**SECURITIES AND EXCHANGECOMMISSION****WASHINGTON, D.C.  20549**

 

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**FORM 10-QSB**

 

**(Mark One)**

**ý****          ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the Quarterly Period Ended June 30,2005**

 

**OR**

 

**o****          ****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the Transition Period from          to          **

 

**Commission file number 0-23181**

 

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

 
| **Delaware**                     | ** ** | **95-4640638**         |
|----------------------------------|------------|------------------------|
| (State or other  jurisdiction of | ** ** | (I.R.S. Employer       |
| incorporation or  organization)  | ** ** | identification number) |

** **

**PAULA FINANCIAL**

**87 East Green Street, Suite 206**

**Pasadena, CA 91105**

(Address of principal executive offices)

 

**(626) 844-7100**

(Issuer’s telephone number, includingarea code)

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange 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.

 

Yes  ý  No  o

 

State the number ofshares outstanding of each of the issuer’s classes of common equity, as of thelatest practicable date.  Number ofshares of Common Stock, $.01 par value, outstanding as of close of business on August 10,2005:  6,339,545 shares.

 

Transitional SmallBusiness Disclosure Format (check one):

 

Yes  ý  No  o

 

 

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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 June 30, 2005 (unaudited) and December 31, 2004                          |   |
|          |                                                                                                                            |   |
|          | Condensed consolidated  statements of income for the three months and six months ended June 30,  2005 and 2004 (unaudited) |   |
|          |                                                                                                                            |   |
|          | Condensed  consolidated statements of comprehensive income for the six months ended  June 30, 2005 and 2004 (unaudited)    |   |
|          |                                                                                                                            |   |
|          | Condensed  consolidated statements of cash flows for the six months ended June 30,  2005 and 2004 (unaudited)              |   |
|          |                                                                                                                            |   |
|          | Notes to condensed  consolidated financial statements for the three months and six months ended  June 30, 2005 (unaudited) |   |
|          |                                                                                                                            |   |
| Item  2.      | Management’s Discussion and  Analysis of Consolidated Financial Condition and Results of Operations                        |   |
|          |                                                                                                                            |   |
| Item  3.      | Controls and procedures                                                                                                         |   |
|          |                                                                                                                            |   |
| PART II. | OTHER INFORMATION                                                                                                               |   |
|          |                                                                                                                            |   |
| Item  4.      | Submission of Matters to a Vote  of Security Holders                                                                            |   |
|          |                                                                                                                            |   |
| Item 5.       | Other Information                                                                                                               |   |
|          |                                                                                                                            |   |
| Item  6.      | Exhibits and Reports on  Form 8-K                                                                                          |   |
|          |                                                                                                                            |   |
| SIGNATURE     |                                                                                                                            |

 

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**PART I****                               FI****NANCIAL INFORMATION**

**Item 1.****                                   Fina****ncial Statements**

 

**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidat****ed Balance Sheets**

(In thousands, except share data)

 
| ** **                                                                                                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                                                                                            | ** ** | **(Unaudited)**   | ** ** | **(*)**               | ** ** |
| ***Assets***                                                                                                                          | * *   | * *          | * *   | * *              | * *   |
| *Current  Assets:*                                                                                                                    | * *   | * *          | * *   | * *              | * *   |
| Cash  (restricted: 2005, $1,638; 2004, $1,844)                                                                                        |       | $                 | 3,170      |                  | $          | 3,241 |   |
| Investments,  available-for-sale (cost: 2005, $1,110)                                                                                 |       | 1,062             |       | —                |       |
| Accounts  receivable, net of allowance for uncollectible accounts (2005 and 2004, $80)                                                |       | 3,173             |       | 3,142                 |       |
| Commissions  receivable                                                                                                               |       | 2,360             |       | 2,155                 |       |
| Income tax  receivable                                                                                                                |       | —            |       | 15                    |       |
| Other  receivables                                                                                                                    |       | 45                |       | 20                    |       |
| Deferred income  taxes                                                                                                                |       | 1,892             |       | 1,769                 |       |
| Other assets                                                                                                                          |       | 162               |       | 188                   |       |
|                                                                                                                                  |       | 11,864            |       | 10,530                |       |
| *Non-Current  Assets:*                                                                                                                | * *   | * *          | * *   | * *              | * *   |
| Property and  equipment, net                                                                                                          |       | 556               |       | 278                   |       |
| Investment in  related party, at cost                                                                                                 |       | 703               |       | 703                   |       |
| Goodwill, net                                                                                                                         |       | 2,124             |       | 2,017                 |       |
| Other  amortizable intangible assets, net                                                                                             |       | 1,944             |       | 1,574                 |       |
| Deferred income  taxes                                                                                                                |       | 2,878             |       | 3,465                 |       |
| Other assets                                                                                                                          |       | 172               |       | 170                   |       |
|                                                                                                                                  |       | $                 | 20,241     |                  | $          | 18,737 |   |
| ***Liabilities and Stockholders’  Equity***                                                                                      |       |              |       |                  |       |
| *Current  Liabilities:*                                                                                                               |       |              |       |                  |       |
| Due to  underwriters and assureds                                                                                                     |       | $                 | 4,667      |                  | $          | 4,800 |   |
| Accounts payable  and accrued expenses                                                                                                |       | 472               |       | 395                   |       |
| Employment  related accruals                                                                                                          |       | 801               |       | 478                   |       |
| Acquisition  related accruals                                                                                                         |       | 701               |       | 772                   |       |
| Income taxes  payable                                                                                                                 |       | 124               |       | —                |       |
| Notes payable to  bank                                                                                                                |       | —            |       | 1,276                 |       |
|                                                                                                                                  |       | 6,765             |       | 7,721                 |       |
| *Non-Current  Liabilities:*                                                                                                           |       |              |       |                  |       |
| Accounts payable  and accrued expenses                                                                                                |       | 218               |       | —                |       |
| Acquisition  related accruals                                                                                                         |       | 1,096             |       | 752                   |       |
| Notes payable to  bank                                                                                                                |       | 1,176             |       | —                |       |
|                                                                                                                                  |       | $                 | 9,255      |                  | $          | 8,473 |   |
| *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: 7,290,879 and  7,270,879 shares in 2005 and 2004, respectively) |       | 73                |       | 73                    |       |
| Additional  paid-in-capital                                                                                                           |       | 14,146            |       | 14,137                |       |
| Accumulated  earnings, after January 1, 2003                                                                                     |       | 2,839             |       | 2,095                 |       |
| Accumulated  other comprehensive loss                                                                                                 |       | (32               | )          | —                |       |
| Unearned  compensation                                                                                                                |       | (22               | )          | (60                   | )          |
| Employee loans  for stock purchase                                                                                                    |       | (23               | )          | (23                   | )          |
| Treasury stock,  at cost (946,398 and 924,734 shares in 2005 and 2004, respectively)                                                  |       | (5,995            | )          | (5,958                | )          |
|                                                                                                                                  |       | $                 | 10,986     |                  | $          | 10,264 |   |
|                                                                                                                                  |       | $                 | 20,241     |                  | $          | 18,737 |   |

 

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* Derived fromaudited financial statements.

 

See notes tocondensed consolidated financial statements.

 

2

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**PAULA FINANCIAL AND SUBSIDIARIES**

**Condensed Consolidated Stateme****nts of Income**

(In thousands, except share and per share data)

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                               | ** ** | **(Unaudited)**        | ** ** | **(Unaudited)**      | ** ** |
| ***Income:***                                            |       |                   |       |                 |       |   |   |   |   |
| Commissions and  placement fees                          |       | $                      | 3,818      |                 | $          | 4,498 |   | $ | 7,272 |   | $ | 8,262 |   |
| Profit sharing  income                                   |       | 23                     |       | 19                   |       | 2,014 |   | 1,297 |   |
| Service fees                                             |       | 244                    |       | 131                  |       | 435 |   | 227 |   |
| Other income                                             |       | 29                     |       | 6                    |       | 44 |   | 20 |   |
|                                                     |       | 4,114                  |       | 4,654                |       | 9,765 |   | 9,806 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| ***Operating  Expenses:***                               |       |                   |       |                 |       |   |   |   |   |
| Salaries and  related expenses                           |       | 2,028                  |       | 2,547                |       | 5,006 |   | 5,221 |   |
| Interest expense                                         |       | 21                     |       | 19                   |       | 41 |   | 46 |   |
| Amortization  expense                                    |       | 181                    |       | 148                  |       | 328 |   | 294 |   |
| Other expenses                                           |       | 1,410                  |       | 1,559                |       | 2,797 |   | 3,004 |   |
|                                                     |       | 3,640                  |       | 4,273                |       | 8,172 |   | 8,565 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Income from  operations before income taxes              |       | 474                    |       | 381                  |       | 1,593 |   | 1,241 |   |
| Income tax  expense                                      |       | 201                    |       | 166                  |       | 659 |   | 468 |   |
| ***Net  income***                                        |       | $                      | 273        |                 | $          | 215 |   | $ | 934 |   | $ | 773 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Earnings per  share - basic                              |       | $                      | 0.04       |                 | $          | 0.03 |   | $ | 0.14 |   | $ | 0.12 |   |
| Weighted average  shares outstanding                     |       | 6,581,618              |       | 6,442,146            |       | 6,587,050 |   | 6,441,198 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Earnings per  share - assuming dilution                  |       | $                      | 0.04       |                 | $          | 0.03 |   | $ | 0.14 |   | $ | 0.11 |   |
| Weighted average  shares outstanding - assuming dilution |       | 6,794,585              |       | 6,766,115            |       | 6,805,335 |   | 6,756,392 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Dividends  declared per common share                     |       | $                      | 0.015      |                 | $          | 0.015 |   | $ | 0.03 |   | $ | 0.015 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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**PAULA FINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Co****mprehensive Income**

(In thousands)

 
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(Unaudited)**                     | ** ** |
|                                                                         |       |                                |       |   |   |
| Net income                                                                   |       | $                                   | 934        |   | $ | 773 |   |
|                                                                         |       |                                |       |   |   |
| Other  comprehensive loss:                                                   |       |                                |       |   |   |
| Net unrealized  holding losses arising during period (tax impact: 2005: $17) |       | (32                                 | )          | — |   |
|                                                                         |       |                                |       |   |   |
| Comprehensive  income                                                        |       | $                                   | 902        |   | $ | 773 |   |

 

Seenotes to condensed consolidated financial statements.

 

4

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**PAULA FINANCIAL AND SUBSIDIARIES**

**Condensed Consolidated Statementsof****Cash Flows**

(In thousands)

 
| ** **                                                                           | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                           | ** ** | **(Unaudited)**                     | ** ** |
| ***Cash  flows from operating activities:***                                         |       |                                |       |   |   |
| Net income                                                                           |       | $                                   | 934        |   | $ | 773 |   |
|                                                                                 |       |                                |       |   |   |
| *Adjustments  to reconcile net income to net cash provided by operating activities:* |       |                                |       |   |   |
| Depreciation                                                                         |       | 83                                  |       | 66 |   |
| Amortization                                                                         |       | 328                                 |       | 294 |   |
| Changes in  operating assets and liabilities:                                        |       |                                |       |   |   |
| (Increase) decrease  in receivables                                                  |       | (246                                | )          | 1,335 |   |
| Decrease in  deferred income taxes                                                   |       | 480                                 |       | 416 |   |
| Increase  (decrease) in accounts payable and accrued expenses                        |       | 355                                 |       | (1,003 | ) |
| Decrease in  unearned compensation                                                   |       | 38                                  |       | 31 |   |
| Other, net                                                                           |       | 8                                   |       | 68 |   |
| ***Net  cash provided by operating activities***                                     |       | 1,980                               |       | 1,980 |   |
|                                                                                 |       |                                |       |   |   |
| ***Cash  flows from investing activities:***                                         |       |                                |       |   |   |
| Purchase of  property and equipment                                                  |       | (84                                 | )          | (106 | ) |
| Cash paid for  investments acquired                                                  |       | (1,110                              | )          | — |   |
| Purchase of book  of business                                                        |       | (531                                | )          | (314 | ) |
| ***Net  cash used in investing activities***                                         |       | (1,725                              | )          | (420 | ) |
|                                                                                 |       |                                |       |   |   |
| ***Cash  flows from financing activities:***                                         |       |                                |       |   |   |
| Payments on line  of credit                                                          |       | (100                                | )          | (200 | ) |
| Dividends paid                                                                       |       | (190                                | )          | (93 | ) |
| Repurchase of  common stock                                                          |       | (36                                 | )          | — |   |
| Payments  received on employee loans for stock purchase                              |       | —                              |       | 13 |   |
| ***Net  cash used in financing activities***                                         |       | (326                                | )          | (280 | ) |
|                                                                                 |       |                                |       |   |   |
| ***Net  increase (decrease) in cash and invested cash***                             |       | (71                                 | )          | 1,280 |   |
| Cash and  invested cash at beginning of period                                       |       | 3,241                               |       | 3,110 |   |
| ***Cash  and invested cash at end of period***                                       |       | $                                   | 3,170      |   | $ | 4,390 |   |

 

See notes to condensedconsolidated financial statements.

 

5

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**PAULA FINANCIAL AND SUBSIDIARIES**

**Notes to Condensed ConsolidatedFina****ncial Statements**

**For the Three Months Ended June 30, 2005(Unaudited)**

 

**Note A -Basis of Presentation**

 

PAULA Financial andsubsidiaries (the “Company”) is a California-based specialty distributor ofcommercial insurance products.  TheCompany’s agency operations place a full array of commercial insurance productsfor their customers.

 

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 Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation 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.

 

Wherenecessary, prior years’ information has been reclassified to conform to the 2005presentation.

 

In2005, the Company made investments in certain marketable securities.  These securities are classified as availablefor sale and are reflected at estimated fair value with unrealized gains andlosses record as a separate component of stockholders’ equity, net of relateddeferred income taxes.  Investments inwhich the decline in market value is deemed other than temporary are reduced tothe estimated realizable value through a charge to income.

 

TheCompany’s operating results tend to be cyclical. Consequently, operatingresults for the six months ended June 30, 2005 are not necessarilyindicative of the results to be expected for the year ending December 31,2005.  For further information, refer tothe consolidated financial statements and footnotes thereto included in theCompany’s Annual Report on Form 10-KSB for the year ended December 31,2004.

 

In December 2002,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard (“SFAS”) No. 148, “Accounting for Stock BasedCompensation – Transition and Disclosure, an amendment of SFAS 123”.  Among other provisions, SFAS 148 amends thedisclosure requirements of SFAS 123 to require prominent disclosures in bothannual and interim financial statements. For the six months ended June 30, 2005, the differences between theas reported net income and income per share amounts and the related pro formaamounts are not material to the consolidated financial statements.  On December 16,2004, SFAS 123 was revised to require all share based payments to employees tobe recognized in the income statement based on their fair values.  The pro forma disclosure will no longer be analternative.  This revised standard willbe effective for the Company in the first quarter of 2006.

 

6

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In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections” whichreplaces Accounting Principles Board Opinions No. 20 “Accounting Changes”and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatements-An Amendment of APB Opinion No. 28.” SFAS 154 provides guidanceon the accounting for and reporting of accounting changes and errorcorrections.  It establishesretrospective application, or the latest practicable date, as the requiredmethod for reporting a change in accounting principle and the reporting of acorrection of an error. SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005 and is required to be adopted by the Company in the first quarter of 2006.The Company currently does not expect it to have a material impact on theCompany’s consolidated financial statements.

 

##### **Note B – Deferred Income Taxes**

##### ** **

As of June 30, 2005and December 31, 2004, the Company’s net deferred tax asset is comprisedof the following:

 
| ** **                        | ** ** | **June 30** | ** ** | **December 31** | ** ** |
|-----------------------------------|------------|------------------|------------|----------------------|------------|
| ** **                        | ** ** | **2005**         | ** ** | **2004**             | ** ** |
| ** **                        | ** ** | **(unaudited)**  | ** ** | ** **           | ** ** |
| Deferred tax  assets:             |       |             |       |                 |       |
| Net operating  loss carry forward |       | $                | 24,575     |                 | $          | 25,203 |   |
| Other                             |       | 2,841            |       | 2,677                |       |
| Gross deferred  tax assets        |       | 27,416           |       | 27,880               |       |
| Less valuation  allowance         |       | (22,646          | )          | (22,646              | )          |
| Deferred tax  assets              |       | $                | 4,770      |                 | $          | 5,234 |   |
| Gross deferred  tax liabilities   |       | $                | —     |                 | $          | — |   |
| Net deferred tax  asset           |       | $                | 4,770      |                 | $          | 5,234 |   |

 

The net operating losscarry forward includes losses generated by PAULA Insurance Company which areavailable to offset future taxable income of the Company.

 

Management believes thatit is more likely than not that the results of future operations will generatesufficient taxable income in the periods necessary to realize the net deferredtax asset.

 

##### **Note C – Acquisitions**

##### ** **

On February 28, 2005, the Company enteredinto an agreement to purchase the existing book of business of Integrated Financial(“Integrated”).  Integrated is based inSacramento, California and specializes in accident and health and financialproducts.  Although the purchaseagreement was entered into on February 28, 2005, the actual effective dateof the transaction was delayed until April 1, 2005.  Therefore, the asset purchase was recorded inthe second quarter of 2005.  Theestimated purchase price is $804.  Of thetotal purchase price, $697 has been allocated to other amortizable intangibleassets, with the remaining $107 allocated to goodwill.  Other amortizable intangible assets relate toexpiration lists and covenants not to compete. As of June 30, 2005, $163 has been paid related to thisacquisition.  The remaining obligation of$641 will be paid over the next five years. The purchase price for Integrated is subject to adjustment based onrevenue earned over the next three years. Consequently, the purchase price will not be finalized until the secondquarter of 2008.

 

7

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**PART I****                               FINA****NCIAL INFORMATION**

 

**Item 2.**                                   Management’s Discussion and Analysis of Consolidated FinancialCondition and Results of Operations

** **

**Overview**

 

The Company’s revenues consist of agency commission and placement feeincome, profit sharing income, and service fees. Commission and placement feeincome is earned from Pan American Underwriters’ (“Pan Am’s”) insurance salesactivity.  Associated premiums areprimarily billed directly by the insurance carrier.  However, in certain instances, Pan Am willinvoice the customer and remit the premium, less commission, to the insurancecarrier.  The Company focuses its salesefforts on agribusiness and rural markets in California and Arizona.  Profit sharing income is related to profitsharing arrangements with insurance carriers. Service fees are primarily received for the performance of servicesrelated to loss control and claims advocacy.

 

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

 

**Resultsof Operations for the Three Months and Six Months Ended June 30, 2005Compared to the Three Months and Six Months Ended June 30, 2004:**

 

**Commissionand placement fee income.** For the three months ended June 30,2005 commission and placement fee income decreased 15.1% to $3.8 millioncompared to $4.5 million for the comparable 2004 period.  For the six months ended June 30, 2005,commission and placement fee income decreased 12.0% to $7.3 million compared to$8.3 million for the comparable 2004 period. The decrease in the 2005 isprimarily related to a decline in the package and workers’ compensation linesof business.  The property and casualtyinsurance marketplace appears to be entering a “soft market” characterized inpart by declines in premium rates charged to policyholders.  As a result, the associated revenue to theagency, which is based on a percentage of premium, also declines.

 

Thesemarket dynamics are not new and they are not unique to the Company.  In fact, the Company has been taking stepsfor several quarters now to better position itself for the inevitable marketsoftening.  First, as discussedmore fully below, the Company restructured its executive compensation programin early 2004.  Additionally, throughout 2004 and continuing in 2005, theCompany has been proactively pulling expenses out of its operating model.  As a result, excluding the impact ofexecutive compensation accruals, the Company’s expenses are down over $0.6million during the first six months of 2005 as compared to the comparable 2004period.  Finally, the Company is activelytaking advantage of the other feature of a “soft market”, more capacity on theunderwriting side, to depopulate its inventory of California StateCompensation Insurance Fund (“SCIF”) business.  Currently SCIF’s maximum commission rate is5.5% while other carriers are paying upwards of 8%.

 

8

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**Profitsharing income.** For the three months ended June 30, 2005profit sharing income increased 21.1% to $23,000 compared to $19,000 for thecomparable 2004 period. For the six months ended June 30, 2005 profit sharingincome increased 55.3% to $2.0 million compared to $1.3 million for thecomparable 2004 period.  Profit sharingincome fluctuates from year to year based on the profitability of theunderlying business and external market conditions which can result in changesto profit sharing programs offered by insurance carriers.

 

Historically, the Companyhas earned a large portion of its profit sharing income on business placed withSCIF.  In the first half of 2005, SCIFrepresented approximately 60% of the Company’s profit sharing income comparedto 40% in the first half of 2004.  Inpolicy year 2005, SCIF has eliminated its profit share arrangements.

 

**Servicefees.**  For the threemonths ended June 30, 2005 service fee income increased 86.3% to $244,000from $131,000 for the comparable 2004 period. For the six months ended June 30, 2005 service fee income increased91.6% to $435,000 from $227,000 for the comparable 2004 period.  The Company receives fees related toproviding loss control for a Bermuda insurance captive.  The volume of business placed with thismarket has increased, resulting in a corresponding increase in the associatedfees.

 

**Salariesand related expenses.**  Forthe three months ended June 30, 2005 salaries and employee benefits decreased20.4% to $2.0 million from $2.5 million for the comparable 2004 period.  For the six months ended June 30, 2005salaries and employee benefits decreased 4.1% to $5.0 million from $5.2 millionfor the comparable 2004 period.  The decreaseis largely due to staff reductions offset by the restructure of executivecompensation in 2004.  Prior to theimpact of executive compensation, which is discussed below, for the six monthsended June 30, 2005 salaries and employee benefits decreased 8.4% to $4.8million from $5.2 million for the comparable 2004 period.  The decrease is largely due to staffreductions.  Salaries and relatedexpenses excluding the executive compensation bonus accrual discussed below was49% of total revenues for the first six months of 2005 compared to 53% for thefirst six months of 2004.

 

In 2004, the Companyrestructured its executive compensation program.  The restructure was discussed in detail inthe Company’s proxy statement for its 2004 Annual Meeting, where approval toincrease the number of shares available for grant under the Company’s stockincentive plan was received.  The compensationfor the Company’s Chief Executive Officer, Jeffrey A. Snider, was restructuredsuch that a larger portion of his compensation is equity denominated.  Mr. Snider is only eligible for a cashbonus to the extent the Company’s operating results over-deliver on certainpre-determined profitability goals. To wit, Mr. Snider did not receive anycash bonus for the 2004 operating results.

 

The operating results inthe first half of 2005 suggest that the Company is on track to exceed theestablished profitability goals for the current period.  While the ultimate validation of the cashbonus for Mr. Snider will not be determined until the year end results arefinalized, an accrual has been established relative to the first six months operatingresults.  Consistent with therestructured executive compensation plan approved by the Board of Directors in2004, the Company will adjust, up or down, the associated bonus accrual basedon operating results as the year progresses.

 

9

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**Otherexpenses.**  For thethree months ended June 30, 2005 other expenses decreased 9.6% or $149,000from the comparable 2004 period.  For thesix months ended June 30, 2005 other expenses decreased 6.9% or $207,000from the comparable 2004 period.  Asdiscussed above, the decline in 2005 is due to a concerted effort on the partof management to pull expenses out of the Company’s operating model.

 

**Income taxexpense.**  Income taxexpense for the three months ended June 30, 2005 was $201,000 compared to$166,000 for the comparable 2004 period. Income tax expense for the six months ended June 30, 2005 was $659,000compared to $468,000 for the comparable 2004 period.  The effective combined income tax rates forthe six months ended June 30, 2005 and 2004 were 41.4% and 37.7%,respectively.  The differences betweenthe applicable Federal tax rate and the effective tax rates is primarily due tothe impact of state taxes.

 

**Netincome.**  Net incomeincreased 27.0% to $273,000 for the three months ended June 30, 2005 from$215,000 for the comparable 2004 period. Net income increased 20.8% to $934,000 for the six months ended June 30,2005 from $773,000 for the comparable 2004 period.  The increase is due to the factors discussedabove.

 

**Liquidityand Capital Resources:**

 

Asa holding company, PAULA Financial’s principal sources of funds are dividendsand expense reimbursements from its operating subsidiaries and proceeds fromthe sale of its capital stock. PAULA Financial’s principal uses of funds arecapital contributions to its subsidiaries, payment of operating expenses, dividendsto shareholders and repurchase of Company common stock.

 

OnNovember 1, 2003, the Company refinanced its outstanding bank debt with a$1,800,000 reducing revolving line of credit (the “Line of Credit”) with USBank (the “Lender”).  The line of credit currentlyhas a total available line of $1,400,000 of which $1,176,000 isoutstanding.  In August 2005, theLine of Credit with the Lender was amended to extend the maturity date to November 1,2006.  Certain covenant terms were alsomodified. All other terms under the original arrangement are unchanged.  PAULA Financial is in compliance with all ofthe covenants.  Balancesoutstanding under the Line of Credit bear interest at the prime rate plus 1.0%.  As of June 30, 2005, the interest ratewas 7.0%.  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 ofDirectors had previously approved a 1,000,000 share repurchase program.  On February 20, 2003, the Board ofDirectors authorized an additional 2,000,000 shares for the share repurchaseprogram.  As of June 30, 2005, theCompany held 946,398 shares in treasury stock.

 

On May 28, 2004, theCompany announced the reinstatement of a quarterly cash dividend in the amountof $0.015 per common share.  The secondquarter 2005 dividend was paid to holders of record as of June 8, 2005 andwas distributed on June 28, 2005.

 

As previously disclosedin the Company’s filings with the Securities and Exchange Commission, in May 2004, the Company received ademand for payment from Reliance Insurance Company in Liquidation in the amountof $1.9 million related to amounts due under a guarantee issued by

 

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PAULAFinancial on behalf of Montlake Insurance Holdings, LLC.  The Company replied to the demand in a letterdated August 13, 2004 stating that the Company believes the obligationssubject to the guarantee were previously discharged.  As it has been a year since the reply and theCompany has received no response, the Company has determined to make no furtherreporting on this matter prospectively unless there is a material newdevelopment.

 

**Off-BalanceSheet Arrangements**

 

TheCompany does not have any off-balance sheet arrangements.

 

**Forward-LookingStatements**

 

Inconnection with, and because it desires to take advantage of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995, the Companycautions readers to recognize the existence of certain forward-lookingstatements in this Form 10-QSB and in any other statement made by, or onbehalf of, the Company, whether or not in future filings with the Securitiesand Exchange Commission.  Forward-lookingstatements are statements not based on historical information and which relateto future operations, strategies, financial results or other developments.  Some forward-looking statements may beidentified by the use of terms such as “expects,” “believes,” “anticipates,” “intends,”or “judgment.” Forward-looking statements are necessarily based upon estimatesand assumptions that are inherently subject to significant business, economicand competitive uncertainties, many of which are beyond the Company’s controland many of which, with respect to future business decisions, are subject tochange.  Examples of such uncertaintiesand contingencies include, among other important factors, those affecting theinsurance industry in general, such as the economic and interest rateenvironment, legislative and regulatory developments and market pricing and competitivetrends, and those relating specifically to the Company and its businesses, suchas the level of commission revenue and fee income, and acquisitions ofcompanies or blocks of business.  Theseuncertainties and contingencies can affect actual results and could causeactual results to differ materially from those expressed in any forward-lookingstatements made by, or on behalf of, the Company. The Company disclaims anyobligation to update forward-looking statements.

 

**Item 3. Controls a****nd Procedures**

 

**Evaluationof Disclosure Controls and Procedures**

 

The Company’s ChiefExecutive Officer and Vice President Finance have evaluated the effectivenessof the Company’s disclosure controls and procedures (as defined in Rules 13a– 15(e) and 15d – 15(e) under the Securities Exchange Act of 1934) asof 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. OTHER INF**ORMATION

 

**Item 4: Submission of****Matters to a Vote of Security Holders**

 

TheCompany held its 2005 Annual Meeting of Stockholders on Wednesday, May 25,2005 for the purpose of voting on the election of directors to hold officeuntil the 2008 Annual Meeting of Stockholders, and thereafter until a successoris elected and qualified. At the meeting, two directors were elected.

 

Thefollowing table indicates the number of shares voted on each director:

 
| ** **                | ** ** | **For**   | ** ** | **Abstain** | ** ** |
|---------------------------|------------|-----------|------------|-------------|------------|
| Joel W.  Geddes, Jr. |       | 5,525,105 |       | 61,267      |       |
| Jerry M. Miller           |       | 5,479,299 |       | 107,073     |       |

 

Theterm of office of each of the following directors continued after the meetingheld May 25, 2005.  They are JeffreyA. Snider, James G. Parker, III and Robert Anderson.

 

**Item 5:  Other In****formation.**

 

EffectiveSeptember 1, 2005, Mr. Jerry M. Miller is retiring from PAULAFinancial’s Board of Directors.

 

EffectiveJuly 18, 2005, the Board of Directors increased the number of directorsfrom five to six, and Mr. Harold Sandstrom and Mr. Lawrence A. Hayeswere elected to the Company’s Board of Directors.  Additionally, Mr. Sandstrom wasappointed to fill the role of Chairman of the Audit Committee.

 

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

 
| (a) |   | Exhibits. |
|-----|--------|-----------|

 
| 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 Chief Financial Officer. |
|   |   |                                                                    |
| 32.1   |   | Section 1350  Certifications of Chief Executive Officer.           |
|   |   |                                                                    |
| 32.2   |   | Section 1350  Certifications of Chief Financial Officer.           |

 
| (b) |   | Reports  on Form 8-K. |
|-----|--------|----------------------------|

 

On April 5, 2005,the Company filed a Form 8-K related to the press release announcingoperating results for the year ended December 31, 2004.

 

On June 16, 2005,the Company filed a Form 8-K related to a change in the Company’sCertifying Accountant which was amended on June 20, 2005.

 

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On August 9, 2005,the Company filed a Form 8-K related to the appointment of a newCertifying Accountant.

 

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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:  August 12, 2005 |   PAULA FINANCIAL    |
|----------------------------------|---------------------------|
|                             |                      |
|                             |
|                             | By:                       |  /s/ Deborah S.  Maddocks |   |
|                             | Vice President -  Finance |
|                                  |                           |  |  |  |

 

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