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

 

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**FORM 10-QSB**

 

**(Mark One)**

 

ý         **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period Ended September 30, 2004**

 

**OR**

 

**o****        TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theTransition Period from           to           **

 

**Commissionfile number 0-23181**

 

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

 
| **Delaware**                                                                 | ** ** | **95-4640638**                           |
|------------------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)             | ** ** | (I.R.S. Employer  identification number) |
| ** **                                                                   | ** ** | ** **                               |
| **PAULA FINANCIAL  87 East Green Street, Suite 206**

**Pasadena, CA 91105** |
| (Address of principal  executive offices)                                    |
| ** **                                                                   | ** ** | ** **                               |
| **(626) 844-7100**                                                           |
| (Issuer’s telephone  number, including area code)                       |

 

Check whether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  ý   No  o

 

State the number of shares outstanding of each of the issuer’s classesof common equity, as of the latest practicable date.  Number of shares of Common Stock, $.01 parvalue, outstanding as of close of business on November 8, 2004:  6,346,145 shares.

 

Transitional Small Business Disclosure Format (check one):

Yes  ý   No  o

 

 

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PAULA FINANCIAL

INDEX TO FORM 10-Q

 
| PART I. FINANCIAL INFORMATION |                                                                                                                                  |
|-------------------------------|---------------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                                  |   |
| Item 1. Financial Statements  |                                                                                                                                  |
|                          |                                                                                                                                  |   |
|                          | Condensed consolidated balance sheets as of  September 30, 2004 (unaudited) and December 31, 2003                           |   |
|                          |                                                                                                                                  |   |
|                          | Condensed consolidated statements of income  for the three months  and nine months ended September 30, 2004 and 2003 (unaudited) |   |
|                          |                                                                                                                                  |   |
|                          | Condensed consolidated statements of cash  flows for the nine months  ended September 30, 2004 and 2003 (unaudited)              |   |
|                          |                                                                                                                                  |   |
|                          | Notes to condensed consolidated financial  statements for the three months  and nine months ended September 30, 2004 (unaudited) |   |
|                          |                                                                                                                                  |   |
| Item 2.                       | Management’s Discussion and Analysis of  Consolidated Financial Condition and Results of Operations                              |   |
|                          |                                                                                                                                  |
| Item 3.                       | Controls and procedures                                                                                                               |   |
|                          |                                                                                                                                  |   |
| PART II. OTHER INFORMATION    |                                                                                                                                  |
|                          |                                                                                                                                  |   |
| Item 6.                       | Exhibits and Reports on Form 8-K                                                                                                      |   |
|                          |                                                                                                                                  |   |
| SIGNATURE                     |                                                                                                                                  |

 

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**PART I****       FINANCIALINFORMATION**

**Item 1. FinancialStatements**

 

**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

(In thousands, except sharedata)

 
| ** **                                                                                                                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                | ** ** | **(Unaudited)**              | ** ** | **(*)**                     | ** ** |
| ***Assets***                                                                                                              |       |                         |       |                        |       |
| *Current  Assets:*                                                                                                        | * *   | * *                     | * *   | * *                    | * *   |
| Cash  (restricted: 2004, $2,789; 2003, $2,496)                                                                            |       | $                            | 3,908      |                        | $          | 3,110 |   |
| Accounts  receivable, net of allowance for uncollectible  accounts (2004 and 2003, $80)                              |       | 2,380                        |       | 1,829                       |       |
| Commissions  receivable                                                                                                   |       | 2,280                        |       | 2,896                       |       |
| Other  receivables                                                                                                        |       | 37                           |       | 13                          |       |
| Deferred  income taxes                                                                                                    |       | 1,232                        |       | 1,662                       |       |
| Other assets                                                                                                              |       | 273                          |       | 372                         |       |
|                                                                                                                      |       | 10,110                       |       | 9,882                       |       |
| *Non-Current  Assets:*                                                                                                    | * *   | * *                     | * *   | * *                    | * *   |
| Property and  equipment, net                                                                                              |       | 286                          |       | 246                         |       |
| Investment  in related party, at cost                                                                                     |       | 703                          |       | 703                         |       |
| Goodwill,  net                                                                                                            |       | 2,017                        |       | 2,069                       |       |
| Other  amortizable intangible assets, net                                                                                 |       | 1,720                        |       | 2,159                       |       |
| Deferred  income taxes                                                                                                    |       | 4,123                        |       | 4,169                       |       |
| Other assets                                                                                                              |       | 172                          |       | 173                         |       |
|                                                                                                                      |       | $                            | 19,131     |                        | $          | 19,401 |   |
| ***Liabilities and Stockholders’ Equity***                                                                           |       |                         |       |                        |       |
|                                                                                                                      |       |                         |       |                        |       |
| *Current  Liabilities:*                                                                                                   |       |                         |       |                        |       |
| Due to  underwriters and assureds                                                                                         |       | $                            | 4,821      |                        | $          | 4,257 |   |
| Accounts  payable and accrued expenses                                                                                    |       | 433                          |       | 1,027                       |       |
| Employment  related accruals                                                                                              |       | 549                          |       | 645                         |       |
| Acquisition  related accruals                                                                                             |       | 840                          |       | 993                         |       |
| Income taxes  payable                                                                                                     |       | 2                            |       | 121                         |       |
| Notes  payable to bank                                                                                                    |       | 400                          |       | 400                         |       |
|                                                                                                                      |       | 7,045                        |       | 7,443                       |       |
| *Non-Current  Liabilities:*                                                                                               |       |                         |       |                        |       |
| Acquisition  related accruals                                                                                             |       | 823                          |       | 1,326                       |       |
| Notes  payable to bank                                                                                                    |       | 976                          |       | 1,276                       |       |
|                                                                                                                      |       | $                            | 8,844      |                        | $          | 10,045 |   |
| *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: 2004, 7,270,879  shares and 2003, 7,118,379 shares) |       | 73                           |       | 71                          |       |
| Additional  paid-in-capital                                                                                               |       | 14,106                       |       | 13,962                      |       |
| Accumulated  earnings, after January 1, 2003                                                                         |       | 2,156                        |       | 1,428                       |       |
| Unearned  compensation                                                                                                    |       | (83                          | )          | (127                        | )          |
| Employee  loans for stock purchase                                                                                        |       | (7                           | )          | (20                         | )          |
| Treasury  stock, at cost (2004 and 2003, 924,734 shares)                                                                  |       | (5,958                       | )          | (5,958                      | )          |
|                                                                                                                      |       | $                            | 10,287     |                        | $          | 9,356 |   |
|                                                                                                                      |       | $                            | 19,131     |                        | $          | 19,401 |   |

 

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* Derived fromaudited financial statements.

 

See notes tocondensed consolidated financial statements.

 

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**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Income**

(In thousands, except share andper share data)

 
| ** **                                               | ** ** | **Three Months Ended   September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **(Unaudited)**                             | ** ** | **(Unaudited)**                            | ** ** |
| ***Income:***                                            |       |                                        |       |                                       |       |   |   |   |   |
| Commissions                                              |       | $                                           | 3,684      |                                       | $          | 4,262 |   | $ | 11,796 |   | $ | 11,784 |   |
| Contingent  commissions                                  |       | 448                                         |       | 739                                        |       | 1,746 |   | 1,921 |   |
| Net  investment income                                   |       | —                                      |       | 1                                          |       | 4 |   | 5 |   |
| Service fees                                             |       | 482                                         |       | 226                                        |       | 858 |   | 418 |   |
| Other income                                             |       | 1                                           |       | 2                                          |       | 17 |   | 20 |   |
|                                                     |       | 4,615                                       |       | 5,230                                      |       | 14,421 |   | 14,148 |   |
|                                                     |       |                                        |       |                                       |       |   |   |   |   |
| ***Operating Expenses:***                                |       |                                        |       |                                       |       |   |   |   |   |
| Salaries and  related expenses                           |       | 2,552                                       |       | 2,714                                      |       | 7,773 |   | 7,516 |   |
| Interest  expense                                        |       | 20                                          |       | 32                                         |       | 66 |   | 113 |   |
| Amortization  expense                                    |       | 145                                         |       | 158                                        |       | 439 |   | 381 |   |
| Other  expenses                                          |       | 1,578                                       |       | 1,483                                      |       | 4,582 |   | 4,571 |   |
|                                                     |       | 4,295                                       |       | 4,387                                      |       | 12,860 |   | 12,581 |   |
|                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Income from  operations before income taxes              |       | 320                                         |       | 843                                        |       | 1,561 |   | 1,567 |   |
| Income tax  expense                                      |       | 178                                         |       | 367                                        |       | 646 |   | 682 |   |
| ***Net income***                                         |       | $                                           | 142        |                                       | $          | 476 |   | $ | 915 |   | $ | 885 |   |
|                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Earnings per  share                                      |       | $                                           | 0.02       |                                       | $          | 0.08 |   | $ | 0.14 |   | $ | 0.14 |   |
| Weighted  average shares outstanding                     |       | 6,491,188                                   |       | 6,239,879                                  |       | 6,458,216 |   | 6,217,682 |   |
|                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Earnings per  share - assuming dilution                  |       | $                                           | 0.02       |                                       | $          | 0.07 |   | $ | 0.14 |   | $ | 0.14 |   |
| Weighted  average shares outstanding - assuming dilution |       | 6,810,950                                   |       | 6,485,212                                  |       | 6,746,049 |   | 6,443,380 |   |
|                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Dividends  declared per common share                     |       | $                                           | 0.015      |                                       | —     |   | $ | 0.030 |   | — |   |

 

See notes to condensed consolidated financial statements.

 

3

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**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

 
| ** **                                                                                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                                 | ** ** | **(Unaudited)**                           | ** ** |
| ***Cash flows from operating activities:***                                                |       |                                      |       |   |   |
| Net income                                                                                 |       | $                                         | 915        |   | $ | 885 |   |
|                                                                                       |       |                                      |       |   |   |
| *Adjustments  to reconcile net income to net cash provided by  operating activities:* |       |                                      |       |   |   |
| Depreciation  and amortization                                                             |       | 540                                       |       | 489 |   |
| (Increase)  decrease in receivables                                                        |       | 41                                        |       | (1,189 | ) |
| Decrease in  deferred income taxes                                                         |       | 476                                       |       | 491 |   |
| Increase  (decrease) in accounts payable and accrued expenses                              |       | (245                                      | )          | 2,496 |   |
| (Increase)  decrease in unearned compensation                                              |       | 44                                        |       | (15 | ) |
| Other, net                                                                                 |       | 125                                       |       | 138 |   |
| ***Net cash provided by operating activities***                                            |       | 1,896                                     |       | 3,295 |   |
|                                                                                       |       |                                      |       |   |   |
| ***Cash flows from investing activities:***                                                |       |                                      |       |   |   |
| Purchase of  property and equipment                                                        |       | (141                                      | )          | (104 | ) |
| Payments on  acquisition accruals                                                          |       | (482                                      | )          | (380 | ) |
| ***Net cash used in investing activities***                                                |       | (623                                      | )          | (484 | ) |
|                                                                                       |       |                                      |       |   |   |
| ***Cash flows from financing activities:***                                                |       |                                      |       |   |   |
| Payments on  note payable to bank                                                          |       | —                                    |       | (975 | ) |
| Payments on  line of credit                                                                |       | (300                                      | )          | — |   |
| Dividends  paid                                                                            |       | (188                                      | )          | — |   |
| Payments  received on employee loans for stock purchase                                    |       | 13                                        |       | 36 |   |
| ***Net cash used in financing activities***                                                |       | (475                                      | )          | (939 | ) |
|                                                                                       |       |                                      |       |   |   |
| ***Net increase in cash and invested cash***                                               |       | 798                                       |       | 1,872 |   |
| Cash and  invested cash at beginning of period                                             |       | 3,110                                     |       | 1,290 |   |
| ***Cash and invested cash at end of period***                                              |       | $                                         | 3,908      |   | $ | 3,162 |   |

 

See notes to condensed consolidated financial statements.

 

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**PAULAFINANCIAL AND SUBSIDIARIES**

**Notes toCondensed Consolidated Financial Statements**

**For theThree Months and Nine Months Ended September 30, 2004 (Unaudited)**

 

**Note A - Basis of Presentation**

 

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

 

The accompanying unaudited condensed consolidated financial statementsof the Company have been prepared in accordance with accounting principlesgenerally accepted in the United States (“GAAP”) for interim financialinformation and with the instructions to Form 10-QSB and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by GAAP for completefinancial statements.  In the opinion ofmanagement, all adjustments, including normally occurring accruals, considerednecessary for a fair presentation have been included.

 

Where necessary, prior years’ information has been reclassified toconform to the 2004 presentation.

 

The Company’s operating results tend to be cyclical. Consequently,operating results for the nine months ended September 30, 2004 are notnecessarily indicative of the results to be expected for the year December 31,2004.  For further information, refer tothe consolidated financial statements and footnotes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

In December 2002, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting forStock Based Compensation – Transition and Disclosure, an amendment of SFAS 123”.  Among other provisions, SFAS 148 amends the disclosurerequirements of SFAS 123 to require prominent disclosures in both annual andinterim financial statements.  For thenine months ended September 30, 2004, the differences between the asreported net income and income per share amounts and the related pro formaamounts are not material to the consolidated financial statements.

 

##### **Note B – Comprehensive Income**

##### ** **

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

 

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##### **Note C – Deferred Income Taxes**

 

As of September 30, 2004 and December 31, 2003, the Company’snet deferred tax asset is comprised of the following:

 
| ** **                        | ** ** | **September 30  2004** | ** ** | **December 31  2003** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **(unaudited)**             | ** ** | ** **                 | ** ** |
| Deferred tax  assets:             |       |                        |       |                       |       |
| Net  operating loss carry forward |       | $                           | 25,238     |                       | $          | 25,222 |   |
| Other                             |       | 2,763                       |       | 3,255                      |       |
| Gross  deferred tax assets        |       | 28,001                      |       | 28,477                     |       |
| Less  valuation allowance         |       | (22,646                     | )          | (22,646                    | )          |
| Deferred tax  assets              |       | $                           | 5,355      |                       | $          | 5,831 |   |
| Gross  deferred tax liabilities   |       | $                           | —     |                       | $          | — |   |
| Net deferred  tax asset           |       | $                           | 5,355      |                       | $          | 5,831 |   |

 

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

 

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

 

##### **Note D – Other Matters**

##### ** **

Inearly 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 theequity method.  During the initial set upof the Montlake operations, PAULA Financial provided assistance in severalareas including license application, insurance placement, human resourcematters and systems support.  As part ofthis support, PAULA Financial executed a guarantee related to certain aspectsof the relationship between Montlake and the issuing company, RelianceInsurance Company (“Reliance”).  At thetime of the guarantee, Reliance did not retain any exposure associated with thepremiums fronted.   Reliance was theissuing carrier for Montlake from March 15, 1999 to  July 31, 2000.

 

InOctober 2001, Reliance was placed in liquidation by the PennsylvaniaDepartment of Insurance.  In October 2002,Montlake was liquidated by the Superior Court of Washington for King County.

 

InMay 2004, the Company received a demand for payment from Reliance inLiquidation in the amount of $1.9 million related to unpaid deductibles by apolicyholder placed under the Montlake fronting arrangement with Reliance.  The policy in question was effective March 2000and was cancelled in September 2000.

 

TheCompany replied to the demand in a letter dated August 13, 2004.  The Company has received no communicationfrom Reliance in Liquidation in response to its letter.  While the Company is still in the earlystages of its investigation into the matter, it believes that there are goodand meritorious arguments that the demand does not represent an obligation ofthe Company.   The Company believes thatthe obligations subject to the guarantee were previously discharged.

 

6

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**PARTI**                               FINANCIAL INFORMATION

 

**Item 2.**                                   Management’sDiscussion and Analysis of Consolidated Financial Condition and Results ofOperations

** **

**Overview**

 

The Company’s revenues consist of agency commission income, contingentcommission income, and service fees. Commission income is earned from PanAmerican Underwriters’ (“Pan Am’s”) insurance sales activity.  Associated premiums are primarily billeddirectly by the insurance carrier. However, in certain instances, Pan Am will invoice the customer andremit the premium, less commission, to the insurance carrier.  The Company focuses its sales efforts onagribusiness and rural markets in California and Arizona.  Contingent commission is related to volumeand profit sharing arrangements with insurance carriers.  Service fees are primarily received for theperformance of services related to loss control and claims advocacy.

 

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

 

**Results of Operations for the Three Monthsand Six Months Ended September 30, 2004 Compared to the Three Months andSix Months Ended September 30, 2003:**

 

**Commission income.**For the three months ended September 30, 2004 commission income decreased13.6% to $3.7 million compared to $4.3 million for the comparable 2003period.  For the nine months ended September 30,2004 commission income was flat at $11.8 million in both periods.  The decrease in commissions in the thirdquarter of 2004 is primarily related to a decline in commission rate at theCalifornia State Compensation Insurance Fund (“SCIF”).  The decrease was effective in August 2003but was not fully reflected in the Company’s book of business until July 2004due to the run off of policies written prior to July.

 

**Contingent commission income.**For the three months ended September 30, 2004 contingent commission incomedecreased 39.4% to $448,000 compared to $739,000 for the comparable 2003 period.  For the nine months ended September 30,2004 contingent commission income was $1.7 million compared to $1.9 million forthe comparable 2003 period.

 

Contingent commission fluctuates from year to year based on theprofitability of the underlying business and external market conditions whichcan result in changes to contingency programs offered by insurancecarriers.  For the 2003 underwritingyear, the Company earned contingent revenue on the SCIF business based on threecriteria:  volume bonuses, retentionbonuses and profit sharing.  In the firstnine months of 2003, the Company accrued the portion of the 2003 underwritingyear contingency applicable to volume and retention as such factors were known.  The profit sharing component related to the2003 underwriting year was earned in early 2004 when such amounts weredetermined.  For underwriting year 2004,SCIF discontinued the contingent commission arrangements associated with volumeand retention bonuses but retained the profit sharing component.  Consequently, the Company has not accrued anyamounts in the first nine months of 2004 related to the 2004 underwritingyear.  Based on what the Company knowstoday regarding the underwriting profitability of the underlying business, theCompany anticipates that contingent commission income related to the 2004underwriting year will approximate contingent revenue recognized in the 2004calendar year on the 2003 underwriting year.

 

7

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**Service fees.**  Service fee income increased to $482,000 forthe three months ended September 30, 2004 from $226,000 for the comparable2003 period.  For the nine months ended September 30,2004 service fee income increased to $858,000 from $418,000 for the comparable2003 period.  The increase in servicefees is due to a number of factors. First, the Company has seen growth in services fees charged for theplacement of insurance.  This isparticularly common in certain programs such as large deductible workerscompensation plans.  Second, the Companyreceives services fees related to providing loss control and claims servicesfor a Bermuda insurance captive.  Thevolume of business placed with this market has increased in 2004, resulting ina corresponding increase in service fees.  Finally, the Company has new servicearrangements where it is paid for providing loss control and other fieldsupport services to selected accounts. Pan Am provides loss control and other services both as a contractor toselected insurance carriers and on a direct basis to its customers.

 

**Salaries and related expenses.**  Salaries and employee benefits decreased 6.0%to $2.6 million for the three months ended September 30, 2004 from $2.7million for the comparable 2003 period. For the nine months ended September 30, 2004 salaries and employeebenefits increased 3.4% to $7.8 million from $7.5 million for the comparable2003 period.  The increase is largely dueto the recruitment of senior leadership in early 2004 related to furtherdeveloping the service fee platform. The costs associated with this investmentin new senior leadership is partially being offset by salary restructurings atthe most senior levels of the Company. Under the new program, variablecompensation is tied to compounded earnings growth with baseline targets inexcess of the Company’s current organic capacity.  Salaries and related expenses was 54% oftotal revenues for the first nine months of 2004 and 53% for the first ninemonths of 2003.

 

**Interest expense.**  Interest expense decreased 37.5.% to $20,000for the three months ended September 30, 2004 from $32,000 for thecomparable 2003 period.  For the ninemonths ended September 30, 2004 interest expense decreased 41.6% to$66,000 from $113,000 for the comparable 2003 period.  The decrease is due to the decline in theoutstanding balance of the related note payable.

 

**Amortization expense.**  Amortization expense decreased 8.2% to$145,000 for the three months ended September 30, 2004 from $158,000 forthe comparable 2003 period.  The decreasein the quarter is primarily due to certain intangibles becoming fullyamortizaed in 2004.  For the nine monthsended September 30, 2004 amortization expense increased 15.2% to $439,000from $381,000 for the comparable 2003 period. The increase is due to an increase in amortizable intangible assetsrelated to acquisitions in mid 2002 and early 2003.

 

**Other expenses.**  Other expenses increased 6.4% to $1.6 millionfor the three months ended September 30, 2004 from $1.5 million for thecomparable 2003 period.  For the ninemonths ended September 30, 2004 and 2003 other expenses remained stable at$4.6 million.  In 2004 the Company hadnon-recurring expenses related to legal matters and employee separations whichaggregated to approximately $500,000 in expenses which are not anticipated torecur in 2005.

 

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**Income tax expense.**  Income tax expense for the three months endedSeptember 30, 2004 was $178,000 compared to $367,000 for the comparable2003 period.  Income tax expense for thenine months ended September 30, 2004 was $646,000 compared to $682,000 forthe comparable 2003 period.  Theeffective combined income tax rates for the nine months ended September 30,2004 and 2003 were 41.4% and 43.5%, respectively.  The differences between the applicableFederal tax rate and the effective tax rates is due to the impact of statetaxes.

 

**Net income.**  Net income decreased 70.2% to $142,000 forthe three months ended September 30, 2004 from $476,000 for the comparable2003 period.  Net income increased 3.4%to $915,000 for the nine months ended September 30, 2004 from $885,000 forthe comparable 2003 period.  The increaseis due to the factors discussed above.

 

**Liquidity and Capital Resources:**

 

As a holding company, PAULA Financial’s principal sources of funds aredividends and expense reimbursements from its operating subsidiaries andproceeds from the sale of its capital stock. PAULA Financial’s principal usesof funds are capital contributions to its subsidiaries, payment of operatingexpenses, dividends to shareholders and repurchase of Company common stock.

 

On November 1, 2003, the Company refinanced its outstanding bankdebt with a $1,800,000 reducing revolving line of credit (the “Line of Credit”)with US Bank (the “Lender”).  The Line ofCredit matures one year from funding, with a one-year automatic option toextend as long as the Company is in compliance with all covenants.  As of September 30, 2004, PAULAFinancial was in compliance with all of the covenants.  Balances outstanding under the Line of Creditbear interest at the prime rate plus 1.0%. As of October 31, 2004, the interest rate was 5.75%.  PAULA Financial’s subsidiaries haveguaranteed the obligations of PAULA Financial under the Line of Credit.  Additionally, the Lender has a securityinterest in the assets of the Company.

 

The Company’s Board of Directors had previously approved a 1,000,000share repurchase program.  On February 20,2003, the Board of Directors authorized an additional 2,000,000 shares for theshare repurchase program.   As of September 30,2004, the Company held 924,734 shares in treasury stock.

 

On May 28, 2004, the Company announced the reinstatement of a quarterlycash dividend in the amount of $0.015 per common share.  The second quarter dividend was paid toholders of record as of June 8, 2004 and was distributed on June 28,2004.  The third quarter dividend waspaid to holders of record as of September 8, 2004 and was distributed on September 28,2004.

 

**Off-Balance Sheet Arrangements**

 

The Company does not have any off-balance sheet arrangements.

 

**Forward-Looking Statements**

 

In connection with, and because it desires to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, theCompany cautions readers to recognize the existence of certain forward-lookingstatements in this Form 10-Q and in any other statement made by, or on behalfof, the Company, whether or not in future filings with the Securities andExchange Commission.  Forward-lookingstatements are statements not based on historical information and which relateto future operations, strategies, financial results or other developments.  Some forward-

 

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looking statements may be identified by the use of terms such as “expects,”“believes,” “anticipates,” “intends,” or “judgment.” Forward-looking statementsare necessarily based upon estimates and assumptions that are inherentlysubject to significant business, economic and competitive uncertainties, manyof which are beyond the Company’s control and many of which, with respect tofuture business decisions, are subject to change.  Examples of such uncertainties andcontingencies include, among other important factors, those affecting theinsurance industry in general, such as the economic and interest rateenvironment, legislative and regulatory developments and market pricing andcompetitive trends, and those relating specifically to the Company and itsbusinesses, such as the level of commission revenue and fee income, andacquisitions of companies or blocks of business.  These uncertainties and contingencies canaffect actual results and could cause actual results to differ materially fromthose expressed in any forward-looking statements made by, or on behalf of, theCompany. The Company disclaims any obligation to update forward-lookingstatements.

 

**Item3:  Controls and Procedures**

 

**Evaluation of Disclosure Controls andProcedures**

 

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

 

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## **PART II. OTHER INFORMATION**

## ** **

**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 |

 

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SIGNATURES

 

In accordance with the requirements of the Exchange, the Registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| Date: November 15, 2004 | PAULA FINANCIAL          |                    |
|------------------------------|--------------------------|-------------------------|
|                         |                     |
|                         |                     |
|                         | By:                      | /s/ Deborah S. Maddocks |   |
|                         | Vice President - Finance |                    |
|                              |                          |                         |  |  |

 

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