**SECURITIES
AND EXCHANGE COMMISSION**
  **WASHINGTON,
D.C. 20549**
 
  **FORM
10-QSB**
  (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, 2005**
  
  **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 small business issuer as specified in its charter)
  **Delaware**
      (State
      or other jurisdiction of
      incorporation
      or organization)
    
    **95-4640638**
      (I.R.S.
      Employer
      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, including area code)
 
 Check
whether the issuer (1) filed all reports required to be filed by Section 13
or 15(d) of the Exchange Act during the past 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
___
 
 State the
number of shares outstanding of each of the issuer's classes of common equity,
as of the latest practicable date. Number of shares of Common Stock, $.01 par
value, outstanding as of close of business on November 9, 2005: 6,464,545
shares.
 
 Transitional
Small Business Disclosure Format (check one):
 Yes X No
___
 
 
  
  
 
   
 
 
 PAULA
FINANCIAL
 INDEX TO
FORM 10-QSB
 
 PART
      I.
    FINANCIAL
      INFORMATIONItem
      1.
    Financial
      Statements
    PageCondensed
      consolidated balance sheets as ofSeptember
      30, 2005 (unaudited) and December 31, 2004
    2Condensed consolidated statements of income for the three
      months and nine months ended September 30, 2005 and 2004
      (unaudited)
    3Condensed consolidated statements of comprehensive income
      for the nine months ended September 30, 2005 and 2004
      (unaudited)
    4Condensed consolidated statements of cash flows for the nine
      months ended September 30, 2005 and 2004 (unaudited)
    5Notes to condensed consolidated financial statements for the
      nine months ended September 30, 2005 (unaudited)
    6Item
      2.
    Management’s Discussion and Analysis of Consolidated
      Financial Condition and Results of Operations
    9Item
      3.
    Controls and procedures
    12PART
      II.
    OTHER
      INFORMATIONItem
      2.
    Changes in Securities and Small Business Issuer Purchases
      of Equity Securities
    13Item
      5.
    Other Information
    13Item
      6.
    Exhibits and Reports on Form 8-K
    14SIGNATURE
    15
 
 
 
 
 
 
 
  
  **PART
I.**  **FINANCIAL
INFORMATION**
 **Item
1.****Financial
Statements**
 
 **PAULA
FINANCIAL AND SUBSIDIARIES**
 **Condensed Consolidated Balance Sheets**
 (In
thousands, except share data)
 September
      30,
    
    December
      31,***Assets***
    
    2005
    
    2004(Unaudited)
    
    (*)*Current
      Assets:*Cash
      (restricted: 2005, $1,946; 2004, $1,844)
    
    $
    4,626
    
    $
    3,241Investments,
      available-for-sale (cost: 2005, $1,126 )
    
    
    1,080
    
    
    -Accounts
      receivable, net of allowance for uncollectible accounts (2005, $130 and
      2004, $80)
    
    
    2,689
    
    
    3,142Commissions
      receivable
    
    
    2,186
    
    
    2,155Income
      tax receivable
    
    
    -
    
    
    15Other
      receivables
    
    
    73
    
    
    20Deferred
      income taxes
    
    
    1,989
    
    
    1,769Other
      assets
    
    
    213
    
    
    18812,856
    
    
    10,530*Non-Current
      Assets:*Property
      and equipment, net
    
    
    573
    
    
    278Investment
      in related party, at cost
    
    
    703
    
    
    703Goodwill,
      net
    
    
    2,124
    
    
    2,017Other
      amortizable intangible assets, net
    
    
    1,763
    
    
    1,574Deferred
      income taxes
    
    
    2,653
    
    
    3,465Other
      assets
    
    
    171
    
    
    170$
    20,843
    
    $
    18,737***Liabilities
      and Stockholders’ Equity****Current
      Liabilities:*Due
      to underwriters and assureds
    
    $
    5,333
    
    $
    4,800Accounts
      payable and accrued expenses
    
    
    512
    
    
    395Employment
      related accruals
    
    
    1,007
    
    
    478Acquisition
      related accruals
    
    
    654
    
    
    772Income
      taxes payable
    
    
    131
    
    
    -Notes
      payable to bank
    
    
    -
    
    
    1,2767,637
    
    
    7,721*Non-Current
      Liabilities:*Accounts
      payable and accrued expenses
    
    
    198
    
    
    -Acquisition
      related accruals
    
    
    784
    
    
    752Notes
      payable to bank
    
    
    976
    
    
    -$
    9,595
    
    $
    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 7,455,879 and
      7,270,879 shares in 2005 and 2004, respectively)
    
    
    75
    
    
    73Additional
      paid-in-capital
    
    
    14,353
    
    
    14,137Accumulated
      earnings, after January 1, 2003
    
    
    2,958
    
    
    2,095Accumulated
      other comprehensive loss
    
    
    (31
    )
    
    -Unearned
      compensation
    
    
    (11
    )
    
    (60
    )Employee
      loans for stock purchase
    
    
    (23
    )
    
    (23
    )Treasury
      stock, at cost (991,334 and 924,734 shares in 2005 and 2004,
      respectively)
    
    
    (6,073
    )
    
    (5,958
    )$
    11,248
    
    $
    10,264$
    20,843
    
    $
    18,737*
      Derived from audited financial statements.See
      notes to condensed consolidated financial statements.
  2
  **PAULA
FINANCIAL AND SUBSIDIARIES**
 **Condensed Consolidated Statements of Income**
 (In
thousands, except share and per share data)
 
 
 
 **Three
      Months Ended**
    
    **Nine
      Months Ended****September
      30,**
    
    **September
      30,****2005**
    
    **2004**
    
    **2005**
    
    **2004**(Unaudited)
    
    (Unaudited)***Income:***Commissions
      and placement fees
    
    $
    3,648
    
    $
    3,690
    
    $
    10,920
    
    $
    11,951Profit
      sharing income
    
    
    473
    
    
    448
    
    
    2,487
    
    
    1,746Service
      fees
    
    
    166
    
    
    476
    
    
    601
    
    
    703Other
      income
    
    
    63
    
    
    1
    
    
    107
    
    
    214,350
    
    
    4,615
    
    
    14,115
    
    
    14,421***Operating
      Expenses:***Salaries
      and related expenses
    
    
    2,418
    
    
    2,552
    
    
    7,424
    
    
    7,773Interest
      expense
    
    
    20
    
    
    20
    
    
    61
    
    
    66Amortization
      expense
    
    
    181
    
    
    145
    
    
    509
    
    
    439Other
      expenses
    
    
    1,359
    
    
    1,578
    
    
    4,156
    
    
    4,5823,978
    
    
    4,295
    
    
    12,150
    
    
    12,860Income
      from operations before income taxes
    
    
    372
    
    
    320
    
    
    1,965
    
    
    1,561Income
      tax expense
    
    
    154
    
    
    178
    
    
    813
    
    
    646***Net
      income***
    
    $
    218
    
    $
    142
    
    $
    1,152
    
    $
    915Earnings
      per share - basic
    
    $
    0.03
    
    $
    0.02
    
    $
    0.18
    
    $
    0.14Weighted
      average shares outstanding
    
    
    6,586,340
    
    
    6,491,188
    
    
    6,504,138
    
    
    6,458,216Earnings
      per share - assuming dilution
    
    $
    0.03
    
    $
    0.02
    
    $
    0.17
    
    $
    0.14Weighted
      average shares outstanding - assuming dilution
    
    
    6,776,317
    
    
    6,810,950
    
    
    6,691,426
    
    
    6,746,049Dividends
      declared per common share
    
    $
    0.015
    
    $
    0.015
    
    $
    0.045
    
    $
    0.030
 See notes
to condensed consolidated financial statements.
 
  3
  **PAULA
FINANCIAL AND SUBSIDIARIES**
 **Condensed Consolidated Statements of Comprehensive Income**
 (In
thousands)
 
 
 **Nine Months Ended**
      **September
      30,****2005**
    
    **2004**(Unaudited)Net
      income
    
    $
    1,152
    
    $
    915Other
      comprehensive loss:Net
      unrealized holding losses arising during period (tax impact: 2005:
      $16)
    
    
    (31
    )
    
    -Comprehensive
      income
    
    $
    1,121
    
    $
    915
 See notes
to condensed consolidated financial statements.
 
 
  4
  **PAULA
FINANCIAL AND SUBSIDIARIES**
 **Condensed Consolidated Statements of Cash
Flows**
 (In
thousands)
 
 **Nine
      Months Ended**
      **September
      30,****2005**
    
    **2004**(Unaudited)***Cash
      flows from operating activities:***Net
      income
    
    $
    1,152
    
    $
    915*Adjustments
      to reconcile net income to net cash provided by operating
      activities:*Depreciation
    
    
    133
    
    
    101Amortization
    
    
    509
    
    
    439Gain
      on sale of property and equipment
    
    
    (29
    )
    
    -Changes
      in operating assets and liabilities:Decrease
      in receivables
    
    
    384
    
    
    41Decrease
      in deferred income taxes
    
    
    608
    
    
    476Increase
      (decrease) in accounts payable and accrued expenses
    
    
    1,280
    
    
    (245
    )Decrease
      in unearned compensation
    
    
    49
    
    
    44Other,
      net
    
    
    (40
    )
    
    125***Net
      cash provided by operating activities***
    
    
    4,046
    
    
    1,896***Cash
      flows from investing activities:***Purchase
      of property and equipment
    
    
    (158
    )
    
    (141
    )Sale
      of property and equipment
    
    
    8
    
    
    -Purchase
      of investments
    
    
    (1,127
    )
    
    -Purchase
      of book of business
    
    
    (700
    )
    
    (482
    )***Net
      cash used in investing activities***
    
    
    (1,977
    )
    
    (623
    )***Cash
      flows from financing activities:***Payments
      on line of credit
    
    
    (300
    )
    
    (300
    )Dividends
      paid
    
    
    (288
    )
    
    (188
    )Exercise
      of stock options
    
    
    18
    
    
    -Repurchase
      of common stock
    
    
    (114
    )
    
    -Change
      in******employee
      loans for stock purchase
    
    
    -
    
    
    13***Net
      cash used in financing activities***
    
    
    (684
    )
    
    (475
    )***Net
      increase in cash and invested cash***
    
    
    1,385
    
    
    798Cash
      and invested cash at beginning of period
    
    
    3,241
    
    
    3,110***Cash
      and invested cash at end of period***
    
    $
    4,626
    
    $
    3,908***Supplemental
      disclosure of non-cash investing activity:***Issuance
      of common stock in conjunction with purchase of book of
      business
    
    $
    191
    
    $
    122
 See notes
to condensed consolidated financial statements.
  5
  **PAULA
FINANCIAL AND SUBSIDIARIES**
 **Notes to Condensed Consolidated Financial
Statements**
 **For
the Nine Months Ended September 30, 2005 (Unaudited)**
 
 
 **Note
A - Basis of Presentation**
 
 PAULA
Financial and subsidiaries (the “Company”) is a California-based specialty
distributor of commercial insurance products. The Company’s agency operations
place a full array of commercial insurance products for their customers.
 
 The
accompanying unaudited condensed consolidated financial statements of the
Company have been prepared in accordance with accounting principles generally
accepted in the United States (“GAAP”) for interim financial information and
with the instructions to Form 10-QSB and Regulation S-B. 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.
 
 Where
necessary, prior years’ information has been reclassified to conform to the 2005
presentation.
 
 In 2005,
the Company made investments in certain marketable securities. These securities
are classified as available for sale and are reflected at estimated fair value
with unrealized gains and losses record as a separate component of stockholders’
equity, net of related deferred income taxes. Investments in which the decline
in market value is deemed other than temporary are reduced to the estimated
realizable value through a charge to income.
 
 Stock
options to purchase 700,000 shares that were outstanding as of September 30,
2005 were not included in the computation of earnings per share for the three
and nine months ended September 30, 2005 as inclusion of such shares would be
antidilutive.
 
 The
Company’s operating results tend to be cyclical. Consequently, operating results
for the nine months ended September 30, 2005 are not necessarily indicative of
the results to be expected for the year ending December 31, 2005. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Company’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 Financial Accounting Standard (“SFAS”) No. 148, “Accounting for
Stock Based Compensation - Transition and Disclosure, an amendment of SFAS 123”.
Among other provisions, SFAS 148 amends the disclosure requirements of SFAS 123
to require prominent disclosures in both annual and interim financial
statements. For the nine months ended September 30, 2005, the differences
between the as reported net income and income per share amounts and the related
pro forma amounts are not material to the consolidated financial statements.
 
  6
  On
December 16, 2004, SFAS 123 was revised to require all share based payments to
employees to be recognized in the income statement based on their fair values.
The pro forma disclosure will no longer be an alternative. This revised standard
will be effective for the Company in the first quarter of 2006.
  In May
2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections"
which replaces Accounting Principles Board Opinions No. 20 "Accounting Changes"
and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements-An
Amendment of APB Opinion No. 28." SFAS 154 provides guidance on the accounting
for and reporting of accounting changes and error corrections. It establishes
retrospective application, or the latest practicable date, as the required
method for reporting a change in accounting principle and the reporting of a
correction of an error. SFAS 154 is effective for accounting changes and
corrections 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 the Company’s
consolidated financial statements.
  **Note
B - Deferred Income Taxes**
 
 As of
September 30, 2005 and December 31, 2004, the Company’s net deferred tax asset
is comprised of the following:
 
 **September
      30**
    
    **December
      31****2005**
    
    **2004****(unaudited)**Deferred
      tax assets:Net
      operating loss carry forward
    
    $
    24,338
    
    $
    25,203Other
    
    
    2,950
    
    
    2,677Gross
      deferred tax assets
    
    
    27,288
    
    
    27,880Less
      valuation allowance
    
    
    (22,646
    )
    
    (22,646
    )Deferred
      tax assets
    
    $
    4,642
    
    $
    5,234Gross
      deferred tax liabilities
    
    $
    -
    
    $
    -Net
      deferred tax asset
    
    $
    4,642
    
    $
    5,234
 
 The net
operating loss carry forward includes losses generated by PAULA Insurance
Company which are available to offset future taxable income of the Company.
 
 Management
believes that it is more likely than not that the results of future operations
will generate sufficient taxable income in the periods necessary to realize the
net deferred tax asset.
 
 **Note
C - Acquisitions**
 
 On
February 28, 2005, the Company entered into an agreement to purchase the
existing book of business of Integrated Financial (“Integrated”). Integrated is
based in Sacramento, California and specializes in accident and health and
financial products. Although the purchase agreement was entered into on February
28, 2005, the actual effective date of the transaction was delayed until April
1, 2005. Therefore, the asset purchase was recorded in the second quarter of
2005. The estimated purchase price is $804. Of the total purchase price, $697
has been allocated to other amortizable intangible assets, with the remaining
$107 allocated to goodwill. Other amortizable
  7
  intangible
assets relate to expiration lists and covenants not to compete. As of September
30, 2005, $181 has been paid related to this acquisition. The remaining
obligation of $623 will be paid over the next five years. The purchase price for
Integrated is subject to adjustment based on revenue earned over the next three
years. Consequently, the purchase price will not be finalized until the second
quarter of 2008.
 
 **Note
D - Change in Stockholders’ Equity**
 
 In the
third quarter of 2005, options to purchase 40,000 shares of common stock at
$0.46 per share were exercised. Additionally, in conjunction with the terms of
an asset purchase agreement, the Company issued 125,000 shares of common stock
and reduced the associated liability by $191,000.
 
 **Note
E - Other Matters**
 
 In early
1999, PAULA Financial made an investment in a start up specialty workers’
compensation insurance company, Montlake Insurance Holdings, LLC (“Montlake”).
This investment was accounted for using the equity method. During the initial
set up of the Montlake operations, PAULA Financial provided assistance in
several areas including license application, insurance placement, human resource
matters and systems support. As part of this support, PAULA Financial executed a
guarantee related to certain aspects of the relationship between Montlake and
the issuing company, Reliance Insurance Company (“Reliance”). At the time of the
guarantee, Reliance did not retain any exposure associated with the premiums
fronted. Reliance was the issuing carrier for Montlake from March 15, 1999 to
July 31, 2000.
 
 In
October 2001, Reliance was placed in liquidation by the Pennsylvania Department
of Insurance. In October 2002, Montlake was liquidated by the Superior Court of
Washington for King County.
 
 In May
2004, the Company received a demand for payment from Reliance in Liquidation in
the amount of $1.9 million related to unpaid deductibles by a policyholder
placed under the Montlake fronting arrangement with Reliance. The policy in
question was effective March 2000 and was cancelled in September
2000.
 
 The
Company replied to the demand in a letter dated August 13, 2004 disputing any
amount due to Reliance in Liquidation. On October 19, 2005, the Company received
a response from Reliance in Liquidation. The correspondence, dated October 17,
2005, reduces the demand related to unpaid deductibles from $1.9 million to
$40,000. However, a new demand, in the amount of $3.0 million is asserted
related to retrospective premium adjustments on the same policy. The Company is
in the process of preparing its response.
 
 The
Company believes there are good and meritorious arguments that the demand does
not represent an obligation of the Company. The Company believes, among other
defenses, that the obligation subject to the guarantee was previously
discharged.
  8
  **PART
I.**  **FINANCIAL
INFORMATION**
 
 **Item
2.****Management’s
Discussion and Analysis of Consolidated Financial Condition and Results of
Operations**
 
 **Overview**
 
 The
Company’s revenues consist of agency commission and placement fee income, profit
sharing income, and service fees. Commission and placement fee income is earned
from Pan American Underwriters’ (“Pan Am’s”) insurance sales activity.
Associated premiums are primarily billed directly by the insurance carrier.
However, in certain instances, Pan Am will invoice the customer and remit the
premium, less commission, to the insurance carrier. The Company focuses its
sales efforts on agribusiness and rural markets in California and Arizona.
Profit sharing income is related to profit sharing arrangements with insurance
carriers. Service fees are primarily received for the performance of services
related to loss control and claims advocacy.
 
 The
Company’s expenses consist of salaries and related expenses, interest expense,
amortization of intangibles and other general and administrative expenses.
 
 **Results
of Operations for the Three Months and Nine Months Ended September 30, 2005
Compared to the Three Months and Nine Months Ended September 30,
2004:**
 
 **Commission
and placement fee income.** Commission and placement fee income for the three months ended September 30,
2005 of $3.6 million were consistent with the comparable 2004 period of $3.7
million. For the nine months ended September 30, 2005, commission and placement
fee income decreased 8.6% to $10.9 million compared to $12.0 million for the
comparable 2004 period. The decrease in 2005 is primarily related to a decline
in the package and workers’ compensation lines of business. In previous filings
we have discussed extensively the downward pressure on premium and commission
rates on these lines. New business activity is beginning to mitigate these
trends as evidenced by the 2005 third quarter results as compared to the
comparable 2004 period.
 
 **Profit
sharing income.** For the
three months ended September 30, 2005 profit sharing income increased 5.6% to
$473,000 compared to $448,000 for the comparable 2004 period. For the nine
months ended September 30, 2005 profit sharing income increased 42.4% to $2.5
million compared to $1.7 million for the comparable 2004 period. Profit sharing
income fluctuates from year to year based on the profitability of the underlying
business and external market conditions which can result in changes to profit
sharing programs offered by insurance carriers.
 
 **Service
fees.** For the
three months ended September 30, 2005 service fee income decreased 65.1% to
$166,000 from $476,000 for the comparable 2004 period. For the nine months ended
September 30, 2005 service fee income decreased 14.5% to $601,000 from $703,000
for the comparable 2004 period. In the third quarter of 2005, the Company
completed its exit from the third party administration business. This has
reduced the amount of fees associated with third party administration along with
the associated reductions of expenses.
 
  9
  **Salaries
and related expenses.** For the
three months ended September 30, 2005 salaries and employee benefits decreased
5.3% to $2.4 million from $2.6 million for the comparable 2004 period. For the
nine months ended September 30, 2005 salaries and employee benefits decreased
4.5% to $7.4 million from $7.8 million for the comparable 2004 period. The
decrease is largely due to staff reductions offset by the restructure of
executive compensation in 2004. Prior to the impact of executive compensation,
which is discussed below, for the nine months ended September 30, 2005 salaries
and employee benefits decreased 8.7% to $7.1 million from $7.8 million for the
comparable 2004 period. The decrease is largely due to staff reductions.
Salaries and related expenses excluding the executive compensation bonus accrual
discussed below was 50.3% of total revenues for the first nine months of 2005
compared to 53.9% for the first nine months of 2004.
 
 In 2004,
the Company restructured its executive compensation program. The restructure was
discussed in detail in the Company’s proxy statement for its 2004 Annual
Meeting, where approval to increase the number of shares available for grant
under the Company’s stock incentive plan was received. The compensation for the
Company’s Chief Executive Officer, Jeffrey A. Snider, was restructured such that
a larger portion of his compensation is equity denominated. Mr. Snider is only
eligible for a cash bonus to the extent the Company’s operating results
over-deliver on certain pre-determined profitability goals. To wit, Mr. Snider
did not receive any cash bonus for the 2004 operating results.
 
 The
operating results in the first nine months of 2005 suggest that the Company is
on track to exceed the established profitability goals for the current period.
While the ultimate validation of the cash bonus for Mr. Snider will not be
determined until the year end results are finalized, an accrual has been
established relative to the first nine months operating results. Consistent with
the restructured executive compensation plan approved by the Board of Directors
in 2004, the Company will adjust, up or down, the associated bonus accrual based
on the full year operating results .
 
 **Other
expenses.** For the
three months ended September 30, 2005 other expenses decreased 13.9% or $219,000
from the comparable 2004 period. For the nine months ended September 30, 2005
other expenses decreased 9.3% or $426,000 from the comparable 2004 period. The
decline in 2005 is due to a concerted effort on the part of management to reduce
expenses.
 
 **Income
tax expense.** Income
tax expense for the three months ended September 30, 2005 was $154,000 compared
to $178,000 for the comparable 2004 period. Income tax expense for the nine
months ended September 30, 2005 was $813,000 compared to $646,000 for the
comparable 2004 period. The effective combined income tax rates for the nine
months ended September 30, 2005 and 2004 were 41.4% and 41.4%, respectively. The
differences between the applicable Federal tax rate and the effective tax rates
is primarily due to the impact of state taxes.
 
 **Net
income.** Net
income increased 53.5% to $218,000 for the three months ended September 30, 2005
from $142,000 for the comparable 2004 period. Net income increased 25.9% to $1.2
million for the nine months ended September 30, 2005 from $915,000 for the
comparable 2004 period. The increase is due to the factors discussed
above.
 
  10
  **Liquidity
and Capital Resources:**
 
 As a
holding company, PAULA Financial's principal sources of funds are dividends and
expense reimbursements from its operating subsidiaries and proceeds from the
sale of its capital stock. PAULA Financial's principal uses of funds are capital
contributions to its subsidiaries, payment of operating expenses, dividends to
shareholders and repurchase of Company common stock.
 
 On
November 1, 2003, the Company refinanced its outstanding bank debt with a
$1,800,000 reducing revolving line of credit (the “Line of Credit”) with US Bank
(the “Lender”). The line of credit currently has a total available line of
$1,400,000 of which $976,000 is outstanding. In August 2005, the Line of Credit
with the Lender was amended to extend the maturity date to November 1,
2006.  While the
Company has been making quarterly payments to pay down the outstanding balance,
the terms of the Line of Credit do not require any principal payment prior to
maturity. Consequently, the entire outstanding balance has been classified as
non-current in the accompanying condensed consolidated balance sheet. Certain
covenant terms were also modified. All other terms under the original
arrangement are unchanged. PAULA Financial is in compliance with all of the
covenants. Balances outstanding under the Line of Credit bear interest at the
prime rate plus 1.0%. As of September 30, 2005, the interest rate was 7.75%.
PAULA Financial's subsidiaries have guaranteed the obligations of PAULA
Financial under the Line of Credit. Additionally, the Lender has a security
interest in the assets of the Company.
 
 The
Company’s Board of Directors had previously approved a 1,000,000 share
repurchase program. On February 20, 2003, the Board of Directors authorized an
additional 2,000,000 shares for the share repurchase program. As of September
30, 2005, the Company held 991,334 shares in treasury stock.
 
 On May
28, 2004, the Company announced the reinstatement of a quarterly cash dividend
in the amount of $0.015 per common share. The third quarter 2005 dividend was
paid to holders of record as of September 8, 2005 and was distributed on
September 28, 2005.
 
 **Off-Balance
Sheet Arrangements**
 
 The
Company does not have any off-balance sheet arrangements.
 
  11
  **Forward-Looking
Statements**
 
 In
connection with, and because it desires to take advantage of the “safe harbor”
provisions of the Private Securities Litigation Reform Act of 1995, the Company
cautions readers to recognize the existence of certain forward-looking
statements in this Form 10-QSB and in any other statement made by, or on behalf
of, the Company, whether or not in future filings with the Securities and
Exchange Commission. Forward-looking statements are statements not based on
historical information and which relate to future operations, strategies,
financial results or other developments. Some forward-looking statements may be
identified by the use of terms such as
 “expects,”
“believes,” “anticipates,” “intends,” or “judgment.” Forward-looking statements
are necessarily based upon estimates and assumptions that are inherently subject
to significant business, economic and competitive uncertainties, many of which
are beyond the Company’s control and many of which, with respect to future
business decisions, are subject to change. Examples of such uncertainties and
contingencies include, among other important factors, those affecting the
insurance industry in general, such as the economic and interest rate
environment, legislative and regulatory developments and market pricing and
competitive trends, and those relating specifically to the Company and its
businesses, such as the level of commission revenue and fee income, and
acquisitions of companies or blocks of business. These uncertainties and
contingencies can affect actual results and could cause actual results to differ
materially from those expressed in any forward-looking statements made by, or on
behalf of, the Company. The Company disclaims any obligation to update
forward-looking statements.
 
 **Item 3. Controls and Procedures**
 
 **Evaluation
of Disclosure Controls and Procedures**
 
 The
Company’s Chief Executive Officer and Vice President Finance have evaluated the
effectiveness of 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) as
of the end of the period covered by this quarterly report. Based on this
evaluation, such officers have concluded that the Company’s disclosure controls
and procedures as of the end of the period covered by this quarterly report were
effective for ensuring that information required to be disclosed in the reports
it files or submits under the Exchange Act is recorded, processed, summarized
and reported in a timely manner. There have not been any significant changes in
the Company’s internal controls or in other factors that could significantly
affect such controls.
  12
 **PART
II.  OTHER
INFORMATION**
  **Item 2.  Changes in
Securities and Small Business Issuer Purchases of Equity
Securities.**
  In the
third quarter of 2005, the Company repurchased 44,936 shares of its common stock
at a total cost of $78,000. Total shares of 44,236 were purchased in July 2005
at a cost of $77,000 with the remainder purchased in August 2005.
  **Item 5.  Other
Information.**
 
 The
Company is in the process of restructuring the composition of its Board of
Directors (the “Board”). As previously disclosed in the June 30, 2005 Form
10-QSB, Mr. Harold Sandstrom and Mr. Lawrence A. Hayes were elected to the Board
effective July 18, 2005 and Mr. Jerry M. Miller retired from the Board effective
September 1, 2005.
 
 Additionally,
effective September 1, 2005, Mr. Joel W. Geddes, Jr. resigned as a director of
the Company and effective September 30, 2005, Mr. Robert Anderson resigned as a
director of the Company. Neither resignation was a result of any disagreement
with the Board or Management of the Company on any matter relating to the
Company’s operations, policies or practices.
 
 Prior to
the most recent resignations, the Board was comprised of six (6) directors, four
(4) of which were independent as defined under the National Association of
Securities Dealers, Inc. listing standards. Effective with Mr. Anderson’s
resignation the Board is comprised of four (4) directors, two (2) of which are
independent.
 
 NASDAQ
rules require that the majority of the Board be independent. However, the rules
provide that if an issuer fails to comply with this requirement due to one
vacancy, the issuer shall regain compliance with the requirement by the earlier
of its next annual shareholders meeting or one year from the occurrence of the
event that caused the failure to comply with this requirement.
 
 On
October 12, 2005, the Board decreased the number of directors constituting a
full Board from six (6) to five (5). The Company has already begun the process
of filling the independent director vacancy and expects to be in compliance with
this requirement by the Company’s 2006 annual shareholders
meeting.
  13
   **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.
  None
 
  14
  
  
  SIGNATURES
  In
accordance with the requirements of the Exchange, the Registrant caused this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.
  Date:
November 14, 2005     PAULA
FINANCIAL
  
  By: /s/
Deborah S. Maddocks
 Vice
President - Finance
  15