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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended June 30, 2002

OR

For the Transition Period from                            to                             

Commission file number 0-23181

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

PAULA FINANCIAL
87 East Green Street, Suite 206
Pasadena, CA 91105
(Address of principal executive offices)

(626) 844-7100
(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 ý Noo

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, 2002: 6,089,879 shares.

PAULA FINANCIAL
INDEX TO FORM 10-Q

PART I    FINANCIAL INFORMATION

Item 1.    Financial Statements

PAULA FINANCIAL AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(In thousands, except share data)

*

Derived from audited financial statements.

See notes to condensed consolidated financial statements.

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PAULA FINANCIAL AND SUBSIDIARIES
Condensed Consolidated Statements of Income
(In thousands, except share and per share data)

See notes to condensed consolidated financial statements.

3

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

See notes to condensed consolidated financial statements.

4

PAULA FINANCIAL AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(In thousands)

See notes to condensed consolidated financial statements.

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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 a California-based specialty distributor of commercial insurance products. The Company's agency operations, Pan American Underwriters, Inc., Pan American Underwriters Insurance Agents and Brokers and Agri-Comp Insurance Agency (collectively "Pan Am") place a full array of commercial insurance products for their customers. In addition, the Company owns Pan Pacific Benefit Administrators ("PPBA"), a third party administration ("TPA") operation which derived substantially all its service fee revenue from PAULA Insurance Company ("PICO").

        Historically, the Company also underwrote workers' compensation insurance products through its underwriting subsidiary, PICO. In the first quarter of 2002, the Company and the California Department of Insurance ("California DOI") entered into an agreement of regulatory oversight which provided that all of the ongoing operations of PICO were subject to California DOI control. The agreement remained in effect until April 26, 2002.On April 26, 2002, the California DOI obtained a court order appointing the Insurance Commissioner of the State of California (the "Commissioner") the conservator of PICO. In accordance with the order the Commissioner took possession of the property, business, books, records, accounts and offices occupied by PICO and assumed responsibility for the business operations of PICO. Effective June 14, 2002, PPBA's TPA arrangement with PICO was terminated at which time PPBA made the necessary expense reductions. On June 21, 2002, the Commissioner obtained a liquidation order.

        In the fourth quarter of 2001, the Company began accounting for its investment in PICO using the equity method. Consequently, PICO's balance sheet and income statement amounts are excluded from the consolidated financial statements as of and for the three and six months ended June 30, 2002 and the consolidated balance sheet as of December 31, 2001. However, the results of PICO's operations are included in the statements of income, comprehensive income and cash flows for the three and six months ended June 30, 2001. As of December 31, 2001, PAULA Financial had written down its investment in PICO to $-0-.

        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, 2002 are not necessarily indicative of the results to be expected for the year ended December 31, 2002. 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, 2001.

Note B—Change in Stockholders' Equity

        In the first quarter of 2002, the Company received $65,000 in payments on employee loans for stock purchase. Additionally, $2,000 in restricted stock grants vested during the period.

        In the second quarter of 2002, the Company received $16,000 in payments on employee loans for stock purchase. Additionally, $208,000 in restricted stock grants vested during the period and 2,800 shares of restricted stock were forfeited and the associated common stock retired.

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PART I    FINANCIAL INFORMATION

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

Overview

        The Company's revenues consist primarily of commission income, service fees and other income. Commission income is earned from Pan Am's distribution of insurance for insurers. Service fee income consists of TPA fees, substantially all of which were generated from PPBA's agreement with PICO, and expense reimbursements from PICO to PAULA Financial. Other income consists of various miscellaneous items. Prior to the fourth quarter of 2001, earned premium also contributed significantly to the Company's revenue.

        The Company's expenses consist of operating expenses. Operating expenses include general and administrative expenses, and are generally fixed in nature. Prior to the fourth quarter of 2001, the Company's expenses also consisted of losses and loss adjustment expenses incurred and dividends provided for policyholders.

        The following table provides information as to the Company's operating segments for the six months ended June 30, 2002 and 2001:

        The "Other" category relates to parent company operations. Note that the third party administration arrangement between PICO and PPBA did not become effective until the second quarter of 2001.

Results of Operations for the Three and Six Months Ended June 30, 2002 Compared to the Three and Six Months Ended June 30, 2001:

        In the fourth quarter of 2001, the Company began accounting for its investment in PICO using the equity method. Consequently, PICO's operating results are excluded from the consolidated financial statements for the three and six months ended June 30, 2002. However, the results of PICO's operations are included in the operating results for the three and six months ended June 30, 2001. This explains the entire fluctuation in the following line items: net premiums earned, losses and loss adjustment expenses incurred and dividends provided to policyholders.

        Commission income.    For the three months ended June 30, 2002 commission income increased 38.4% to $2.6 million compared to $1.9 million for the comparable 2001 period. For the six months ended June 30, 2002 commission income increased 47.6% to $5.4 million compared to $3.7 million for the comparable 2001 period. Commissions paid to Pan Am on PICO business were eliminated in the

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consolidated income statement for the 2001 periods. Also contributing to the increase is rate increases on underlying business.

        Net investment income.    Net investment income decreased 99.8% to $4,000 for the three months ended June 30, 2002 from $1.9 million for the comparable 2001 period. Net investment income decreased 99.8% to $8,000 for the six months ended June 30, 2002 from $4.1 million for the comparable 2001 period. Net investment income in the 2001 period was primarily derived by PICO.

        Service fees.    Service fee income increased to $1.8 million for the three months ended June 30, 2002 from $3,000 for the comparable 2001 period. Service fee income increased to $4.2 million for the six months ended June 30, 2002 from $29,000 for the comparable 2001 period. Fees paid by PICO to PPBA were eliminated in consolidation for the 2001 periods.

        Operating expenses.    Operating expenses decreased 9.4% to $4.7 million for the three months ended June 30, 2002 from $5.1 million for the comparable 2001 period. Operating expenses decreased 8.9% to $10.1 million for the six months ended June 30, 2002 from $11.1 million for the comparable 2001 period. Operating expenses in the 2001 period include all PICO expenses while the 2002 period only includes PICO related expenses incurred by PPBA in conjunction with the TPA arrangement.

        Income taxes.    Income tax expense for the three months ended June 30, 2002 was $51,000 compared to an income tax expense of $81,000 for the comparable 2001 period. Income tax expense for the six months ended June 30, 2002 was $0.2 million compared to $90,000 for the comparable 2001 period. The effective combined income tax rates for the six months ended June 30, 2002 and 2001 were 43.7% and 21.2%, respectively. The effective tax rate in the 2001 period is below the statutory rate due to the impact of tax exempt investment income earned by PICO.

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 and payment of operating expenses.

        As of December 31, 2001, the company had an outstanding balance on its bank term loan of $4.1 million. Under the terms of the amended credit agreement, the Company will make principal payments totaling $1.3 million during 2002 with the remaining principal balance of $2.8 million due on January 1, 2003. As of June 30, 2002, the outstanding balance was $3.4 million. Management believes that funds currently available and expected to be generated by the agency operations will be sufficient to meet the required principal and interest payments on the term loan in 2002. The Company has plans to refinance the January 1, 2003 payment. Management believes that such financing is available and can be obtained under appropriate and reasonable terms.

        Since December 31, 2001, the Company had been out of compliance with certain of its debt covenants related to PICO matters. However, PAULA Financial has always been and remains current on the term loan's regularly scheduled principal and interest payments. On March 22, 2002, the Company received a waiver of the breach of covenants from the lender. According to the waiver the lender has waived all now existing and hereafter arising events of default resulting solely from PICO being placed on supervised status by the California DOI and the subsequent winding down of PICO's business. The Company believes that it will be able to maintain compliance with the revised covenants throughout 2002.

        Each of PAULA Financial's non-insurance subsidiaries has guaranteed all obligations of PAULA Financial under the Credit Agreement.

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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 level of its commission and fee income and acquisitions of companies or blocks of business. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company disclaims any obligation to update forward-looking 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, 2001.

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PART II.    OTHER INFORMATION

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

        The Company held its 2002 Annual Meeting of Stockholders on Wednesday, May 22, 2002 for the purpose of electing three directors.

        At the Meeting, the Company's stockholders re-elected Messrs. Joel W. Geddes, Jr., Jerry M. Miller and James A. Nicholson to the Company's Board of Directors for three year terms.

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

        The term of office of each of the following directors continued after the meeting held May 22, 2002: Messrs. Jeffrey A. Snider, Robert Anderson, Karl T. Hansen, and James G. Parker, III.

        Effective with the Annual Meeting, Mr. Ronald W. Waisner retired as a director of the Company. Mr. Waisner's retirement was not a result of any disagreement with the Company, its management or the Board of Directors.

Item 5:    Other Information.

        Effective May 31, 2002, Mr. James A. Nicholson retired from the Company and resigned his positions as Senior Vice President, Chief Financial Officer, Corporate Secretary and Director. Mr. Nicholson's retirement was not a result of any disagreement with the Company, its management or the Board of Directors. Mr. Nicholson's financial responsibilities were assumed by Ms. Deborah S. Maddocks, Vice President—Finance. Additionally, Ms. Maddocks is now the Corporate Secretary.

        Effective June 26, 2002, PAULA Financial (PFCO) transferred its listing from the NASDAQ National Market to the NASDAQ SmallCap Market. Currently, the Company's trading range falls below the minimum $1.00 bid price per share requirement of the NASDAQ SmallCap Market. (For the period July 1, 2002 to August 8, 2002 PFCO has had a trading range of $0.81 to $1.00.) PAULA Financial is currently in a grace period for this requirement that extends until September 18, 2002. If the Company does not meet the minimum $1.00 bid price per share requirement prior to this date, PFCO will begin trading over the counter. If the Company's shares are eventually traded over the counter, electronic information about the Company will continue to be available real time. The Company has identified www.otc.com as one of several sources for accessing bulletin-board listed companies.

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

(a)

Exhibits.

11.

Computation of Earnings Per Share.

99.1

Certification by the Chief Executive Officer and Chief Financial Officer Relating to a Period Report Containing Financial Statements.

(b)

Reports on Form 8-K.

The Company filed a report on Form 8-K on April 30, 2002 related to the conservation of PICO by the California DOI.

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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.

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