---

---

SECURITIES AND EXCHANGE COMMISSIONWashington, 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 June 30, 2001

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(State or other jurisdiction of
incorporation or organization)

95-4640468(I.R.S. Employer
identification number)PAULA FINANCIAL
300 North Lake Avenue, Suite 300
Pasadena, CA 91101(Address of principal 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 July 31, 2001: 5,970,979 shares.

---

---

---

PAULA FINANCIAL  INDEX TO FORM 10-Q

|          |  |                                                                                                                                        |  | Page
|--------- |  | -------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|PART I.   |  | FINANCIAL INFORMATION                                                                                                                  |  |     
|Item 1.   |  | Financial Statements                                                                                                                   |  |     
|          |  | Condensed consolidated balance sheets as of June 30, 2001 and December 31, 2000 (unaudited)                                            |  | 2   
|          |  | Condensed consolidated statements of operations for the three and six months ended June 30, 2001 and 2000 (unaudited)                  |  | 3   
|          |  | Condensed consolidated statements of comprehensive income (loss) for the three and six months ended June 30, 2001 and 2000 (unaudited) |  | 4   
|          |  | Condensed consolidated statements of cash flows for the six months ended June 30, 2001 and 2000 (unaudited)                            |  | 5   
|          |  | Notes to condensed consolidated financial statements for the three and six months ended June 30, 2001 (unaudited)                      |  | 6   
|Item 2.   |  | Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations                                     |  | 7   
|Item 3.   |  | Quantitative and Qualitative Disclosures about Market Risk                                                                             |  | 10  
|PART II.  |  | OTHER INFORMATION                                                                                                                      |  |     
|Item 4.   |  | Submission of Matters to a Vote of Security Holders                                                                                    |  | 11  
|Item 6.   |  | Exhibits and Reports on Form 8-K                                                                                                       |  | 11  
|SIGNATURE |  | 12                                                                                                                                    

---



PART I FINANCIAL INFORMATION

Item 1. Financial Statements

PAULA FINANCIAL AND SUBSIDIARIES  Condensed Consolidated Balance Sheets

(In
thousands, except share data)

|                                                                                                       |                                                                                                  | June 30,
2001                                      |         | December 31,
2000 |        
|------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------ | -------------------------------------------------- | ------- | ----------------- | -------
|
|Assets                                                                                                 |                                                                                                  |                                                    |         |                  
|Investments:                                                                                           |                                                                                                  |                                                    |         |                   |        
|                                                                                                       | Fixed maturities, available for sale, at market (amortized cost: 2001, $104,313; 2000, $135,772) |                                                    | $       | 104,723           |        
|                                                                                                       | Equity securities, at market                                                                     |                                                    |         |                   |        
|                                                                                                       |                                                                                                  | Preferred stock (cost: 2001, $1,000; 2000, $1,000) |         |                   | 856    
|                                                                                                       |                                                                                                  | Common stock (cost: 2001, $397; 2000, $1,900)      |         |                   | 322    
|                                                                                                       | Invested cash, at cost (approximates market)                                                     |                                                    |         | 13,715            |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  | Total investments                                  |         |                   | 119,616
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|Cash (restricted: 2001, $947; 2000, $2,075)                                                            |                                                                                                  |                                                    | 7,190   |                   |        
|Accounts receivable, net of allowance for uncollectible accounts (2001, $915; 2000, $1,491)            |                                                                                                  |                                                    | 15,287  |                   |        
|Reinsurance recoverable on paid and unpaid losses and loss adjustment expenses                         |                                                                                                  |                                                    | 27,724  |                   |        
|Deferred income taxes                                                                                  |                                                                                                  |                                                    | 17,218  |                   |        
|Other assets                                                                                           |                                                                                                  |                                                    | 11,825  |                   |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  | $                                                  | 198,860 |                   | $      
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|Liabilities and Stockholders' Equity                                                                   |                                                                                                  |                                                    |         |                  
|Liabilities:                                                                                           |                                                                                                  |                                                    |         |                   |        
|Unpaid losses and loss adjustment expenses                                                             |                                                                                                  | $                                                  | 129,018 |                   | $      
|Unearned premiums                                                                                      |                                                                                                  |                                                    | 15,480  |                   |        
|Accrued policyholder dividends                                                                         |                                                                                                  |                                                    | 621     |                   |        
|Accounts payable and accrued expenses                                                                  |                                                                                                  |                                                    | 9,860   |                   |        
|Notes payable                                                                                          |                                                                                                  |                                                    | 5,813   |                   |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  |                                                    | 160,792 |                   |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|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: 2001, 6,648,079; 2000, 6,337,079) |                                                                                                  |                                                    | 67      |                   |        
|Additional paid-in-capital                                                                             |                                                                                                  |                                                    | 67,803  |                   |        
|Accumulated deficit                                                                                    |                                                                                                  |                                                    | (23,359 | )                 |        
|Unearned compensation                                                                                  |                                                                                                  |                                                    | (288    | )                 |        
|Accumulated other comprehensive loss:                                                                  |                                                                                                  |                                                    |         |                   |        
|                                                                                                       | Net unrealized gain (loss) on investments                                                        |                                                    |         | 126               |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  |                                                    | 44,349  |                   |        
|Treasury stock, at cost (2001, 995,100; 2000, 995,100 shares)                                          |                                                                                                  |                                                    | (6,281  | )                 |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  |                                                    | 38,068  |                   |        
|                                                                                                       |                                                                                                  |                                                    |         |                   |        
|                                                                                                       |                                                                                                  | $                                                  | 198,860 |                   | $      
|                                                                                                       |                                                                                                  |                                                    |         |                   |        

---

See notes to condensed consolidated financial statements.

2

---

PAULA FINANCIAL AND SUBSIDIARIES  Condensed Consolidated Statements of Operations

(In
thousands, except share and per share data)

|                                                      |                        | Three Months Ended
June 30, |           | Six Months Ended
June 30, |  
|----------------------------------------------------- | ---------------------- | --------------------------- | --------- | ------------------------- | -
|
|
|Income:                                               |                        |                             |           |                           |  
|Premiums earned:                                      |                        |                             |           |                           |  
|                                                      | Workers' compensation  |                             | $         | 10,906                    |  
|                                                      | Group medical and life |                             |           |                          |  
|Commissions                                           |                        |                             | 1,855     |                           |  
|Net investment income                                 |                        |                             | 1,881     |                           |  
|Net realized investment gains (losses)                |                        |                             | 56        |                           |  
|Other                                                 |                        |                             | 263       |                           |  
|                                                      |                        |                             |           |                           |  
|                                                      |                        |                             | 14,961    |                           |  
|                                                      |                        |                             |           |                           |  
|Expenses:                                             |                        |                             |           |                           |  
|Losses and loss adjustment expenses incurred          |                        |                             | 9,488     |                           |  
|Dividends provided for policyholders                  |                        |                             | 38        |                           |  
|Operating                                             |                        |                             | 5,139     |                           |  
|                                                      |                        |                             |           |                           |  
|                                                      |                        |                             | 14,665    |                           |  
|                                                      |                        |                             |           |                           |  
|Equity in net loss of unconsolidated affiliate        |                        |                             |          |                           |  
|                                                      |                        |                             |           |                           |  
|Income (loss) before income taxes                     |                        |                             | 296       |                           |  
|Income tax expense (benefit)                          |                        |                             | 81        |                           |  
|                                                      |                        |                             |           |                           |  
|                                                      | Net income (loss)      |                             | $         | 215                       |  
|                                                      |                        |                             |           |                           |  
|Earnings (loss) per share                             |                        | $                           | 0.04      |                           | $
|Weighted average shares outstanding                   |                        |                             | 5,372,737 |                           |  
|Earnings (loss) per shareassuming dilution           |                        | $                           | 0.04      |                           | $
|Weighted average shares outstandingassuming dilution |                        |                             | 5,372,737 |                           |  

See
notes to condensed consolidated financial statements.

3

---



PAULA FINANCIAL AND SUBSIDIARIES  Condensed Consolidated Statements of Comprehensive Income (Loss)

(In
thousands)

|                                        |                                           | Three Months Ended
June 30,                                                                                                       |     | Six Months Ended
June 30, |     
|--------------------------------------- | ----------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------- | --- | ------------------------- | ----
|
|
|Net income (loss)                       |                                           | $                                                                                                                                 | 215 |                           | $   
|Other comprehensive income, net of tax: |                                           |                                                                                                                                   |     |                           |     
|                                        | Unrealized gains (losses) on investments: |                                                                                                                                   |     |                           |     
|                                        |                                           | Unrealized holding gains (losses) arising during period (tax impact: 2001: $72 and $528; 2000: $215 and $260)                     |     |                           | (139
|                                        |                                           | Reclassifications adjustment for gains (losses) included in net income (loss) (tax impact: 2001: $87 and $118; 2000: $27 and $53) |     |                           | 168 
|                                        |                                           |                                                                                                                                   |     |                           |     
|                                        |                                           |                                                                                                                                   | 29  |                           |     
|                                        |                                           |                                                                                                                                   |     |                           |     
|                                        | Comprehensive income (loss)               |                                                                                                                                   | $   | 244                       |     
|                                        |                                           |                                                                                                                                   |     |                           |     

See
notes to condensed consolidated financial statements.

4

---

PAULA FINANCIAL AND SUBSIDIARIES  Condensed Consolidated Statements of Cash Flows

(In
thousands)

|                                                                                                   |                                                                           | Six Months Ended
June 30, |        
|-------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------- | ------------------------- | -------
|
|
|Cash flow from operating activities:                                                               |                                                                           |                           |        
|                                                                                                   | Net income (loss)                                                         |                           | $      
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |                                                                           |                           |        
|                                                                                                   | Depreciation and amortization                                             |                           |        
|                                                                                                   | Amortization of fixed maturity premium, net                               |                           |        
|                                                                                                   | Equity in net loss of unconsolidated affiliate                            |                           |        
|                                                                                                   | Loss on sale of property and equipment                                    |                           |        
|                                                                                                   | (Gain) loss on sales and calls of investments                             |                           |        
|                                                                                                   | (Increase) decrease in receivables                                        |                           |        
|                                                                                                   | (Increase) decrease in deferred income taxes                              |                           |        
|                                                                                                   | Decrease in unpaid losses and loss adjustment expenses                    |                           |        
|                                                                                                   | Increase in accrued policyholder dividends                                |                           |        
|                                                                                                   | Increase in accounts payable and accrued expenses                         |                           |        
|                                                                                                   | Increase in unearned premiums                                             |                           |        
|                                                                                                   | Other, net                                                                |                           |        
|                                                                                                   |                                                                           |                           |        
|Net cash provided by (used in) operating activities                                                |                                                                           |                           | (22,889
|                                                                                                   |                                                                           |                           |        
|Cash flows from investing activities:                                                              |                                                                           |                           |        
|                                                                                                   | Proceeds from sale of available for sale fixed maturities                 |                           |        
|                                                                                                   | Proceeds from maturities and calls of available for sale fixed maturities |                           |        
|                                                                                                   | Proceeds from sale of common stock                                        |                           |        
|                                                                                                   | Proceeds from sale of property and equipment                              |                           |        
|                                                                                                   | Purchase of available for sale fixed maturities                           |                           |        
|                                                                                                   | Purchase of property and equipment                                        |                           |        
|                                                                                                   | Adjustment to purchase price of insurance agency                          |                           |        
|                                                                                                   |                                                                           |                           |        
|Net cash provided by (used in) investing activities                                                |                                                                           |                           | 32,931 
|                                                                                                   |                                                                           |                           |        
|Cash flows from financing activities:                                                              |                                                                           |                           |        
|                                                                                                   | Payments on notes payable                                                 |                           |        
|                                                                                                   | Repurchase of common stock                                                |                           |        
|                                                                                                   | Retirement of common stock                                                |                           |        
|                                                                                                   | Issuance of common stock                                                  |                           |        
|                                                                                                   |                                                                           |                           |        
|Net cash used in financing activities                                                              |                                                                           |                           | (6,631 
|                                                                                                   |                                                                           |                           |        
|Net increase (decrease) in cash and invested cash                                                  |                                                                           |                           | 3,411  
|Cash and invested cash at beginning of period                                                      |                                                                           |                           | 17,494 
|                                                                                                   |                                                                           |                           |        
|Cash and invested cash at end of period                                                            |                                                                           | $                         | 20,905 
|                                                                                                   |                                                                           |                           |        

See
notes to condensed consolidated financial statements.

5

---



PAULA FINANCIAL AND SUBSIDIARIES  Notes to Condensed Consolidated Financial Statements

For
the Three and Six Months Ended June 30, 2001 (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, and New Mexico.

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 six months ended June 30, 2001 are not necessarily indicative of the results to be expected for the year ended December 31, 2001. 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,
2000.

Note BChange in Stockholders' Equity

In the second quarter of 2001, the Company offered its current employees, directors and consultants the opportunity to exchange all options outstanding under
the 1994 Stock Incentive Plan and the Amended and Restated 1997 Stock Incentive Plan (collectively, the "Plans") for shares of restricted stock to be issued under the Plans. The restricted stock vests
one-third upon issuance, one-third on the
first anniversary of the date of issuance and one-third on the second anniversary of the date of issuance. The tender offer closed on June 22, 2001 with options to purchase 311,000
shares of common stock exchanged for 311,000 shares of restricted stock.

Note CNew Accounting Standards Not Yet Adopted

In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard ("SFAS") No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting and
requires separate recognition of intangible assets that meet certain criteria. This statement applies to all business combinations after June 30, 2001. SFAS No. 142 requires that an
acquired intangible asset be initially recognized and measured based on its fair value. This statement also provides that goodwill should not be amortized, but shall be tested for impairment annually,
or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount. SFAS No. 142 is effective for fiscal periods beginning after
December 15, 2001. The Company will continue to amortize existing goodwill through the remainder of fiscal 2001, at which time amortization will cease and the Company will perform a
transitional goodwill impairment test. The Company is currently evaluating the impact of the new accounting standards on existing goodwill and other intangible assets. The ultimate impact of the new
accounting standards has not yet been determined. Goodwill amortization expense for the six months ended June 30, 2001 was $382,000.

6

---

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").

The
Company's revenues consist primarily of premiums earned from workers' compensation insurance underwriting, 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. Gross premiums written for the three months
ended June 30, 2001 and 2000, were $15.1 million and $28.1 million, respectively. Gross premiums written for the six months ended June 30, 2001 and 2000, were
$36.2 million and $61.6 million, respectively. Commission income is earned from Pan Am's distribution of insurance for insurers other than PICO and PAULA Assurance Company ("PACO"). Net
investment income represents earnings on the Company's investment portfolio, less investment expenses. Other income consists of various miscellaneous items.

The
Company's expenses consist 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
following combined ratio information is derived from the insurance subsidiaries', PICO and PACO, GAAP operating results:

|                            |  | Three Months Ended |   | Six Months Ended |   
|--------------------------- |  | ------------------ | - | ---------------- | --
|
|Loss ratio                  |  | 87.0               | % | 83.7             | % 
|Expense ratio               |  | 26.4               | % | 24.1             | % 
|Policyholder dividend ratio |  | 0.4                | % | (0.2             | )%
|                            |  |                    |   |                  |   
|Combined ratio              |  | 113.8              | % | 107.6            | % 
|                            |  |                    |   |                  |   

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.

7

---

Results of Operations for the Three and Six Months Ended June 30, 2001 Compared to the Three and Six Months Ended June 30, 2000:

Gross premiums written.The Company's gross premiums written for the three months ended June 30, 2001 decreased
46.1% to $15.1 million from $28.1 million for the comparable 2000 period. The
Company's gross premiums written for the six months ended June 30, 2000 decreased 41.2% to $36.2 million from $61.6 million for the comparable 2000 period. The decrease in both
periods is largely attributable to the Company's election to cease writing business in certain geographic regions, primarily Texas and Florida. In the first six months of 2000, these regions accounted
for 27% of gross written premiums compared to 2% in the 2001 period. The remaining decrease relates to California where the Company continues to focus on rate adequacy. Rate increases on the Company's
California book of business averaged 23% in the first six months of 2001.

Net premiums earned.The Company's net premiums earned for the three months ended June 30, 2001 decreased 65.9%
to $10.9 million from $32.0 million for comparable 2000 period and decreased 62.7% to $22.3 million for the six months ended June 30, 2001 from $59.6 million for the
comparable 2000 period. In the first six months of 2001, the Company ceded approximately 33% of its earned premium under two quota share agreements which were not in effect in the 2000 period.

Commission income.For the three months ended June 30, 2001 commission income increased 42.5% to
$1.9 million compared to $1.3 million for the comparable 2000 period. For the six months ended June 30, 2001 commission income increased 35.4% to $3.7 million compared to
$2.7 million for the comparable 2000 period. The increase is primarily a result of increased premiums placed with insurance carriers other than PICO and PACO. 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 decreased 29.4% to $1.9 million for the three months ended
June 30, 2001 from $2.7 million for the comparable 2000 period. Net investment income decreased 20.4% to $4.1 million for the six months ended June 30, 2001 from
$5.2 million for the comparable 2000 period. Average invested assets decreased to $134.7 million for the six months ended June 30, 2001 from $158.5 million for the
comparable period in 2000. The Company's average yield on its portfolio was 6.1% for the six month period in 2001 and 6.5% for the six month period in 2000. The 2000 average invested assets and yield
calculations are skewed by a significant increase in invested assets in January 2000 following the receipt of a $42.0 million reinsurance settlement.

Losses and loss adjustment expenses incurred.The Company's net loss ratio for the three months ended June 30,
2001 was 87.0% compared to 83.7% for the 2000 period. The Company's net loss ratio for the six months ended June 30, 2001 was 85.6% compared to an 84.2% for the 2000 period.

The
net loss ratios for the 2001 periods are higher than those for the 2000 periods largely due to the impact of unallocated loss adjustment expenses ("ULAE"). Under our quota share
reinsurance agreements we receive expense recoveries (for both operating expenses and ULAE) in the form of ceding commissions. These ceding commissions are reflected entirely as recoveries of
operating expenses. This has the effect of increasing the Company's overall loss ratio and reducing the expense ratio. For the first six months of 2001, if the current ULAE costs are compared to
earned premium prior to the impact of quota share agreements, the ULAE component of the loss ratio declines by close to 6% (600 basis points).

Operating expenses.Operating expenses decreased 45.6% to $5.1 million for the three months ended
June 30, 2001 from $9.5 million for the comparable 2000 period. Operating expenses in 2001 included the benefit of $2.1 million in ceding commissions received in conjunction with
the Company's quota share agreements. Contributing to the decline in operating expenses in the second quarter of 2001 was a $0.9 million decline in fixed expense levels from the 2000 period.

8

---

Operating expenses decreased 41.5% to $11.1 million for the six months ended June 30, 2001 from $19.0 million for the comparable 2000 period. Operating expenses
in 2001 include the benefit of $3.6 million in ceding commissions received in conjunction with the Company's quota share agreements. Contributing to the decline in operating expenses in the
first six months of 2001 was a $1.6 million decline in fixed expense levels from the 2000 period due to the Company's continued focus on managing expense levels.

Income taxes.Income tax expense for the three months ended June 30, 2001 was $0.1 million compared to an
income tax benefit of $0.3 million for the comparable 2000 period. Income tax expense for the six months ended June 30, 2001 was $0.1 million compared to an income tax benefit of
$0.9 million for the comparable 2000 period. The effective combined income tax rates for the six months ended June 30, 2001 and 2000 were 21.2% and (36.4%), respectively. The effective
tax rate in the 2001 period is below the statutory rate due to the impact of tax exempt investment income.

Equity in net loss of unconsolidated affiliate.The equity in net loss of unconsolidated affiliate represents the
Company's share of the net loss of Montlake Insurance Holdings, LLC ("Montlake"). Based on Montlake's unfavorable 2000 operating results, specifically adverse loss development at its Bermuda captive,
which is in run-off, as of December 31, 2000, the Company reduced the carrying value of its investment in Montlake to $0. The Company accounted for this investment using the equity
method.

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, 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, 2000, PAULA Financial would not be able to receive dividends in 2001 from PICO without obtaining prior regulatory approval from the California Department of Insurance ("DOI"). No
dividends were paid by PICO to PAULA Financial during the six months ended June 30, 2001.

The
Company has been in the process of liquidating PACO. This process was substantially completed in the first quarter of 2001. Consequently, in March 2001, PAULA Financial
received a $4.0 million dividend from PACO. The proceeds from the dividend were used to make the required March 31, 2001 payment of $4.5 million on PAULA Financial's term loan. In
the second quarter of 2001, PAULA Financial received a $0.7 million cash dividend from PACO. The proceeds from the dividend were used to make the required June 30, 2001 payment of
$0.9 million on PAULA Financial's term loan.

As
of June 30, 2001, the Company has an outstanding balance on its bank term loan of $5.8 million. The Company will make additional principal payments totaling
$1.4 million during 2001 with the remaining principal balance of $4.4 million due on December 31, 2001. Management believes that funds are available to meet the required principal
and interest payments except for a portion of its December 31, 2001 balloon payment. The Company is in the process of pursuing alternative financing arrangements to meet this obligation.
Management believes that such financing is available and can be obtained under appropriate and reasonable terms. While the Company believes that it is remote that it will not meet its required
principal and interest payments when due, in the event of default, the commercial bank may exercise the rights and remedies available to it under applicable law. These remedies could be adverse to the
Company's financial condition.

9

---

Each of PAULA Financial's non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement. Additionally, the Company has pledged as
collateral its stock in PICO.

The
Company's operating cash flows in the first six months of 2000 were positively impacted by the receipt of a $42.0 million reinsurance settlement.

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.

As
of June 30, 2001, the carrying value of the Company's fixed maturity securities portfolio was $119.6 million with 97.1% of the portfolio 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 June 30, 2001,
securities with a par value of $107.7 million held by authorized depositories pursuant to these deposit requirements. In addition to the deposits, PICO must maintain regulated levels of capital
and surplus in relation to premiums written and risks retained.

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-Q 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 ability to write insurance premiums at attractive rates, the level of its insurance premiums and fee income, the claims experience of its
insurance products, the performance of its investment portfolio, acquisitions of companies or blocks of business, and the ratings by major rating organizations of its insurance subsidiaries. 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 information.

Item 3: Quantitative and Qualitative Disclosures About Market Risk.

There have been no significant changes since the Company's Annual Report on Form 10-K filed for the year ended December 31, 2000.

10

---



PART II. OTHER INFORMATION

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

The Company held its 2001 Annual Meeting of Stockholders on Wednesday, June 27, 2001 for the purpose of electing two directors and voting on a proposal
to increase the number of shares reserved for issuance under the Company's Amended and Restated 1997 Stock Incentive Plan ("the 1997 Plan") by 700,000 shares.

At
the Meeting, the Company's stockholders re-elected Messrs. Karl T. Hansen and Ronald W. Waisner to the Company's Board of Directors for three year terms.
Additionally, the proposal to increase the number of shares reserved for issuance under the 1997 Plan was approved.

The
following table shows the number of shares voted for each nominee for director and the number of shares withheld for each nominee:

|Nominee           |  | Shares Voted for Election |  | Shares Withheld
|----------------- |  | ------------------------- |  | ---------------
|Karl T. Hansen    |  | 3,557,315                 |  | 1,202,745      
|Ronald W. Waisner |  | 3,751,326                 |  | 1,008,734      

The
term of office of each of the following directors continued after the meeting held June 27, 2001: Messrs. Jeffrey A. Snider, Robert Anderson, Joel W. Geddes, Jr.,
Jerry M. Miller, James A. Nicholson, and James G. Parker, III.

The
following table indicates the number of shares voted on the proposal to increase the number of shares reserved for issuance under the 1997 Plan:

|        |  | Shares Voted |  | 
|------- |  | ------------ |  | 
|For     |  | 2,694,411    |  | 
|Against |  | 1,419,582    |  | 
|Abstain |  | 11,530       |  | 

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



11

---



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.

|Dated August 13, 2001 |  | PAULA FINANCIAL
|--------------------- |  | ---------------
|                      |  | By:            

12

---

QuickLinks