**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

| **(Mark One)**                                              |
|-------------------------------------------------------------|
|                                                        |   |   |
| **ý**                                                  |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |   |
|                                                        |   |   |
| **For  the Quarterly Period Ended September 30, 2003** |
|                                                        |   |   |
| **OR**                                                      |
|                                                        |   |   |
| **o**                                                       |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |   |
|                                                             |  |  |  |  |

 

**For the Transition Periodfrom               to**

 

**Commission file number 0-23181**

 

**PAULAFINANCIAL**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                     |   | **95-4640638**                            |
|------------------------------------------------------------------|--------|-------------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  identification number) |
|                                                             |   |                                      |
| **PAULA  FINANCIAL**                                             |
| **87  East Green Street, Suite 206**                             |
| **Pasadena,  CA 91105**                                          |
| (Address  of principal executive offices, zip code)              |
|                                                             |   |                                      |
| **(626)  844-7100**                                              |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 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.

 

| Yes   ý |   | No   o |
|-----------------------------|--------|-----------------------|

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

| Yes   o |   | No   ý |
|------------------------|--------|----------------------------|

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.  Number of shares of Common Stock, $.01 parvalue, outstanding as of close of business on October 31, 2003: 6,239,879shares.

 

 

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PAULA FINANCIAL

INDEX TO FORM 10-Q

 
| PART I. FINANCIAL INFORMATION |                                                                                                                           |
|-------------------------------|--------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                           |   |
| Item 1.                       | Financial Statements                                                                                                           |   |
|                          |                                                                                                                           |   |
|                          | Condensed consolidated balance sheets as of  September 30, 2003 and December 31, 2002 (unaudited)                    |   |
|                          |                                                                                                                           |   |
|                          | Condensed consolidated statements of income  for the three  and nine months ended September 30, 2003 and 2002 (unaudited) |   |
|                          |                                                                                                                           |   |
|                          | Condensed consolidated statements of cash  flows for the nine months  ended September 30, 2003 and 2002 (unaudited)       |   |
|                          |                                                                                                                           |   |
|                          | Notes to condensed consolidated financial  statements for the three  and nine months ended September 30, 2003 (unaudited) |   |
|                          |                                                                                                                           |   |
| Item 2.                       | Management’s Discussion and Analysis of  Consolidated Financial Condition and Results of Operations                       |   |
|                          |                                                                                                                           |   |
| Item 3.                       | Quantitative and Qualitative Disclosures  about Market Risk                                                                    |   |
|                          |                                                                                                                           |   |
| Item 4.                       | Controls and Procedures                                                                                                        |   |
|                          |                                                                                                                           |   |
| PART II. OTHER INFORMATION    |                                                                                                                           |
|                          |                                                                                                                           |   |
| Item 1.                       | Legal Proceedings                                                                                                              |   |
|                          |                                                                                                                           |   |
| Item  5.                      | Other  Information                                                                                                             |   |
|                          |                                                                                                                           |   |
| Item 6.                       | Exhibits and  Reports on Form 8-K                                                                                              |   |
|                          |                                                                                                                           |   |
| SIGNATURE                     |                                                                                                                           |

 

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**PART I****                               FINANCIALINFORMATION**

### Item 1.                                     FinancialStatements

###  

**PAULA FINANCIAL AND SUBSIDIARIESCondensed Consolidated BalanceSheets**(Inthousands, except share data)

 
|                                                                                                               |   | **September 30,  2003** |     | **December 31,  2002** |     |
|--------------------------------------------------------------------------------------------------------------------|--------|------------------------------|----------|-----------------------------|----------|
|                                                                                                               |   | **(Unaudited)**              |     | **(*)**                     |     |
| ***Assets***                                                                                                       |   |                         |     |                        |     |
| *Current Assets:*                                                                                                  |   |                         | * * |                        | * * |
| Cash (restricted: 2003, $2,622; 2002, $851)                                                                        |   | $                            | 3,162    |                        | $        | 1,290 |   |
| Accounts receivable, net of allowance for  uncollectible accounts (2003, $80; 2002, $140)                          |   | 1,046                        |     | 875                         |     |
| Commissions receivable                                                                                             |   | 2,451                        |     | 1,284                       |     |
| Income tax receivable                                                                                              |   | —                       |     | 141                         |     |
| Other receivables                                                                                                  |   | 84                           |     | 92                          |     |
| Deferred income taxes                                                                                              |   | 1,352                        |     | 1,274                       |     |
| Other assets                                                                                                       |   | 277                          |     | 262                         |     |
|                                                                                                               |   | 8,372                        |     | 5,218                       |     |
| *Non-Current Assets:*                                                                                              |   |                         |     |                        |     |
| Property and equipment, net                                                                                        |   | 262                          |     | 266                         |     |
| Investment in related party                                                                                        |   | 703                          |     | 703                         |     |
| Goodwill                                                                                                           |   | 1,940                        |     | 1,452                       |     |
| Other amortizable intangible assets, net                                                                           |   | 2,503                        |     | 1,194                       |     |
| Deferred income taxes                                                                                              |   | 4,799                        |     | 5,368                       |     |
| Other assets                                                                                                       |   | 172                          |     | 99                          |     |
|                                                                                                               |   | $                            | 18,751   |                        | $        | 14,300 |   |
| ***Liabilities and Stockholders’ Equity***                                                                    |   |                         |     |                        |     |
| *Current Liabilities:*                                                                                             |   |                         |     |                        |     |
| Due to underwriters and assureds                                                                                   |   | $                            | 3,678    |                        | $        | 1,890 |   |
| Accounts payable and accrued expenses                                                                              |   | 957                          |     | 760                         |     |
| Employment related accrued expenses                                                                                |   | 798                          |     | 403                         |     |
| Acquisition related accruals                                                                                       |   | 891                          |     | 238                         |     |
| Income tax payable                                                                                                 |   | 116                          |     | —                      |     |
| Notes payable to bank                                                                                              |   | 1,300                        |     | 1,300                       |     |
|                                                                                                               |   | 7,740                        |     | 4,591                       |     |
| Non-Current Liabilities:                                                                                           |   |                         |     |                        |     |
| Acquisition related accruals                                                                                       |   | 1,745                        |     | 600                         |     |
| Notes payable to bank                                                                                              |   | 476                          |     | 1,450                       |     |
|                                                                                                               |   | $                            | 9,961    |                        | $        | 6,641 |   |
|                                                                                                               |   |                         |     |                        |     |
| *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: 2003   7,127,029; 2002  7,023,379) |   | 71                           |     | 70                          |     |
| Additional paid-in-capital                                                                                         |   | 13,960                       |     | 68,294                      |     |
| Accumulated earnings (deficit), after  January 1, 2003, net of $54,405   deficit eliminated)             |   | 885                          |     | (54,405                     | )        |
| Unearned compensation                                                                                              |   | (41                          | )        | (26                         | )        |
| Employee loans for stock purchase                                                                                  |   | (189                         | )        | (397                        | )        |
|                                                                                                               |   | 14,686                       |     | 13,536                      |     |
| Treasury stock, at cost (2003, 887,150;  2002, 873,500 shares)                                                     |   | (5,896                       | )        | (5,877                      | )        |
|                                                                                                               |   | 8,790                        |     | 7,659                       |     |
|                                                                                                               |   | $                            | 18,751   |                        | $        | 14,300 |   |

 

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* Derived from audited financial statements.

 

See notes to condensed consolidated financialstatements.

 

2

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**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Income**(In thousands, except share and per share data)

 
|                                                                                                    |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|---------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                    |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                                                                                    |   | **(Unaudited)**                             |   | **(Unaudited)**                            |   |
| ***Income:***                                                                                           |   |                                        |   |                                       |   |   |   |   |   |
| Commissions                                                                                             |   | $                                           | 4,458  |                                       | $      | 3,312 |   | $ | 11,980 |   | $ | 8,244 |   |
| Contingent commissions                                                                                  |   | 543                                         |   | 156                                        |   | 1,725 |   | 1,247 |   |
| Net investment income                                                                                   |   | 1                                           |   | 20                                         |   | 5 |   | 28 |   |
| Service fees                                                                                            |   | 226                                         |   | 12                                         |   | 418 |   | 47 |   |
| Other                                                                                                   |   | 2                                           |   | 20                                         |   | 20 |   | 126 |   |
|                                                                                                    |   | 5,230                                       |   | 3,520                                      |   | 14,148 |   | 9,692 |   |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| ***Expenses:***                                                                                         |   |                                        |   |                                       |   |   |   |   |   |
| Salaries and related expenses                                                                           |   | 2,714                                       |   | 2,310                                      |   | 7,516 |   | 5,546 |   |
| Interest expense                                                                                        |   | 32                                          |   | 58                                         |   | 113 |   | 190 |   |
| Amortization expense                                                                                    |   | 158                                         |   | 97                                         |   | 381 |   | 389 |   |
| Other expenses                                                                                          |   | 1,483                                       |   | 803                                        |   | 4,571 |   | 2,642 |   |
|                                                                                                    |   | 4,387                                       |   | 3,268                                      |   | 12,581 |   | 8,767 |   |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| Income from continuing operations before  income taxes                                                  |   | 843                                         |   | 252                                        |   | 1,567 |   | 925 |   |
| Income tax expense                                                                                      |   | 367                                         |   | 105                                        |   | 682 |   | 396 |   |
| Income from continuing operations                                                                       |   | $                                           | 476    |                                       | $      | 147 |   | $ | 885 |   | $ | 529 |   |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| Discontinued operations:                                                                                |   |                                        |   |                                       |   |   |   |   |   |
| Loss from operations of discontinued  underwriting segment (including loss on disposal in 2002 of $275) |   | —                                      |   | (71                                        | )      | — |   | (278 | ) |
| Income tax benefit                                                                                      |   | —                                      |   | (30                                        | )      | — |   | (118 | ) |
| Loss on discontinued operations                                                                         |   | —                                      |   | (41                                        | )      | — |   | (160 | ) |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| ***Net  income***                                                                                       |   | $                                           | 476    |                                       | $      | 106 |   | $ | 885 |   | $ | 369 |   |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| Earnings per share:                                                                                     |   |                                        |   |                                       |   |   |   |   |   |
| Income from continuing operations                                                                       |   | $                                           | 0.08   |                                       | $      | 0.03 |   | $ | 0.14 |   | $ | 0.09 |   |
| Loss on discontinued operations                                                                         |   | —                                      |   | $                                          | (0.01  | ) | — |   | $ | (0.03 | ) |
| Net income                                                                                              |   | $                                           | 0.08   |                                       | $      | 0.02 |   | $ | 0.14 |   | $ | 0.06 |   |
| Weighed average shares outstanding                                                                      |   | 6,239,879                                   |   | 6,089,879                                  |   | 6,217,682 |   | 6,091,397 |   |
|                                                                                                    |   |                                        |   |                                       |   |   |   |   |   |
| Earnings per share - assuming dilution                                                                  |   |                                        |   |                                       |   |   |   |   |   |
| Income from continuing operations                                                                       |   | $                                           | 0.07   |                                       | $      | 0.03 |   | $ | 0.14 |   | $ | 0.09 |   |
| Loss on discontinued operations                                                                         |   | —                                      |   | $                                          | (0.01  | ) | — |   | $ | (0.03 | ) |
| Net income                                                                                              |   | $                                           | 0.07   |                                       | $      | 0.02 |   | $ | 0.14 |   | $ | 0.06 |   |
| Weighted average shares outstanding -  assuming dilution                                           |   | 6,485,212                                   |   | 6,125,340                                  |   | 6,443,380 |   | 6,113,261 |   |

 

See notes to condensed consolidated financial statements.

 

3

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**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Cash Flows**(In thousands)

 
|                                                                                 |   | **Nine  Months Ended  September 30,** |   |
|--------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                 |   | **2003**                                   |   | **2002** |   |
|                                                                                 |   | **(Unaudited)**                            |   |
| ***Cash  flow from operating activities:***                                          |   |                                       |   |   |   |
| Net income                                                                           |   | $                                          | 885    |   | $ | 369 |   |
| Loss from discontinued operations                                                    |   | —                                     |   | 160 |   |
| Income from continuing operations                                                    |   | 885                                        |   | 529 |   |
| *Adjustments to reconcile net income to net  cash provided by operating activities:* |   |                                       |   |   |   |
| Depreciation and amortization                                                        |   | 489                                        |   | 374 |   |
| Loss on sale of property and equipment                                               |   | —                                     |   | 3 |   |
| Increase in receivables                                                              |   | (1,189                                     | )      | (924 | ) |
| Decrease in deferred income taxes                                                    |   | 491                                        |   | 337 |   |
| Increase in accounts payable and accrued  expenses                                   |   | 2,496                                      |   | 1,579 |   |
| Other, net                                                                           |   | 123                                        |   | 713 |   |
| ***Net  cash provided by operating activities***                                     |   | 3,295                                      |   | 2,611 |   |
|                                                                                 |   |                                       |   |   |   |
| ***Cash  flows used in investing activities:***                                      |   |                                       |   |   |   |
| Purchase of property and equipment                                                   |   | (104                                       | )      | (233 | ) |
| Purchase of book of business                                                         |   | (380                                       | )      | (221 | ) |
| ***Net  cash used in investing activities***                                         |   | (484                                       | )      | (454 | ) |
|                                                                                 |   |                                       |   |   |   |
| ***Cash  flows used in financing activities:***                                      |   |                                       |   |   |   |
| Payments on notes payable                                                            |   | (975                                       | )      | (976 | ) |
| Payments received on employee loans for  stock purchase                              |   | 36                                         |   | 85 |   |
| Retirement of common stock                                                           |   | —                                     |   | (4 | ) |
| Issuance of common stock                                                             |   | —                                     |   | — |   |
| Funding of discontinued operations                                                   |   | —                                     |   | (278 | ) |
| ***Net  cash used in financing activities***                                         |   | (939                                       | )      | (1,173 | ) |
|                                                                                 |   |                                       |   |   |   |
| ***Net  increase in cash and invested cash***                                        |   | 1,872                                      |   | 984 |   |
| Cash and invested cash at beginning of  period                                       |   | 1,290                                      |   | 1,997 |   |
| ***Cash  and invested cash at end of period***                                       |   | $                                          | 3,162  |   | $ | 2,981 |   |

 

See notes to condensed consolidated financial statements.

 

4

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**PAULAFINANCIAL AND SUBSIDIARIES**

**Notesto Condensed Consolidated Financial StatementsFor the Three and Nine Months Ended September 30, 2003 (Unaudited)**

 

**Note A - Basis ofPresentation**

 

PAULA Financial and subsidiaries (the “Company”) is a California-basedspecialty distributor of commercial insurance products.  The Company’s agency operations place a fullarray of commercial insurance products for their customers.  In addition, the Company owns a third partyadministration operation which has minimal operations.

 

The accompanying unaudited condensed consolidated financial statementsof the Company have been prepared in accordance with accounting principlesgenerally accepted in the United States (“GAAP”) for interim financial informationand with the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall of the information and footnotes required by GAAP for complete financialstatements.  In the opinion ofmanagement, all adjustments, including normally occurring accruals, considerednecessary for a fair presentation have been included.

 

The Company’s operating results tend to be cyclical. Consequently,operating results for the three and nine months ended September 30, 2003are not necessarily indicative of the results to be expected for the year endedDecember 31, 2003.  For furtherinformation, refer to the consolidated financial statements and footnotesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2002.

 

In December 2002, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting forStock Based Compensation – Transition and Disclosure, an amendment of SFAS123”.  Among other provisions, SFAS 148amends the disclosure requirements of SFAS 123 to require prominent disclosuresin both annual and interim financial statements.  For the three and nine months ended September 30, 2003, thedifferences between the as reported net income and income per share amounts andthe related pro forma amounts are not material to the consolidated financialstatements.

 

**NoteB – Change in Stockholders’ Equity**

 

Effective January 1, 2003, the Company implemented aquasi-reorganization of its capital accounts. At December 31, 2002, the Company had an accumulated deficit of$54.4 million which was primarily generated by the Company’s underwritingoperations, PAULA Insurance Company (“PICO”). PICO was disposed of in 2002 (see Note D – Discontinued Operations).  After approval by the stockholders onMay 21, 2003, the Company effected the quasi-reorganization pursuant towhich the Company eliminated its accumulated deficit and charged thecorresponding amount to additional paid-in-capital.

 

5

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In the first quarter of 2003,the Company issued 80,000 shares of restricted stock.  As of September 30, 2003, 50,000 shares were unvested.  Of the 80,000 shares issued, 60,000 sharesrelated to the addition to the Company’s crop insurance platform of Roudebush& Avina Insurance Agency, Inc. (“R&A”).  R&A is based in Modesto, California and specializes inproviding crop insurance to commercial wine grape growers.  Since 2002, the Company has made efforts todramatically expand crop insurance sales, primarily through producerrecruitment.  As part of the agreement,the Company purchased R&A’s existing book of business.  Balances owing under the arrangement will bepaid over a five year period.  As ofSeptember 30, 2003, the obligation related to this transaction was$526,000 with $126,000 of the balance due in the next twelve months.  Of the total purchase price, $503,000 hasbeen allocated to other amortizable intangible assets, with the remaining$323,000 allocated to goodwill.  Otheramortizable intangible assets relate to expiration lists and covenants not tocompete.

 

Additionally, in the first nine months of 2003, the Company receivedpayments on employee loans for stock purchase totaling $36,000, wrote off loanstotaling $145,000 and increased the valuation allowance on the remaining loansby $27,000.

 

##### **NoteC – Comprehensive Income**

##### ** **

The Company has not included a statement of comprehensive income in theaccompanying consolidated financial statements as the Company does not have anyother comprehensive income adjustments.

 

##### **NoteD – Discontinued Operations**

##### ** **

Historically, the Company also operated a workers’ compensationunderwriting facility, PICO.  As ofDecember 31, 2001, PICO’s Risk Based Capital fell into the “Mandatory ControlLevel.”  Consequently, on March 12,2002 PICO and the California Department of Insurance (“California DOI”) enteredinto an Oversight Agreement which effectively gave the California DOI controlover PICO’s operations.  As a result ofthese events, in the fourth quarter of 2001, the Company began accounting forits investment in PICO using the equity method.  In the fourth quarter of 2001, the Company wrote its investmentin PICO down to $-0-.  Consequently, nodirect PICO operating activity is included in the consolidated financialstatements for the 2002 period.

 

On April 26, 2002, the California DOI obtained a conservationorder which was followed on June 21, 2002 by a liquidation order.  Subsequent to the liquidation order, theCompany provided limited operational support to PICO.  Given the continued activity with PICO through the third quarterof 2002, the Company was precluded from treating PICO as a discontinuedoperation for accounting purposes.

 

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

 

Amounts related to discontinued operations in the 2002 period primarilyrelate to employee severance costs associated with the discontinuance of PICOoperations.

 

6

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##### **NoteE – Goodwill**

##### ** **

The increase in goodwill in the first nine months of 2003 is related tothe previously discussed purchase of R&A’s book of business as well as thepurchase of a large account agribusiness book of business inJuly 2002.  As structured, theCompany acquires the business as the related accounts are renewed.  The final purchase price determinations willbe made in the fourth quarter of 2003 related to the 2002 acquisition and inthe first quarter of 2004 related to the R&A acquisition.

 

##### **NoteF – Deferred Income Taxes**

##### ** **

As of September 30, 2003 and December 31, 2002, the Company’snet deferred tax asset is comprised of the following:

 
|                              |   | **Sept 30  2003** |   | **Dec 31  2002** |   |
|-----------------------------------|--------|-------------------|--------|------------------|--------|
|                              |   | **(unaudited)**   |   |             |   |
| Deferred tax  assets:             |   |              |   |             |   |
| Net  operating loss carry forward |   | $                 | 27,371 |             | $      | 27,996 |   |
| Other                             |   | 1,426             |   | 1,292            |   |
| Gross  deferred tax assets        |   | 28,797            |   | 29,288           |   |
| Less  valuation allowance         |   | (22,646           | )      | (22,646          | )      |
| Deferred tax  assets              |   | $                 | 6,151  |             | $      | 6,642 |   |
| Gross  deferred tax liabilities   |   | $                 | — |             | $      | — |   |
| Net deferred  tax asset           |   | $                 | 6,151  |             | $      | 6,642 |   |

 

The net operating loss carry forward includes losses generated by PICOwhich are available to offset future taxable income of the Company.

 

Management believes that it is more likely than not that the results offuture operations will generate sufficient taxable income in the periodsnecessary to realize the net deferred tax asset.

 

7

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| **PART I** | **FINANCIAL  INFORMATION**                                                                                |
|------------|-----------------------------------------------------------------------------------------------------------|
|       |                                                                                                      |
| Item 2.    | Management’s  Discussion and Analysis of Consolidated Financial Condition and Results of  Operations |

 

**Overview**

 

The Company’s revenues consist primarily of agency commission,contingent commission income, and service fees.  Commission income is earned from Pan Am’s insurance salesactivity.  Associated premiums areprimarily billed directly by the insurance carrier.  However, in certain instances, Pan Am will invoice the customerand remit the premium, less commission, to the insurance carrier.  The Company focuses its sales efforts onagribusiness and rural markets in California and Arizona.  Contingent commission is related to volumeand profit sharing arrangements with insurance carriers.  Service fees are primarily received for theperformance of services related to loss control and claims advocacy.

 

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

 

**Results of Operationsfor the Three and Nine Months Ended September 30, 2003 Compared to theThree and Nine Months Ended September 30, 2002:**

 

**Commission income.**For the three months ended September 30, 2003 commission income increased35% to $4.5 million compared to $3.3 million for the comparable 2002period.  For the nine months endedSeptember 30, 2003 commission income increased 45% to $12.0 millioncompared to $8.2 million for the comparable 2002 period.  For the nine months, 40% of the increase isdue to increases in the placement of crop insurance while 36% is due toincreases in the workers compensation line of business.

 

Crop insurance has various renewal cycles depending on the underlyingcommodity.  In the third quarter of2003, the 2003 crop year was substantially completed and the associated revenuewas recognized.  Prior to the 2003 cropyear, the Company’s revenue activity associated with this line of business wasnominal.

 

Currently the California State Compensation Insurance Fund (“SCIF”) isthe largest single market for workers’ compensation insurance in thestate.  Consequently, the Company placesa significant portion of its related business with SCIF.  Prior to August 2003, SCIF’s maximumcommission rate was 8.0%.  EffectiveAugust 2003, the maximum commission rate is 5.5%.  Since commission rates are only adjusted atrenewal, the full impact of this change will not be reflected in the Company’sconsolidated financial statements until the last half of 2004.  Partially offsetting the reduced commissionrate, SCIF increased premium rates in July 2003.

 

The Company is attempting to mitigate the impact of the SCIF commissionadjustment in a number of significant ways. First, the Company is actively engaged in offering alternative riskstructures, including proprietary access to a Bermuda captive.  Second, the Company is diversifying itsrevenue base by expanding its property and casualty commissions and developinga significant crop insurance platform. Since 2002, the Company has made effortsto dramatically expand crop insurance sales, primarily through producerrecruitment.  In March 2003,R&A joined the Company.  R&A isbased

 

8

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in Modesto, California andspecializes in providing crop insurance to commercial wine grape growers.

 

The Company is now seeing the impact of its diversificationefforts.  For the nine months endedSeptember 30, 2003, workers’ compensation accounted for 43% of commissionincome as compared to 46% for the comparable 2002 period.

 

**Contingent commissionincome.** For the three months ended September 30,2003 contingent commission income increased to $543,000 compared to $156,000for the comparable 2002 period. For the nine months ended September 30,2003 commission income increased 38% to $1.7 million compared to $1.2 millionfor the comparable 2002 period. Contingent commission fluctuates from year to year based on theprofitability of the underlying business and external market conditions whichcan result in changes to contingency programs offered by insurance carriers.

 

**Service fees.**  Service fee income increased to $226,000 forthe three months ended September 30, 2003 from $12,000 for the comparable2002 period.  For the nine months endedSeptember 30, 2003 service fee income increased to $418,000 compared to$47,000 for the comparable 2002 period. The increase in service fees is due to new service arrangements wherethe Company is paid for providing loss control and other field support servicesto selected accounts.

 

**Salaries and relatedexpenses.** Salaries and employee benefits increased 17% to $2.7 million for thethree months ended September 30, 2003 from $2.3 million for the comparable2002 period.  For the nine months endedSeptember 30, 2003 salaries and employee benefits increased 36% to $7.5million from $5.5 million for the comparable 2002 period.  The increase is due to three primaryfactors: the transfer of selected employees from PICO’s payroll to Pan Am inearly to mid-2002, the addition of new employees beginning in July 2002and the elimination of previous cost sharing arrangements that were in effectwith PICO through mid-2002.  For thenine months ended September 30, 2003, salaries and related expenses was53% of total revenues as compared to 57% for the comparable 2002 period.

 

**Interest expenses.**  Interest expense decreased 45% to $32,000for the three months ended September 30, 2003 from $58,000 for thecomparable 2002 period. For the nine months ended September 30, 2003interest expense decreased 41% to $113,000 from $190,000 for the comparable2002 period.  The decrease is due to thedecline in the outstanding balance of the related note payable.

 

**Operating expenses.**  Operating expenses increased 82% to $1.6million for the three months ended September 30, 2003 from $900,000 forthe comparable 2002 period. For the nine months ended September 30, 2003operating expenses increased 63% to $5.0 million compared to $3.0 million forthe comparable 2002 period.  Theincrease is primarily due to the elimination of previous cost sharingarrangements that were in effect with PICO until mid-2002 as well as the costsassociated with an increased number of employees, including insurance andfacilities expense.  Also contributingto the increase in operating expenses are accruals associated with legalmatters.

 

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**Income taxes oncontinuing operations.**  Income tax expense for the three months ended September 30,2003 was $367,000 compared to $105,000 for the comparable 2002 period.  Income tax expense for the nine months endedSeptember 30, 2003 was $682,000 compared to $396,000 for the comparable2002 period.  The effective combinedincome tax rates for the nine months ended September 30, 2003 and 2002were 44% and 43%, respectively.

 

**Loss fromdiscontinued operations before taxes.**  In 2002, these costs primarily includedemployee severance costs associated with the discontinuance of PICO operations.

 

**Income taxes ondiscontinued operations.**  Income tax benefit on discontinued operations for the threemonths ended September 30, 2002 was $30,000.  Income tax benefit on discontinued operations for the nine monthsended September 30, 2002 was $118,000. The effective combined income tax rates for the nine months endedSeptember 30, 2002 was  42%.

 

**Liquidity and CapitalResources:**

 

As a holding company, PAULA Financial’s principal sources of funds aredividends and expense reimbursements from its operating subsidiaries andproceeds from the sale of its capital stock. PAULA Financial’s principal uses of funds are capital contributions toits subsidiaries and payment of operating expenses.

 

As of December 31, 2002, the Company had an outstanding balance onits bank term loan of $2.8 million. Under the terms of the amended creditagreement, the loan balance will be paid over the next fifteen months with thefinal principal payment due January 1, 2005.  As of September 30, 2003, the outstanding balance was $1.8million. Each of PAULA Financial’s subsidiaries has guaranteed all obligationsof PAULA Financial under the Credit Agreement.

 

Management is in the process of finalizing the refinancing this loanunder a revolving line of credit. Management expects that the refinancing will be compete within the nextseveral weeks.

 

The Company’s Board of Directors had previously approved a 1,000,000share repurchase program.  As ofSeptember 30, 2003, the Company held 887,150 shares in treasurystock.  On February 20, 2003, theBoard of Directors authorized an additional 2,000,000 shares for the sharerepurchase program.  The Company’scurrent credit agreement restricts its ability to repurchase capital stock.

 

FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”is not applicable to the Company.

 

**Forward-LookingStatements**

 

In connection with, and because it desires to take advantage of the“safe harbor” provisions of the Private Securities Litigation Reform Act of1995, the Company cautions readers to recognize the existence of certainforward-looking statements in this Form 10-Q and in any other statement madeby, or on behalf of, the Company, whether or not in future filings with theSecurities and Exchange Commission. Forward-looking statements are statements not based on historicalinformation and which relate to future operations, strategies, financialresults or other developments.  Someforward-looking statements may be identified by the use of terms such as“expects,” “believes,” “anticipates,” “intends,” or “judgment.” Forward-lookingstatements are necessarily based upon estimates and

 

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assumptions that are inherently subject to significant business,economic and competitive uncertainties, many of which are beyond the Company’scontrol and many of which, with respect to future business decisions, aresubject to change.  Examples of suchuncertainties and contingencies include, among other important factors, thoseaffecting the insurance industry in general, such as the economic and interestrate environment, legislative and regulatory developments and market pricingand competitive trends, and those relating specifically to the Company and itsbusinesses, such as the level of its commission and fee income and acquisitionsof companies or blocks of business. These uncertainties and contingencies can affect actual results andcould cause actual results to differ materially from those expressed in anyforward-looking statements made by, or on behalf of, the Company. The Companydisclaims any obligation to update forward-looking information.

 

Item 3:  Quantitative andQualitative Disclosures About Market Risk.

 

There have been no significant changes since the Company’s AnnualReport on Form 10-K filed for the year ended December 31, 2002.

 

Item 4:  Controls and Procedures

 

**Evaluationof Disclosure Controls and Procedures**

 

The Company’s Chief Executive Officer and Vice President Finance haveevaluated the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a – 15(e) and 15d – 15(e) under the Securities ExchangeAct of 1934) as of the end of the period covered by this quarterly report.  Based on this evaluation, such officers haveconcluded that the Company’s disclosure controls and procedures as of the endof the period covered by this quarterly report were effective for ensuring thatinformation required to be disclosed in the reports it files or submits underthe Exchange Act is recorded, processed, summarized and reported in a timelymanner.  There have not been anysignificant changes in the Company’s internal controls or in other factors thatcould significantly affect such controls.

 

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## **PART II.  OTHERINFORMATION**

 

Item 1:  LegalProceedings:

 

As previously disclosed in the Company’s Form 10-K for the year endedDecember 31, 2002, Pan American Underwriters Insurance Agents and Brokers,Inc., the Company’s agency operation in Arizona (the “Arizona Company”), is adefendant in an action filed in Arizona Superior Court, Maricopa County, by twohospitals and two individuals seeking damages for the Arizona Company’s sale ofSGP Benefit Plan, Inc. (“SGP”), a Multi-Employer Welfare Arrangement (“MEWA”)licensed by the State of California. SGP operated in California and Arizona and has filed for Chapter 7bankruptcy protection in the United States Bankruptcy Court for the EasternDivision of California.

 

At the time of the filing of the bankruptcy, SGP allegedly owedplaintiffs certain unpaid benefits under its plans.  Plaintiff’s allege that those benefits total approximately$935,000.  The plaintiffs contend thatthe MEWA required a license from the Arizona Department of Insurance, that theMEWA lacked such a license, and that the Arizona Company is liable for unpaidbenefits pursuant to Arizona Revised Statute 20-402 (B) which provides for anagents liability when an unlicensed insurer fails to pay any claim or losswithin the provisions of the insurance contract.

 

The Arizona Company has filed an answer to the complaint denyingliability and has filed a counterclaim against the hospital plaintiffs and across complaint against a third party, Sunkist Growers, Inc. alleging that itis responsible in whole or part for any damages caused to plaintiffs.  Discovery has not yet begun in the action.

 

It is difficult to predict the outcome of any litigation, as the natureof litigation is always uncertain, but the Arizona Company believes that thereexist substantial legal and factual defenses to plaintiffs’ claims and willconsequently defend itself vigorously.

 

Item 5:  OtherInformation

 

Effective November 1, 2003, Mr. Karl T. Hansenceased to be an employee of the Company and resigned his position as ExecutiveVice President of Pan American Underwriters, Inc. and as a director of theCompany.  Mr. Hansen’s departure was nota result of any disagreement with the Company, its management or the Board ofDirectors.

 

Item 6: Exhibits and Reports on Form 8-K:

 

(a)          Exhibits.

 

11.                                 Computationof Earnings Per Share.

 

31.1                           Rule13a -14a /15d -14a Certification of Chief Executive Officer.

 

31.2                           Rule13a -14a /15d -14a Certification of Chief Financial Officer.

 

32.1                           Section 1350Certifications of Chief Executive Officer.

 

32.2                           Section 1350Certifications of Chief Financial Officer.

 

(b)         Reportson Form 8-K.

 

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On September 29, 2003, the Company filed a Form8-K related to a change in auditors.  Inresponse to a staff comment letter dated October 10, 2003, regarding theCompany’s Form 8-K filed on September 29, 2003, on October 17, 2003the Company filed an Amended Form 8-K. In response to the staff’s supplemental request regarding the Company’sForm 8-KA filed on October 17, 2003, the Company filed an Amended Form 8-Kon November 10, 2003.

 

Additionally, onSeptember 2, 2003, the Company filed a Form 8-K related to the pressrelease announcing operating results for the second quarter of 2003.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, asamended, the Registrant has duly caused this Quarterly Report on Form 10-Q tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| Date:   November 13, 2002 | PAULA FINANCIAL               |
|-------------------------------------|-------------------------------|
|                                |                          |
|                                |                          |
|                                | By:                           | /s/ Deborah S. Maddocks |   |
|                                | Vice President – Finance |

 

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