Chief Executive Officer,Vice President—Finance and the Audit Committee evaluated the effectiveness of theCompany’s disclosure controls and procedures.  Disclosure controls and procedures are thosecontrols and procedures designed to ensure that information required to bedisclosed by the Company in the reports that it files with the Securities andExchange Commission (the “Commission”) is accumulated and communicated to theCompany’s management in order to allow timely decisions regarding requireddisclosure and that such information is recorded, processed, summarized andreported by the Company within the time periods specified by theCommission.  Our Chief Executive Officer,Vice President – Finance and Audit Committee have determined that the Company’sdisclosure controls and procedures were not effective because they failed toadequately account for and disclose matters related to its restructuredexecutive compensation program and executive bonuses paid pursuant to theprogram.  See Note F - ExecutiveCompensation.  Additionally, the Company’sdisclosure controls and procedures failed to adequately account for mattersrelated to its accruals for vacations, “errors and omission” and operatingexpenses.  

TheCompany has undertaken, and will continue to undertake, steps to address theidentified significant deficiencies and to improve its disclosure controls andprocedures.  Based on the processes andcontrol modifications that it has initiated, the Company believes that theinformation required to be disclosed in this report has been recorded,processed, summarized and reported properly herein.  

TheCompany’s management is responsible for establishing and maintaining adequateinternal control over financial reporting for the Company.  Internal control over financial reporting isa process to provide reasonable assurance regarding the reliability of theCompany’s financial reporting for external purposes in accordance withgenerally accepted accounting principles. Internal control over financial reporting includes maintaining recordsthat in reasonable detail accurately and fairly reflect the transactions anddispositions of the assets of the Company; providing reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements and that receipts and expenditures of the Company are being madeonly in accordance with authorizations of management and directors of theCompany; and providing reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use or disposition of the Company’sassets that could have a material effect on the financial statements.  Because of its inherent limitations, internalcontrol over financial reporting is not intended to provide absolute assurancethat a misstatement of our financial statements would be prevented ordetected.  

In thecourse of the preparation of the Company’s condensed consolidated financialstatements for the quarter ended June 30, 2006, the Company’s Chief ExecutiveOfficer, Vice President—Finance and the Audit Committee identified certainsignificant deficiencies in the Company’s internal controls, which collectivelyconstitute a material weakness.  

Thefollowing is a summary of the significant deficiencies identified by theCompany:

·                  The Companyinitially recorded certain draws made by its Chief Executive Officer inFebruary and May 2006 against the bonus accrued for him as of December 31, 2005(totaling net advances of $135,000) as other receivables.  The Company has concluded that those drawsshould have been recorded as a reduction of the accrued bonus liability to theChief Executive Officer.  Further,although the Company initially recorded the accrued bonus as a continuingpayable to the Chief Executive Officer, the Chief Executive Officer’s receiptof 115,385 immediately vested shares of the Company on June 5, 2006, satisfiedthat payable. Such vested shares were not initially recorded as a reduction tothe accrued bonus.  

·                  The Companymaintained several accruals and reserves that were misstated as of June 30, 2006,resulting in nine accounting adjustments of between $4,000 and $123,000each.  The Company’s failure to performdetailed reviews of its accruals and reserves at each quarter end contributedto the adjustments.

·                  The Company did not maintain detailed records whichcould be easily obtained to analyze certain of its accrued liability accounts,including the Company’s vacation accruals and its “errors and omission”accruals.

·                  The Company originally accounted for the receipt byits Chief Executive Officer of 400,000 shares of common stock (see Note F ofItem 1 above) using a measurement date of April 26, 2006, rather than themeasurement date of June 5, 2006, as required under FAS 123R.  The change in measurement date and thefailure to offset the cash advances

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againstthe bonus accrual resulted in an additional charge of $209,000 in relatedstock-based compensation not initially identified by the Company’s internalcontrols.

As aresult of the review process above, we have implemented and will continue toimplement the following actions:

·                  Wehave revised certain accounting methodologies and documentation procedures atthe recommendation of our independent auditors, including our methodologies formaintaining our reserves and accruals.

·                  Wehave hired an additional financial controller to support the preparation offinancial statements and reports to be filed with the SEC.

·                  Wewill continue our thorough review of our internal controls as part of ourongoing preparation for compliance with the requirements of Section 404 of theSarbanes-Oxley Act of 2002. 

·                  Weintend to periodically review our internal controls to ensure that additionalenhancements to our internal controls are implemented as necessary to meet ouroperational needs and the requirements of federal securities laws.

·                  Wewill engage outside consultants to advise our management as areas of concernare identified.

·                  Wewill also further develop and enhance our disclosure and internal controlpolicies, procedures, systems and staff to allow us to mitigate the risk thatdisclosures are not timely made or that material accounting errors might goundetected and be included in our consolidated financial statements.

Managementis committed to sound internal controls. The Company intends to commit adequateresources to the aforementioned reviews and remedies. The Company believes thatit has undertaken appropriate actions to address the significant deficienciesidentified above, and it believes that it is in the process of furtherimproving its infrastructure, personnel, processes and controls to help ensurethat it is able to produce accurate disclosures and financial statements withappropriate supporting documentation on a timely basis.

**Changesin Internal Controls Over Financial Reporting**

Except as described above, there have been no changes in theCompany’s internal controls over financial reporting (as such term is definedin Rule 13a-15(f) or Rule 15d-15(f) under the Exchange Act) during the periodcovered by this report that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

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## **PART II. OTHER INFORMATION**

Items 1, 3 and5 of Part II are not applicable and have been omitted.

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

**SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES**
| **Period**                      | ** ** | **(a) Total  Numbers of  Shares  Purchased** | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as Part  of Publicly Announced  Plans or Programs** | ** ** | **(d) Maximum Number of  Shares that May Yet be  Purchased Under the Plans  or Programs** | ** ** |
|---------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Month #1  4/1/2006 to 4/30/2006 |       | 45,492                                                 |       | $                                                 | 1.95       |                                                                                                                                          | 1,142,634  |                                                                                                                                             | 1,857,366  |   |
| Month #2  5/1/2006 to 5/31/2006 |       | 200                                                    |       | $                                                 | 1.99       |                                                                                                                                          | 1,142,834  |                                                                                                                                             | 1,857,166  |   |
| Month #3  6/1/2006 to 6/30/2006 |       | 1,700                                                  |       | $                                                 | 2.28       |                                                                                                                                          | 1,144,534  |                                                                                                                                             | 1,855,466  |   |
| Total                           |       | 47,392                                                 |       | $                                                 | 1.96       |                                                                                                                                          |       |                                                                                                                                             |       |   |

OnAugust 12, 1998, the Company announced the approval of the Board of Directorsof a 500,000 share stock repurchase program. On October 29, 1998, the Board authorized an additional 500,000 sharesbringing the total authorization under the program to 1,000,000 shares.  On February 20, 2003, the Board of Directorsauthorized an additional 2,000,000 shares for the share repurchase program(bringing the total authorization under the program to 3,000,000 shares).  No aggregate repurchase dollar amount orexpiration date was designated for this repurchase program.

Theredemption of shares was done in accordance with the Safe-Harbor provisions ofRule 10b-18.

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

TheCompany held its 2006 Annual Meeting of Stockholders on Wednesday, May 24, 2006for the purpose of voting on the election of directors to hold office until the2009 Annual Meeting of Stockholders, and thereafter until a successor iselected and qualified. At the meeting, two directors were elected.

The following table indicates the numberof shares voted on each director:
|                      | ** ** | **For**   | ** ** | **Abstain** | ** ** |
|----------------------|------------|-----------|------------|-------------|------------|
| Jeffrey A.  Snider   |       | 5,337,621 |       | 157,444     |       |
| James G. Parker, III |       | 5,321,435 |       | 173,630     |       |

 

The term of office ofeach of the following directors continued after the meeting held May 24,2006.  They are Peter L. Beard, LawrenceA. Hayes and Harold Sandstrom.

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**Item 6.    Exhibits:**

**Exhibits filed for the Companythrough the filing of this Form 10-QSB:**
| 11.    | Computation of Earnings Per Share.                                  |
|--------|---------------------------------------------------------------------|
|   |                                                                |
| 31.1   | Rule 13a -14a /15d -14a Certification of Chief  Executive Officer.  |
|   |                                                                |
| 31.2   | Rule 13a -14a /15d -14a Certification of Vice  President - Finance. |
|   |                                                                |
| 32.1   | Section 1350 Certifications of Chief Executive  Officer.            |
|   |                                                                |
| 32.2   | Section 1350 Certifications of Vice President -  Finance.           |

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SIGNATURES

In accordance with therequirements of the Exchange, the registrant caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.
| Date: September 21, 2006 | PAULA FINANCIAL           |
|--------------------------|---------------------------|
|                     |                      |
|                     |                      |
|                     | By:                       | /s/ Deborah S. Maddocks |   |
|                     | Vice President -  Finance |

 

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