<PAGE>


--------------------------------------------------------------------------------


                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                  -------------
                                    FORM 10-Q

                                   (Mark One)

              /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

                     OF THE SECURITIES EXCHANGE ACT OF 1934



                FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998



                                       OR

              / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

                     OF THE SECURITIES EXCHANGE ACT OF 1934

                        FOR THE TRANSITION PERIOD FROM TO

                         COMMISSION FILE NUMBER 0-23181

                                 PAULA FINANCIAL
             (Exact name of registrant as specified in its charter)

             DELAWARE                                     95-4640368
 (State or other jurisdiction of                       (I.R.S. Employer
  incorporation or organization)                    identification number)

                                 PAULA FINANCIAL
                        300 NORTH LAKE AVENUE, SUITE 300
                               PASADENA, CA 91101
                    (Address of principle executive offices)

                                 (626) 304-0401
              (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
                                                       Yes  X     No 
                                                           ---       ---

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. Number of shares of Common
Stock, $.01 par value, outstanding as of close of business on October 30, 1998:
5,985,315 shares.

--------------------------------------------------------------------------------
<PAGE>


PAULA FINANCIAL
INDEX TO FORM 10-Q

<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION                                                           Page
                                                                                        ----
<S>                                                                                        <C>
Item 1.  Financial Statements

           Condensed consolidated balance sheets as of
                  December 31, 1997 and September 30, 1998 (unaudited) ......................2

           Condensed consolidated statements of operations for the three and nine
                  months ended September 30, 1997 and 1998 (unaudited).......................3

           Condensed consolidated statements of comprehensive income (loss) for
                  the three and nine months ended September 30, 1997 and 1998
                  (unaudited)................................................................4

           Condensed consolidated statements of cash flows for the nine months
                  ended September 30, 1997 and 1998 (unaudited)..............................5

           Notes to condensed consolidated financial statements for the three and
                  nine months ended September 30, 1998 (unaudited) ..........................6

Item 2.   Management's Discussion and Analysis of Consolidated Financial
                  Condition and Results of Operations........................................8

PART II. OTHER INFORMATION

         Item 2.  Changes in Use of Proceeds................................................17
         Item 6.  Exhibits and Reports on Form 8-K..........................................17

SIGNATURE...................................................................................18
</TABLE>

<PAGE>


PART I   FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS

                        PAULA FINANCIAL AND SUBSIDIARIES
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                        (In thousands, except share data)
<TABLE>
<CAPTION>
                                                                           December 31,        September 30,
                                ASSETS                                         1997                 1998
                                                                           ------------        -------------
                                                                               (*)              (Unaudited)
<S>                                                                           <C>                    <C>
Investments:
   Fixed maturities, available for sale, at market
      (amortized cost: 1997, $112,294; 1998, $157,500)                         $114,525             $159,122
   Equity securities, at market
      Preferred stock (cost: 1997, $3,019; 1998, $999)                            3,112                1,035
      Common stock (cost: 1997, $5,546; 1998, $5,138)                             5,545                5,015
   Invested cash, at cost (approximates market)                                  14,682                5,449
                                                                               --------             --------
         Total investments                                                      137,864              170,621
                                                                               --------             --------

Cash (restricted: 1997, $1,491; 1998, $1,591)                                     4,770                8,884
Accounts receivable, net of allowance for uncollectible
     accounts (1997, $600; 1998, $742)                                           24,320               29,264
Reinsurance recoverable on paid and unpaid losses and
     loss adjustment expenses                                                     6,394                8,220
Deferred income taxes                                                             3,247                5,746
Other assets                                                                     11,669               14,032
                                                                               --------             --------
                                                                               --------             --------
                                                                               $188,264             $236,767
                                                                               --------             --------
                                                                               --------             --------

                 LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Unpaid losses and loss adjustment expenses                                     $ 77,784             $124,826
Unearned premiums                                                                15,390               22,764
Accrued policyholder dividends                                                    --                     253
Accounts payable and accrued expenses                                             9,814               12,316
Notes payable                                                                       456                   92
                                                                               --------             --------
                                                                                103,444              160,251
                                                                               --------             --------


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: 1997,
      6,321,177; 1998, 6,337,815)                                                    63                   64
Additional paid-in-capital                                                       67,176               67,386
Retained earnings                                                                16,048                9,949
Accumulated other comprehensive income:
   Net unrealized gain on investments                                             1,533                1,013
                                                                               --------             --------
                                                                                 84,820               78,412
Treasury stock, at cost (1998, 252,500 shares)                                    --                  (1,896)
                                                                               --------             --------
                                                                                 84,820               76,516
                                                                               --------             --------
                                                                               $188,264             $236,767
                                                                               --------             --------
                                                                               --------             --------
</TABLE>

*  Derived from audited financial statements.

   See notes to condensed consolidated financial statements.


                                       2
<PAGE>


                        PAULA FINANCIAL AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                 (In thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                   THREE MONTHS ENDED                  NINE MONTHS ENDED
                                                      SEPTEMBER 30,                       SEPTEMBER 30,
                                                   1997           1998                1997           1998
                                                ---------      ---------           ---------       ---------
                                                       (Unaudited)                        (Unaudited)
<S>                                            <C>            <C>                 <C>             <C>
INCOME:
Premiums earned:
   Workers' compensation                        $  23,190      $  40,569           $  64,492         105,430
   Group medical and life                             228            214                 703             582
Commissions                                           890            780               2,607           2,410
Net investment income                               1,351          2,437               3,850           6,610
Net realized investment gains                         173          1,784                 173           1,731
Other                                                 182            311                 529             671
                                                ---------      ---------           ---------       ---------
                                                   26,014         46,095              72,354         117,434
                                                ---------      ---------           ---------       ---------

EXPENSES:
Losses and loss adjustment
   expenses incurred                               16,051         32,997              44,498          96,531
Dividends provided for policyholders                  436             87                 745             594
Operating                                           7,620         10,954              22,372          29,507
                                                ---------      ---------           ---------       ---------
                                                   24,107         44,038              67,615         126,632
                                                ---------      ---------           ---------       ---------

Income (loss) before income taxes                   1,907          2,057               4,739          (9,198)
Income tax expense (benefit)                          636            423               1,174          (3,854)
                                                ---------      ---------           ---------       ---------
      NET INCOME (LOSS)                         $   1,271      $   1,634           $   3,565         ($5,344)
                                                ---------      ---------           ---------       ---------
                                                ---------      ---------           ---------       ---------

Earnings (loss) per share                       $    0.67      $    0.26           $    1.87          ($0.85)

Weighed average shares outstanding              1,898,793      6,276,451           1,901,582       6,309,895

Earnings (loss) per share - assuming                $0.30          $0.25               $0.87          ($0.85)
dilution

Weighted average shares outstanding -
     assuming dilution                          4,197,408      6,506,654           4,098,244       6,309,895
</TABLE>

See notes to condensed consolidated financial statements.


                                       3
<PAGE>


                        PAULA FINANCIAL AND SUBSIDIARIES
          CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
                                 (In thousands)
<TABLE>
<CAPTION>
                                                    THREE MONTHS ENDED           NINE MONTHS ENDED
                                                       SEPTEMBER 30,                SEPTEMBER 30,
                                                    1997           1998          1997          1998
                                                   ------         ------        ------        ------
                                                        (Unaudited)                  (Unaudited)

<S>                                               <C>            <C>            <C>          <C>
Net income (loss)                                  $1,271         $1,634         $3,565       ($5,344)
                                                                              
Other comprehensive income, net of tax:                                       
 Unrealized gains (losses) on investments:                                    
    Unrealized holding gains                                                  
       arising during period (tax impact:                                     
       1997: $199 and $208; 1998: $206                                        
         and $169)                                    387            400            405           328
    Reclassifications adjustment for gains                                    
         (losses) included in net income                                      
         (tax impact:  1997: $58 and $24;                                     
             1998:  $510 and $437)                   (114)          (990)           (48)         (848)
                                                   ------         ------         ------       -------
                                                      273           (590)           357          (520)
                                                   ------         ------         ------       -------
      COMPREHENSIVE INCOME (LOSS)                  $1,544         $1,044         $3,922       ($5,864)
                                                   ------         ------         ------       -------
                                                   ------         ------         ------       -------
</TABLE>

See notes to condensed consolidated financial statements.


                                       4
<PAGE>


                        PAULA FINANCIAL AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)
<TABLE>
<CAPTION>
                                                                                       NINE MONTHS ENDED
                                                                                         SEPTEMBER 30,
                                                                                    1997                1998
                                                                                    ----                ----
                                                                                           (Unaudited)

<S>                                                                             <C>               <C>
CASH FLOW FROM OPERATING ACTIVITIES:                                          
   Net income (loss)                                                             $ 3,565             ($5,344)
ADJUSTMENTS TO RECONCILE NET INCOME (LOSS) TO NET CASH PROVIDED BY                               
   OPERATING ACTIVITIES:                                                                        
   Depreciation and amortization                                                     965               1,074
   Amortization of fixed maturity premium, net                                       477                 600
   Loss on sale of property and equipment                                             21                   7
   Loss on sales and calls of investments                                           (173)             (1,731)
   Increase in accounts receivable                                                (8,858)             (7,767)
   (Increase) decrease in deferred income taxes                                      106              (2,231)
   Increase in unpaid losses and loss adjustment expenses                         12,614              47,042
   Increase in accrued policyholder dividends                                         41                 253
   Increase in accounts payable and accrued expenses                               7,046               2,502
   Increase in unearned premiums                                                   4,050               7,374
   Other, net                                                                       (819)               (650)
                                                                                 -------           ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES                                         19,035              41,129
                                                                                 -------           ---------
                                                                                                 
CASH FLOWS FROM INVESTING ACTIVITIES:                                                            
   Proceeds from sale of common and preferred stocks                                 499               6,423
   Proceeds from sale of available for sale fixed maturities                        --                77,879
   Proceeds from maturities and calls of available for sale fixed                 11,605               7,026
     maturities
   Proceeds from sale of property and equipment                                       30                  15
   Purchase of preferred and common stocks                                        (3,202)             (4,231)
   Purchase of available for sale fixed maturities                               (19,326)           (128,744)
   Purchase of property and equipment                                               (813)             (1,430)
   Purchase of insurance agency                                                      (41)               (378)
                                                                                 -------           ---------
NET CASH USED IN INVESTING ACTIVITIES                                            (11,248)            (43,440)
                                                                                 -------           ---------
                                                                                                
CASH FLOWS FROM FINANCING ACTIVITIES:                                                           
   Borrowings under line of credit agreement, net                                  2,471               --
   Payments on notes payable                                                      (1,721)               (364)
   Dividends paid                                                                   --                  (754)
   Exercise of stock options                                                        --                   206
   Repurchase of common stock                                                       --                (1,896)
   Sale of common stock                                                               46               --
   Retirement of common stock                                                        (62)              --
                                                                                 -------           ---------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES                                  734              (2,808)
                                                                                 -------           ---------
                                                                                                 
NET INCREASE (DECREASE) IN CASH AND INVESTED CASH                                  8,521              (5,119)
Cash and invested cash at beginning of period                                     10,707              19,452
                                                                                 -------           ---------
                                                                                 -------           ---------
CASH AND INVESTED CASH AT END OF PERIOD                                          $19,228             $14,333
                                                                                 -------           ---------
                                                                                 -------           ---------
</TABLE>

See notes to condensed consolidated financial statements.


                                       5
<PAGE>


                        PAULA FINANCIAL AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
       FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 (UNAUDITED)




NOTE A - BASIS OF PRESENTATION

PAULA Financial and subsidiaries (the "Company") is an integrated insurance
organization specializing in the production, underwriting and servicing of
workers' compensation and accident and health insurance primarily for
agribusiness clients in California, Arizona, Oregon, Idaho, Alaska, Texas,
Florida, New Mexico and Nevada.

The accompanying unaudited condensed consolidated financial statements of the
Company have been prepared in accordance with generally accepted accounting
principles ("GAAP") for interim financial information and with the instructions
to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments, including normally
occurring accruals, considered necessary for a fair presentation have been
included.

Operating results for the three and nine months ended September 30, 1998 are not
necessarily indicative of the results to be expected for the year ended
December 31, 1998. For further information, refer to the consolidated 
financial statements and footnotes thereto included in the Company's Annual 
Report on Form 10-K for the year ended December 31, 1997.

NOTE B - ADOPTION OF NEW ACCOUNTING STANDARDS

During the first quarter of 1998, the Company adopted the provisions of
Financial Accounting Standards Board ("FASB") Statement No. 130, "Reporting
Comprehensive Income" ("SFAS 130"). SFAS 130 requires companies to report
comprehensive income and its components in a financial statement and display the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in-capital. Comprehensive income includes all
changes in equity during a period except those resulting from investments by
stockholders and distributions to stockholders. In accordance with the interim
reporting requirements of SFAS 130, the Company has included condensed
consolidated statements of comprehensive income in the accompanying condensed
consolidated financial statements.

Also, during the first quarter of 1998, the Company adopted the provisions of
FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related
Information: ("SFAS 131"). This statement specifies revised guidelines for
determination of an entity's operating segments and the type and level of
financial information to be disclosed. Based on the guidance included in 
SFAS 131, the Company has determined that it operates in a single segment: 
the production, underwriting and servicing of workers' compensation and 
accident and health insurance.

                                       6
<PAGE>


                        PAULA FINANCIAL AND SUBSIDIARIES
          NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONT.)




NOTE C - NEW ACCOUNTING STANDARDS NOT YET ADOPTED

During the fourth quarter of 1997, the American Institute of Certified Public
Accountants issued Statement of Position No. 97-3, "Accounting by Insurance and
Other Enterprises for Insurance-Related Assessments" ("SOP 97-3"). SOP 97-3
addresses the recognition and measurement of assets and liabilities related to
guaranty funds and other assessments. SOP 97-3 is effective for fiscal years
beginning after December 31, 1998, although early adoption is encouraged. The
Company has not determined the impact of SOP 97-3 and has not yet adopted 
SOP 97-3.


                                       7
<PAGE>


PART I   FINANCIAL INFORMATION
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL 
         CONDITION AND RESULTS OF OPERATIONS



OVERVIEW

The Company is a California-based specialty underwriter and distributor of
commercial insurance products which, through its subsidiary PAULA Insurance
Company ("PICO"), is one of the largest underwriters specializing in workers'
compensation insurance products and services for the agribusiness industry. The
Company sells complementary products through the Company's insurance agency
subsidiaries (collectively "Pan Am"), including group health and life products
provided by the Company's subsidiary PAULA Assurance Company ("PACO"), and
third-party claims administration services provided by the Company's subsidiary
Pan Pacific Benefit Administrators, Inc.

The Company's revenues have consisted primarily of premiums earned from workers'
compensation insurance underwriting, premiums earned from group medical
insurance, commission income, net investment income and other income. Premiums
earned during a period represent the portion of direct premiums written for
which all or a portion of the coverage period has expired, net of reinsurance.
Premiums written for the three months ended September 30, 1998 and 1997, were
$38.9 million and $25.5 million, respectively. Premiums written for the nine
months ended September 30, 1998 and 1997, were $116.7 million and $71.4 million,
respectively. Commission income is earned from Pan Am's distribution of
insurance for insurers other than PICO and PACO. Net investment income
represents earnings on the Company's investment portfolio, less investment
expenses. Other income consists of third party administration fees and other
miscellaneous items.

The Company's expenses have consisted of losses and loss adjustment expenses
incurred, dividends provided for policyholders and operating expenses. Losses
include reserves for future payments for medical care and rehabilitation costs
and indemnity payments for lost wages. Loss adjustment expenses include expenses
incurred in connection with services provided by third parties, including
expenses of independent medical examinations, surveillance costs, and legal
expenses as well as staff and related expenses incurred to administer and settle
claims. Loss and loss adjustment expenses are offset in part by estimated
recoveries from reinsurers under reinsurance treaties. Operating expenses
include commission expenses to third party insurance agencies and other expenses
that vary with premium volume, such as premium taxes, state guaranty fund
assessments and underwriting and marketing expense, as well as general and
administrative expenses, which are less closely related to premium volume.

The Company's revenues are seasonal, and have tended to be highest in the second
and third quarters of each year. This is due primarily to the seasonality of the
size of the workforce employed by the Company's agribusiness clients.


                                       8
<PAGE>


RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998:

PREMIUMS WRITTEN. The Company's growth rate for premiums written slowed in the
third quarter. The Company's premiums written for the three months ended
September 30, 1998 increased 52.5% to $38.9 million from $25.5 million for the
comparable 1997 period. The majority of this growth reflects activity from prior
periods. During the third quarter of 1998, policy count increased 2.4% from
10,886 as of June 30, 1998 to 11,148 as of September 30, 1998. The Company's
premiums written for the nine months ended September 30, 1998 increased 63.5% to
$116.7 million from $71.4 million for the comparable 1997 period. The growth in
premiums written was primarily attributable to the net addition of new
policyholders and increased policyholder payrolls. The Company's growth was
particularly strong in Texas during the third quarter.

PREMIUMS EARNED. For the reasons described above for premiums written, the
Company's premiums earned for the three months ended September 30, 1998
increased 74.2% to $40.8 million from $23.4 million for comparable 1997 period
and increased 62.6% to $106.0 million for the nine months ended September 30,
1998 from $65.2 million for comparable 1997 period.

COMMISSION INCOME. For the three months ended September 30, 1998 commission
income was $0.8 million compared to $0.9 million for the comparable 1997 period.
Commission for the nine months ended September 30, 1998 was $2.4 million
compared to $2.6 million for the comparable 1997 period. The decreases are
primarily a result of decreased premiums placed with carriers other than PICO
and PACO due to a Company decision to focus on writing PICO workers compensation
insurance. Commissions paid to Pan Am on PICO and PACO business are eliminated
in the Company's consolidated financial statements.

NET INVESTMENT INCOME. Net investment income increased 80.4% to $2.4 million for
the three months ended September 30, 1998 from $1.4 million for the comparable
1997 period. Net investment income increased 71.7% to $6.6 million for the nine
months ended September 30, 1998 from $3.9 million for the comparable 1997
period. The increase was the result of significant cash flow increases from
PICO's underwriting activity and the proceeds from the Company's initial public
offering in October 1997. Average invested assets increased to $152.3 million
for the nine months ended September 30, 1998 from $93.4 million for the
comparable period in 1997. The Company's average yield on its portfolio was 5.8%
for the nine month period in 1998 and 5.5% for the nine month period in 1997.

NET REALIZED INVESTMENT GAINS. Net realized investment gains increased to 
$1.8 million for the three months ended September 30, 1998 from $0.2 million 
for the comparable 1997 period. Net realized investment gains increased to 
$1.7 million for the nine months ended September 30, 1998 from $0.2 million 
for the comparable 1997 period. The increase is a result of a tax planning 
strategy to reposition a portion of the investment portfolio from tax exempt 
to taxable securities which was effected in the third quarter of 1998.

LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED. The Company's loss ratio for the
three months ended September 30, 1998 increased to 80.9% from 68.5% for the
comparable 1997 period. The Company's loss ratio for the nine months ended
September 30, 1998 increased to 91.1% from 68.3% for the comparable 1997 period.
The increase in the 1998 loss ratios is due to higher 1998 losses on


                                       9
<PAGE>


the Company's California book of business. Additionally, the increase in the
nine month loss ratio compared to the 1997 period is largely attributable to
actions taken by the Company to increase loss reserves on the 1997 and 1998
accident years by a total of $14.8 million in the second quarter of 1998.

In the first two quarters of 1998, the Company saw reserve development on the
1997 accident year for California business in excess of its expectations, given
prior year reserving trends. The Company's second quarter 1998 reserve
adjustment, expressed as a percentage of 1997 and six month 1998 combined
premiums, implied a pricing deficiency for those periods. The Company began to
address this pricing deficiency early in 1998 through rate increases and
non-renewal activity.

DIVIDENDS PROVIDED FOR POLICYHOLDERS. Dividends provided for policyholders as a
percentage of premiums earned for the three months ended September 30, 1998 was
0.2% compared to 1.9% for the comparable 1997 period. Dividends provided for
policyholders as a percentage of premiums earned for the nine months ended
September 30, 1998 was 0.6% compared to 1.1% for the comparable 1997 period.
During the first quarter of 1998, the Company paid $0.3 million in policyholder
dividends related to certain Arizona policies in which the loss experience
developed better than anticipated.

OPERATING EXPENSES. Operating expenses increased 43.8% to $11.0 million for the
three months ended September 30, 1998 from $7.6 million for the comparable 1997
period, primarily due to a $2.5 million increase in variable expenses,
principally commissions paid to unaffiliated agencies. Operating expenses
increased 31.9% to $29.5 million for the nine months ended September 30, 1998
from $22.4 million for the comparable 1997 period largely due to a $5.9 million
increase in variable expenses, principally commissions paid to unaffiliated
agencies.

INCOME TAXES. Income tax expense for the three months ended September 30, 1998
was $0.4 million compared to an income tax expense of $0.6 million for the
comparable 1997 period. Income tax benefit for the nine months ended 
September 30, 1998 was $3.9 million compared to income tax expense of 
$1.2 million for the comparable 1997 period. The effective combined income 
tax rates for the three months ended September 30, 1998 and 1997 were 20.6% 
and 33.4%, respectively. The effective combined income tax rates for the nine 
months ended September 30, 1998 and 1997 were (41.9%) and 24.8%, 
respectively. These rates vary from the combined statutory rate due to the 
investment income on tax-exempt securities.

NET INCOME (LOSS). Net income for the three months ended September 30, 1998 was
$1.6 million compared to net income of $1.3 million for the comparable 1997
period. Net loss for the nine months ended September 30, 1998 was $5.3 million
compared to net income of $3.6 million for the comparable 1997 period. The net
loss for the nine months of 1998 is primarily attributable to actions taken by
the Company to increase loss reserves on the 1997 and 1998 accident years by a
total of $14.8 million in the second quarter of 1998.


                                       10
<PAGE>


LIQUIDITY AND CAPITAL RESOURCES:

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

California law places significant restrictions on the ability of the insurance
subsidiaries to pay dividends to PAULA Financial. Based on these restrictions
and the Company's results for the year ended December 31, 1997, PAULA Financial
would be able to receive $6.4 million in dividends in 1998 from its insurance
subsidiaries without obtaining prior regulatory approval from the California
Department of Insurance ("DOI"). No dividends were paid by the insurance
subsidiaries to PAULA Financial during the nine months ended September 30, 1998.

Through June 30, 1998, the Company retained $16.6 million from the proceeds of
its initial public offering at the parent company level in various investment
grade securities. In August 1998, the Company contributed $8.2 million to PICO
to support its underwriting activities. An additional $3.7 million was
contributed to PICO in September 1998. Management believes that the remaining
offering proceeds, funds available under the Credit Agreement described below,
and expense reimbursements and dividends from its operating subsidiaries will be
sufficient to meet the parent company's normal operating cash needs for at least
twelve months.

In March 1997, PAULA Financial entered into the Credit Agreement with a
commercial bank providing PAULA Financial with a revolving credit facility of
$15.0 million until December 31, 1999. At such time PAULA Financial may elect to
convert all or a portion of the borrowings then outstanding under such facility
into a term loan payable in quarterly installments and maturing on December 31,
2001. Each of PAULA Financial's non-insurance subsidiaries has guaranteed all
obligations of PAULA Financial under the Credit Agreement. As of October 30,
1998, $2.0 million was outstanding under this facility. This use of the Credit
Agreement was for repurchase of the Company's common stock.

On August 12, 1998, the Company announced the approval by the Board of Directors
of a 500,000 share stock repurchase program. On October 29, the Board authorized
an additional 500,000 shares, bringing the total authorization under the program
to 1,000,000 shares. The shares are expected to be repurchased over the next 33
months through open market and/or privately negotiated purchases. As of October
30, 1998, the Company had repurchased 352,500 shares.

The Company's investments consist primarily of taxable and tax-exempt United
States government and other investment grade securities and investment grade
fixed maturity commercial paper and, to a lesser extent, equity securities. The
Company does not generally invest in below investment grade fixed maturity
securities, mortgage loans or real estate. During the third quarter of 1998, the
Company repositioned a substantial portion of the investment portfolio from tax
exempt to taxable securities. The overall asset quality and duration of the
portfolio was unchanged. The repositioning was done for tax planning purposes.
The Company has invested in the equity securities of two founders of the PAULA
Trading Company (an affiliated agency) other than Pan Am as a part of the parent
company's investment portfolio.


                                       11
<PAGE>


As of September 30, 1998, the carrying value of the Company's fixed maturity
securities portfolio was $159.1 million of which $150.8 million was rated. Of
the rated fixed maturities portfolio 97.1% was rated "A" or better by S&P,
Moody's or Fitch.

California workers' compensation insurance companies are required to maintain
some of their investments on deposit with the California DOI for the protection
of policyholders. Other states in which PICO is licensed have also required PICO
to post deposits for the protection of those states' policyholders. Pursuant to
applicable state laws, PICO had, as of September 30, 1998, securities with a par
value of $86.1 million held by authorized depositories pursuant to these deposit
requirements. In addition to the deposits, the Company's insurance company
operating subsidiaries must maintain regulated levels of capital and surplus in
relation to premiums written and the risks retained by the subsidiaries.

Effective October 1, 1998, the Company entered into a excess of loss 
reinsurance agreement with a retention of $50,000. Concurrent with this 
agreement, the Company entered into an excess of loss agreement which covers 
a portion of losses in the $40,000 excess of $10,000 layer and a quota share 
agreement which covers a portion of losses below $10,000. In addition, 
effective July 1, 1998, the Company modified its prior existing excess of 
loss reinsurance treaty coverage on the $250,000 excess of $250,000 layer to 
retain the first $2.0 million in aggregate losses, with a corresponding 
reduction in the Company's reinsurance rate.

YEAR 2000 CONSIDERATIONS

OVERVIEW. The Company's Year 2000 Project (the "Project") is proceeding on
schedule. The Project involves resolving the potential impact of the Year 2000
on the processing of date-sensitive information by the Company's internal
computer systems and equipment and by the computer systems and equipment
utilized by third parties with whom the Company maintains material
relationships.

The Company believes that it has identified substantially all of its own
information technology systems ("IT Systems") and non-information technology
(embedded technology) systems ("Non-IT Systems") which require modification in
order to become Year 2000 compliant. In addition, the Company believes that it
has identified those third parties whose inability to handle date-sensitive
processing could materially and adversely impact the Company if corrective
action is not taken in a timely manner.

The Company has identified five major internal IT Systems which require
attention as part of the Project: General Ledger ("GL"), Agency Operations
("Agency"), Underwriting, which includes policy issuance, maintenance of policy
records, billing and auditing ("Underwriting"), Claims Adjudication ("Claims")
and Third Party Administration, which includes life insurance and accident and
health insurance policy issuance, maintenance and billing operations ("TPA").
The Company's approach to each of these systems differs based on the Company's
use of the system and whether the system was purchased from a third party or
developed in-house.

GL SYSTEM. The Company has completed in-house construction and testing of a new
GL system. The new GL system was made Year 2000 compliant as part of its
construction. The Company has completed all work on this system.


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<PAGE>


AGENCY SYSTEM. The Company's in-house developed Agency System is not Year 2000
compliant. The Company has chosen not to correct the in-house system and instead
to outsource Agency System processing to a third party. The Company began the
process of out-sourcing its Agency System needs to James G. Parker Insurance
Associates ("Parker"), one of the founders of the PAULA Trading Company, in
1997. Parker utilizes an agency software system provided by a third party vendor
which is Year 2000 compliant. The Company has received oral assurance of this
fact from the software provider and expects written confirmation soon. The
Company intends to have outsourced all of its Agency System functions by the end
of 1998.

UNDERWRITING SYSTEM. The Company's in-house Underwriting system is not Year 2000
compliant. Correcting this situation is the Company's most significant Year 2000
project. The Company is currently constructing a new in-house Underwriting
system that will be Year 2000 compliant, but this new system is not expected to
address the Year 2000 issues in a timely fashion.

The Company has chosen to make its existing Underwriting system Year 2000
compliant using a technique known as "windowing," which is a solution that will
work for many years, but not permanently. Windowing is faster and requires less
testing than permanent solutions. The Company believes permanent solutions are
not necessary in light of the new system under development.

The Company has purchased a software tool to perform the windowing project and
has retained several consultants familiar with the software tool to perform the
project. The consultants will work under the supervision of the Company's
information services staff. The Company has identified the programs to be
modified, prioritized those programs based on their earliest expected date of
failure and has begun customizing the software tool to perform the correction to
the programs. The Company has prepared a testing environment to perform the
corrective procedures.

The Company expects phase I of the windowing project to be completed by November
15, 1998. This phase involves correcting and testing programs utilizing policy
expiration dates. The Company expects to begin to issue policies with 2000
expiration dates commencing November 16, 1998. Due to the short time frame, the
Company is performing the windowing procedure on the phase I programs manually
rather than using the software tool.

The Company expects the software tool to be configured and ready to work on
phase II programs by mid-January 1999. Phase II programs are involved in
month-end calculations and reporting. The Company expects correction and testing
of phase II programs to be completed prior to month-end January 1999. The
Company expects phase III of the windowing project, involving correction and
testing of all other Underwriting system programs, to be completed during the
second quarter of 1999.

CLAIMS SYSTEM. The Company's Claims system is licensed from a third party
vendor. The Claims system uses two distinct products, one for claims reporting
and one for claims adjudication. The Company has added custom features to the
standard version of each of the products provided by the vendor.

The Company has licensed and expects delivery of an upgrade to its Claims
adjudication system in late December 1998 which will be Year 2000 compliant.
However, that upgrade will not include all of the features added to the older
version of the Claims adjudication system. The Company is working with the
vendor to identify the features which must be added to the upgraded Claims


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<PAGE>


adjudication system after delivery in December 1998. The vendor has agreed to
perform the customization. The features identification will be completed during
the fourth quarter of 1998. The Company expects the customization to be
completed during the first quarter of 1999 and final installation, testing and
training to be complete by the end of the second quarter of 1999.

The Company does not believe that utilizing the non-Year 2000 compliant version
of the Claims adjudication system through the second quarter of 1999 will
materially impair operations. The Company is performing ongoing testing to
verify this belief, which it will complete during the fourth quarter. In the
event that the Company determines that the Claims adjudication system must be
made Year 2000 compliant prior to the completion of testing of the customized
upgrade, the Company intends to modify the programs of the existing version of
the Claims system to make it Year 2000 compliant. The Company would utilize the
windowing technique, the software tool and the outside consultants described
above under "Underwriting System" if correcting the Claims adjudication system
programs becomes necessary. The Company will decide whether to take this
alternative step by the end of 1998. The Company is currently performing testing
to ascertain how long it would take to correct the existing version of the
Claims adjudication system.

The Company's Claims reporting system will not be made Year 2000 compliant by
the vendor. The Company has chosen to outsource the claims reporting function to
the vendor which maintains a Year 2000 compliant version on its internal
mainframe computer and personnel to perform initial claim input on behalf of the
Company. The outsource will be effective at the beginning of the second quarter
of 1999. The Company's Claims reporting system must be corrected to properly
process certain claims prior to January 1, 1999. The Company has identified a
corrective procedure which involves the windowing technique described above
under "Underwriting System." If the Company does not receive a better procedure
from the vendor, the Company will implement its procedure beginning mid-November
1998 and believes it will be fully implemented and tested by December 31, 1998.

TPA SYSTEM. The Company has licensed a third party claims administration
software product that the Company uses for all TPA functions. The Company has
been informed by the vendor that a Year 2000 upgrade to the version used by the
Company will be delivered during the fourth quarter of 1998. The Company has
added some features to the older version of the standard product supplied by the
vendor. The Company is currently evaluating the differences between the features
of the Company's existing version and the upgraded version. The Company is also
evaluating whether to customize the upgraded version in-house or retain the
vendor to perform the customization. The Company expects to complete the
features assessment and make the decision as to which enterprise will perform
the customization by the end of 1998. The Company believes that the
customization, installation and testing of the Year 2000 upgrade will be
completed during the first quarter of 1999 regardless of the party performing
the customization.

NON-IT SYSTEMS. The Company has addressed its primary Year 2000 issues relating
to Non-IT Systems by purchasing a new IBM mainframe computer to run its IT
Systems. The Company intends to purchase a new second mainframe from IBM to
extend the Company's computing capacity during the first quarter of 1999. At
that time, the Company's old IBM mainframe will be relegated to a back-up role.
The Company has obtained satisfactory evidence that the operating system of the
Company's new mainframe computers are Year 2000 compliant from IBM's Internet
website.


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<PAGE>


The Company is beginning to inventory its other Non-IT Systems as part of the
Project. These systems include the Company's personal computer network,
telephone switching equipment and other office equipment. Once these systems are
inventoried, the Company will prioritize the impact of their failure due to Year
2000 issues and then begin testing and correcting to bring them into Year 2000
compliance. The Company expects the inventory and prioritization phases to be
completed by year-end 1998 and corrective action to be completed during the
second quarter of 1999.

The Company does not believe that it is materially exposed to any
Company-specific Non-IT System Year 2000 issues other than those addressed by
purchasing new mainframe computers due to the nature of the Company's business.
The Company has no material property, plant or equipment.

THIRD PARTY YEAR 2000 ISSUES. The Company has begun a process to obtain Year
2000 compliance assurances from third parties with whom the Company has material
trading arrangements, or upon whom the Company relies to a material extent in
its normal operations. These third parties include third party utilization
review companies, third party claims administrators, claims adjudication tool
vendors and others. The Company will endeavor to satisfy itself that each third
party performing important functions for the Company has taken necessary
measures to ensure that their IT and Non-IT Systems will be Year 2000 compliant
in a timely manner. To the extent that the Company concludes this not to be
possible, the Company will either change to new third party suppliers or assist
the existing third parties' compliance efforts with staff, financial assistance
or outsourcing alternatives. The Company cannot project the cost of such
assistance at this time. The Company's priorities in addressing third party
compliance are those third parties who assist the Company with policy issuance,
policy maintenance and claims adjudication.

COSTS. The total cost associated with required program modifications, software
upgrades and equipment purchases to become Year 2000 compliant is not expected
to be material to the Company's financial position, results of operations or
cash flows. The Company's total budget for its Year 2000 compliance program,
which began in 1997, is $875,000. This estimate does not include the Company's
potential share of Year 2000 costs that may be incurred by the Company's trading
partners which the Company may choose to bear to increase the likelihood of
their timely Year 2000 compliance.

Of the total budget amount, $80,000 was spent in 1997, $175,000 has been 
spent in 1998 through September 30, 1998, $155,000 is expected to be spent in 
the fourth quarter of 1998 and $465,000 will be spent during 1999. 
Approximately $105,000 of the expenditures through September 30, 1998 have 
been for new hardware, $50,000 has been spent to support Parker's start-up of 
Agency IT system operations, $30,000 has been spent on the Underwriting 
system windowing project, and $70,000 has been spent on all other aspects of 
the Project. The costs associated with the Company's new Underwriting System 
are not included in the Year 2000 budget. The Company is utilizing cash flow 
from operations to fund its Year 2000 budget needs.

CONTINGENCIES. The Company is currently reviewing its alternatives in the 
event that it is not able to complete its Year 2000 compliance plans in a 
timely manner. These alternatives include, without limitation, purchasing 
third party insurance company software packages, acceleration of the 
construction of the Company's new Underwriting system and outsourcing the 
non-compliant Company functions to third parties. Each of these alternatives 
is less advantageous to the Company than its current Year 2000 compliance 
plan and, if required, could have a material adverse effect on the Company's 
financial position, results of operations or cash flows.

                                       15
<PAGE>


RISKS. The failure to correct a material Year 2000 problem could result in an
interruption in, or a failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, financial condition and cash flow. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the
uncertainty of the Year 2000 readiness of third-party suppliers and customers,
the Company is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact on the Company's results of
operations, financial condition or cash flows. The Company believes the Project
will significantly reduce the Company's level of uncertainty about the Year 2000
problem.

CONSULTANTS. The Company has not used the services of independent Year 2000
consultants to assess its IT System and Non-IT System needs, although the
Company is utilizing the services of independent consultants in its Underwriting
System windowing project and in constructing its new Underwriting system.

FORWARD-LOOKING STATEMENTS

The discussions above contain statements that constitute "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended and Section 21E of the Securities and Exchange Act of 1934, as amended.
The words "believe," "estimate," "expect," "intend," "anticipate," and similar
expressions and variations thereof identify certain of such forward-looking
statements, which speak only as of the dates on which they are made. PAULA
Financial undertakes no obligation to publicly update or revise any
forward-looking statement, whether as a result of new information, future
events, or otherwise. Readers are cautioned that any such forward-looking
statements are no guarantees of future performance and involve risks and
uncertainties, and that actual results may differ materially from those
indicated in the forward-looking statements as a result of various factors.
Readers are cautioned not to place undue reliance on these forward-looking
statements.


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<PAGE>


PART II.  OTHER INFORMATION


Item 2:  Changes in Use of  Proceeds.

         In August 1998, the Company contributed $8.2 million of initial public
offering proceeds to PICO to support underwriting activities. An additional 
$3.7 million of initial public offering proceeds was contributed to PICO in 
September 1998. As of September 30, 1998 all initial public offering proceeds 
had been utilized for the purposes intended.

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

          (a)     Exhibits.

                   3.2     Certificate of Designations of Series B Junior 
                           Participating Cumulative Preferred Stock of PAULA 
                           Financial.

                   4.2     Specimen certificate for Common Stock, par value $.01
                           per share, including legend evidencing attached Stock
                           Purchase Rights.

                   10.18   Sixth Amendment, dated May 11, 1998, and Seventh
                           Amendment, dated September 17, 1998, to the Company's
                           Lease for its Pasadena, California office dated
                           January 1, 1989, as amended and as assigned to date,
                           between LACERA Gateway Property, Inc., as lessor and
                           PAULA Insurance Company, as lessee.

                   10.19   Endorsement 8, dated March 9, 1998, and Endorsement
                           9, dated August 28, 1998, to Agreement of Reinsurance
                           No. 7448 dated February 16, 1990, as amended and
                           endorsed to date, between General Reinsurance
                           Corporation and PAULA Insurance Company.

                  11.       Computation of Earnings Per Share.

                  27.      Financial Data Schedule.

          (b)     Reports on Form 8-K.

                  During the quarter ended September 30, 1998, the Company filed
                  a report on Form 8-K dated September 24, 1998 relating to the
                  adoption of the Company's Stockholder Rights Plan.


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<PAGE>


                                  SIGNATURES


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

Date:  November 12, 1998               PAULA FINANCIAL



                                       By: /s/ James A. Nicholson
                                          --------------------------------------
                                       Senior Vice President and Chief Financial
                                       Officer


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